Uncertainty, Liquidity Hoarding, and Financial Crises
One of the most interesting phenomena marking the recent financial crisis was the disruptions in the interbank market, where banks borrow and lend reserves to each other. This post draws upon my paper with Douglas Gale, “Liquidity Hoarding,” to discuss this practice by banks during times of increased uncertainty about future liquidity needs and its consequences for the efficient transfer of liquidity in the interbank market.
Disruptions in the Interbank Market
As early as fall 2007, following the collapse of the market for asset-backed commercial paper, European banks reported an inability to borrow in the interbank market. At the same time, interbank borrowing rates reached record-high levels. Furthermore, there was a dramatic change in markets for the sale of repurchase agreements (repos)—a major source of funding for financial institutions that borrow money in exchange for securities, agreeing to buy them back at a later date. These markets, which are typically highly liquid, shrank dramatically and experienced unprecedented high “haircuts”—markdowns in the market value of collateral being used for the loans—in all asset classes, including nonsubprime-related classes (Gorton and Metrick offer interesting papers on repo runs and haircuts). Difficulty obtaining liquidity in the interbank market was subsequently experienced in many countries. As a result, central bank borrowing facilities became an essential source of liquidity for financial institutions.
One possible explanation for the disruptions in the interbank market is counterparty risk—the risk that the borrowing bank can’t repay in full. Because of the widespread exposure to subprime asset-backed securities, banks had good reason to be wary of lending to any bank that might be a credit risk because of this or any other exposure. Another explanation, which isn’t unrelated, is that banks were hoarding liquidity because of fears that their own future access to liquidity might be compromised. There’s substantial evidence that banks reduced their lending to other banks to build up cash positions (see papers by Acharya and Merrouche; Heider, Hoerova, and Holthausen; and Ashcraft, McAndrews, and Skeie). Even if the interbank market initially experienced disruptions because of counterparty risk, liquidity hoarding would still be a rational response to fears of future lack of access to liquidity.
Why Hoard Liquidity?
In a world of asymmetric information, where different agents can hold different sets of information and rumors of distress are enough to cause a run by counterparties, every bank has to be concerned that it might be perceived as a source of counterparty risk and lose access to markets. Banks that are currently perceived as “sound” and have adequate access to liquidity may nonetheless be uncertain about their future access and may make provisions for this possibility by hoarding liquid assets. While hoarding can be a rational response of banks to increased future uncertainty, it can also be a very costly form of self-insurance resulting in “pockets” of liquidity within the system that aren’t utilized.
There’s also a speculative motive for hoarding. If the future demand for cash is expected to be very high, asset prices will be low. In the event that a bank enters those situations with sufficient liquidity in its portfolio, it may profit from buying illiquid assets at “fire-sale” prices. Clearly, these two motives can’t be separated: cash holdings serve both precautionary and speculative motives simultaneously.
Whatever the motivation, hoarding reduces the supply of liquidity, which, in turn, strengthens the incentive to hoard. In short, fears of future illiquidity, for whatever reason, can lead to hoarding, which restricts access by other banks and provides the motivation for even more hoarding.
Provision of Liquidity
When there are disruptions in the interbank market, a policy that aims at facilitating lending or lending directly to banks can improve market efficiency. One policy is that central banks can provide liquidity to markets in general through open market operations (OMOs); liquidity then is transferred to institutions in need through the interbank market. When the interbank market functions properly, central banks can provide sufficient liquidity via OMOs and the interbank market will then allocate the liquidity among banks in an efficient way. However, uncertainty about future liquidity conditions and hoarding incentives can seriously impair the functioning of the interbank market and therefore the effectiveness of OMOs. This can occur if most of the liquidity provided by the authorities was kept on banks’ balance sheets, rather than used to facilitate lending in the interbank market. Governor of the Bank of England Mervyn King and Chancellor of the Exchequer Alistair Darling, during hearings on the Northern Rock episode in fall 2007, pointed out that to channel the £14 billion that Northern Rock borrowed from the Bank of England to that institution would have required many more billions of pounds to be injected through OMOs. At the same hearing, Professor Willem Buiter of the London School of Economics suggested: “That would take an enormous amount of money injections . . . so it really may take a large injection of liquidity to get an appreciable result if the market is really fearful.”
When uncertainty about future liquidity needs is heightened, lending to individual institutions directly can complement OMOs in the public provision of liquidity and help mitigate distress in the interbank market. This can be an important rationale for the introduction of various liquidity facilities during crises. However, when uncertainty remains, banks may still prefer to hoard liquidity and refrain from lending to each other, which would weaken the beneficial effects of the liquidity facilities.
Hence, liquidity hoarding, while it can be a rational response to heightened uncertainty by banks, can be another important impediment to the efficient functioning of the interbank market, in addition to the usual difficulties posed by counterparty risk, asymmetric information, and the possible stigma associated with borrowing from central banks.
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.
Tanju Yorulmazer is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.