Liquidity risk and interbank markets
11 important questions on Liquidity risk and interbank markets
What is the rational behind liquidity regulation? What was the key lesson?
- Bank liquidity was traditionally seen as equally important to solvency. But the attention diminished in recent decades (absence of liquidity in Basel I). The sentiment was that sufficient capital was enough, liquidity was not an issue.
- The Financial crisis exposed severe liquidity issues (unrelated to capital) and showed that ignoring liquidity comes at an cost
The key lesson is that wholesale funding can dry op quickly creating liquidity shortages for banks, thus banks should not rely extensively on wholesale funding
- Does liquidity regulation actually raise liquidity?
- What markets have more liquidity?
- No, liquidity requirements does not imply higher liquidity buffers(not one on one) but does imply lower volatility. Liquidity regulation only works when you combine it with market openness.
- In smaller countries and less used currencies there are larger liquidity buffers. If a market is deep there is little liquidity and currency risk, so banks don't need a large liquidity buffers, can use the market.
Why doesn't it say anything if banks have large liquidity buffers?
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What is the liquidity risk framework recommended by the BCBS in response to the crisis? (3 things)
- Revisions of principles of sound liquidity risk management and supervision
- Development of monitoring metrics.
- Two internationally standards for liquidity and funding (LCR and NSFR)
LCR: requires institutions to have enough liquidity for 30 days of stress. Short-term ratio (cash out next 30 days)
NSFR: requires institutions to have enough longer term stable funding to fund their assets (1 year)
- Why is the LCR itself a minimum requirement stress test?
- How to calculate the LCR?
LCR = IDIOSYNCRATIC RISK + MARKET WIDE RISK
The value of high quality liquid assets (HQLA)
LCR = ---------------------------------- > 100%
The total net cash outflows(NCO) over a specified stress period(30 days)
HQLA: Level 1 (0% haircut) + level 2A(15% haircut) + Level 2B(25 to 50% haircut)
NCO: total outflows - minimum (total inflows; 75% * total outflows)
- The Net Stable Funding Ratio is designed to.....
- How is it calculated
- The Net Stable Funding Ratio is designed to disincentive excessive maturity/ or liquidity transformation and minimise pro-cyclical balance sheet contraction.
Available stable funding over the next year (ASF)
NSFR = -------------------------------------------- >100%
required stable funding over the next year (RSF)
ASF: Funding that can be relied upon during the next year
RSF: Part of the balance sheet that could not be monetised within 1 year
Does the LCR stop banks undertaking maturity transformation?
Does the LCR unfairly penalise retail banks? It were investment banks that caused the crisis
Will the LCR restrict lending to the real economy?
What are the limitations of the LCR and the NSFR (6)
- Both ratios are limited to aggregate horizons (30 days 1 year)
- Cliff effects and certain maturity mismatches are not detected
- Concentration risks and diversity do not play a role
- Both ratios consider a certain type of stress scenario but many more are possible
- One size fits all
- The ratios are not enough to ensure liquidity supervision (Efficient pillar II is essential)
Where can liquidity stress tests (LST) add?
Findings of a report:
- Limit the role of central banks to standard monetary policy operations in LST
- Separate treatment of capital and liquidity understates aggregate bank risk
- Set supervisory expectations regarding the interaction of LST results in to banks business perspective
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