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This post is the sixth in a series of six Liberty Street Economics posts on liquidity issues.
Prior to the Great Recession, the focus of bank regulation was on bank capital with little consensus about the need for liquidity regulation. This view was in contrast with an existing body of academic research that pointed to inefficiencies in environments with strictly private provision of liquidity, via either interbank markets or credit line agreements. In spite of theoretical results pointing to the possible benefits of liquidity regulation for reducing fire sales in crises or the risk of panics due to coordination failures, a common view was that its costs might exceed its benefits, especially given a situation in which there is an active lender of last resort (LLR).
This post is the fifth in a series of six Liberty Street Economics posts on liquidity issues.
One of the most innovative and potentially far-reaching consequences of regulatory reform since the financial crisis has been the development of liquidity regulations for the banking system. While bank regulation traditionally focuses on requiring a minimum amount of capital, liquidity requirements impose a minimum amount of liquid assets. In this post, we provide a conceptual framework that allows us to evaluate the impact of liquidity requirements on economic growth, the creation of systemic risk, and household welfare. Importantly, the framework addresses both liquidity requirements and capital requirements, thus allowing the study of trade-offs and complementarities between these regulatory tools. The reader will find a more detailed discussion in our recent staff report “Liquidity Policies and Systemic Risk.”
This post is the fourth in a series of six Liberty Street Economics posts on liquidity issues.
Liquidity transformation—funding longer-term assets with short-term liabilities—is one of the main functions that banks provide. However, this liquidity mismatch exposes banks to liquidity risk. This risk was clearly demonstrated in the 2008 financial crisis when banks’ funding liquidity dried up and their market liquidity evaporated. Since the crisis, liquidity risk management has become one of the top priorities for regulators, and new liquidity requirements, such as the Liquidity Coverage Ratio and the Net Stable Funding Ratio, have been proposed in Basel III, apart from conventional capital requirements. In this post, we present a new measure of liquidity mismatch—the liquidity stress ratio (LSR). We analyze how it has evolved for large banks, and study the correlation between the LSR and key bank characteristics over time.
This post is the third in a series of six Liberty Street Economics posts on liquidity issues.
Imagine that many large and levered banks suffer heavy losses and must quickly sell assets to reduce their leverage. We expect the market price of the assets sold to decline, at least temporarily. As a result, any other financial institutions that happen to hold the same assets will experience balance sheet losses through no fault of their own —a negative fire-sale externality. In this post, we show that the vulnerability to fire-sale externalities was high during the crisis and that the capital injections of the government’s Troubled Asset Relief Program (TARP) helped reduce it considerably. In fact, we argue that given the total amount injected, TARP was close to optimal. Fire sales are difficult to isolate and observe directly, especially in a crisis when multiple shocks concurrently afflict the financial system. But it is a bit less difficult to quantify the vulnerability of the financial sector to fire-sale externalities. To do so, consider the following hypothetical sequence of events, which captures the main aspects of any fire sale:
This post is the second in a series of six Liberty Street Economics posts on liquidity issues.
The recent financial crisis caused the largest rise in the number of bank failures since the unprecedented banking crisis of the 1980s and early 1990s. This post examines how depositors responded to the amplified risks of bank failure over the last three decades. We show that uninsured depositors discipline troubled banks by withdrawing their funds. Focusing on the recent financial crisis, we find that banks experienced an outflow of uninsured time deposits after the near-failure of Bear Stearns and bankruptcy of Lehman Brothers. This depositor risk sensitivity subsided after the Federal Deposit Insurance Corporation (FDIC) introduced the Transaction Guarantee Account program in October 2008, which raised the maximum deposit insurance limit from $100,000 to $250,000.
This post is the first in a series of six Liberty Street Economics posts on liquidity issues.
During the 2007-09 financial crisis, banks experienced widespread funding shortages, with shortfalls even hindering adequately capitalized banks. The Federal Reserve responded to the funding shortages by creating liquidity backstops to insulate the real economy from the banking sector’s liquidity crisis. The regulatory reforms initiated by the Dodd-Frank Act and Basel III introduced systematic liquidity risk management into bank regulations. In the past year, research economists from the Federal Reserve Bank of New York have undertaken a number of research projects to further the conceptual and empirical understanding of banks’ role in liquidity creation and to guide the design of arrangements to minimize the impact of liquidity shortages on financial stability and the real economy. On the Liberty Street Economics blog this week, we will publish a series of posts summarizing this work. This post provides an overview of the research projects.
How does any firm decide on its capital structure—how much equity (capital) to use, how much debt? And what does research tell us about why banks have so much more financial leverage than other firms? How does this inform capital regulation? This post provides a fresh perspective on these questions, identifying the forces that shape the privately optimal capital structure choices of banks, the manner in which government safety nets distort these choices, and how capital regulation ought to be redesigned in light of these distortions. In particular, we discuss a novel approach (developed in Acharya, Mehran, and Thakor ) to capital regulation that involves a two-tier capital requirement as well as how such a requirement can enhance banking stability.
This post is the thirteenth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
The motivation for the Economic Policy Review series was to understand better the behavior of large and complex banks, and we have covered a lot of ground toward that end. We have examined large banks’ economies of scale, their proclivity toward risk taking, their possible funding advantages (pre-Dodd Frank), the sources and types of their complexity, and the sources and means of dealer bank financing. We have also looked at resolution issues surrounding large and complex banks, including a case study on the Lehman bankruptcy, a review of resolution methods, and two studies of the rationale for a long-term debt requirement for large and complex banks (bail-in), which could provide a source of loss absorbency in resolution. In this post, we provide our own thoughts on what the series has taught us.
James McAndrews, Donald P. Morgan, Joao Santos, and Tanju Yorulmazer
This post is the twelfth in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
If the Lehman Brothers failure proved anything, it was that large, complex bank failures are messy; they destroy value and can destabilize financial markets. We certainly don’t mean to trivialize matters by calling large bank failures “messy,” as it their messiness, particularly the destabilizing aspect, that creates the “too-big-to-fail” problem. In our contribution to the Economic Policy Review volume, we venture an explanation about why large bank failures are so messy and discuss a policy that can make them less so.
This post is the eleventh in a series of thirteen Liberty Street Economics posts on Large and Complex Banks. For more on this topic, see this special issue of the Economic Policy Review.
“[T]he instinct of the trader does somehow anticipate the conclusions of the closet.”
Walter Bagehot is always good for an epigraph. And this epigraph is a good one: going well beyond traders. It also applies to the conjoint instinct of bankers, legislators, and regulators. The “bail-in,” or “single point of entry,” technique of large bank insolvency was conceived by bankers, authorized by Congress, and is being implemented by the FDIC. (Calello and Ervin (2010); 12 USC § 5381 et seq.; Single Point of Entry Strategy). This nascent practice needs a conceptual framework. This post, and the companion article in the Economic Policy Review, suggests one. The framework does more than justify bail-in. It applies more generally to financial firm insolvency. It also provides a new and surprising perspective on bank capital.
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