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April 18, 2014

How Liquidity Standards Can Improve Lending of Last Resort Policies

João A.C. Santos and Javier Suarez

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).

The liquidity problems that banks experienced during the recent financial crisis convinced policymakers about the need for some form of liquidity regulation for banks. Banks’ liquidity problems appear to have started in the summer of 2007 following the collapse of the asset-backed commercial paper market. These problems grew worse with the collapse or near collapse of several other markets, including the repo and the financial commercial paper markets, and even several segments of the interbank market, and with banks’ collateral shortages arising in part from downward spirals in market and funding liquidity.

These problems also motivated new academic research on bank liquidity standards. This research, however, does not provide a clear reason for the dominance of liquidity standards such as the liquidity coverage ratio (LCR) of Basel III over alternatives like capital requirements, Pigovian charges for liquidity risk, or just the effective provision of emergency liquidity by the LLR. In a recent paper, we help close this gap in the literature with a theory that relies on a novel way of thinking about a liquidity requirement—an instrument that, by making banks better able to withstand the initial phases of a crisis, gives the LLR time to ascertain the potential implications of an early, disorderly liquidation of a bank in trouble.

We consider a model in which liquidity crises may cause banks to fail unless they are able to borrow from the LLR. In making a lending decision, the LLR faces the classical problem that some of the banks seeking liquidity support may be fundamentally insolvent. While it is optimal to grant liquidity to solvent banks, in the case of an insolvent bank, LLR support may still make sense if the negative externalities that will arise with the bank’s early liquidation are sufficiently large. Yet assessing these externalities in real time is quite difficult. Following this view, we assume that the LLR is generally uncertain about the extent of the external costs of an early liquidation, but that the presence of liquidity standards increases the likelihood of the LLR knowing whether its decision to deny liquidity support will lead to a systemic crisis. The idea is that liquidity standards, by lengthening the time a bank can withstand a liquidity shock, give the LLR more “breathing room” to find out the systemic implications of a bank’s default.

In our setting, liquidity standards affect both the ex post (that is, after the crisis begins) efficiency of LLR policies and bankers’ adoption of precautions against a crisis. Our model shows that liquidity standards are beneficial from both perspectives when banks are ex ante considered likely to be systemically important, but only from the first point of view (and counterproductive to the second one) when banks are ex ante considered unlikely to be systemically important. The intuition for this result is that, if the presence of systemic banks is highly likely, an uninformed LLR will end up supporting any bank in trouble, which augments banks’ prospects of being supported in a crisis and thus erodes their incentives to prevent a crisis. Liquidity standards help the LLR discover insolvent banks that are actually not systemic and, hence, can be denied support, which is good from the perspective of reducing banks’ moral hazard problem.

In light of this insight, the lessons of the Lehman Brothers debacle about the relevance of systemic externalities and the concerns about the moral hazard implications of implementing too-generous support policies in future crises can rationalize the importance of liquidity standards. Buying the time needed to make better informed support decisions will not only improve the efficiency of the ex post decisions, but it will also reduce banks’ prospects of unconditional support in a future crisis and the moral hazard problem associated with such support. Our paper is also novel in providing a framework in which one can analyze the implications of identifying systemically important financial institutions ahead of time.

The views expressed in this post are those of the authors 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 authors.


João A.C. Santos is a vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Javier Suarez is a professor of finance at Universidad Carlos III de Madrid.

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