A Naive View on Liquidity

An interesting paper appeared this month as an IMF Working Paper: A Simple Macroprudential Liquidity Buffer, by D.C. Hardy and P. Hochreiter.

In this paper the authors claim that a liquidity crisis is primarily a systemic crisis (impacting a group of interconnected banks at the same time) and should therefore be managed with the help of a macroprudential liquidity buffer, rather than a liquidity buffer whose requirement is set at the individual bank level.

In order to implement the macroprudential liquidity buffer requirement, the authors propose the following ratio:

Systemically Liquid Assets / Liabilities Minus Regulatory Capital

This ratio is calculated at the bank level and should always be above a time-dependent required minimum level, the minimum required SLA ratio, or SLAR.

So far, this ratio looks close to the Liquidity Coverage Ratio (LCR), but the innovation is the time-dependency of the SLAR.

The authors propose to increase the required ratio of liquid assets in times when banks’ liabilities grow faster than their trend growth rate:

SLAR

In this equation, theta is the desired average level of the SLAR,  gamma is a scaling parameter and tau is the trend growth rate of the liabilities.

The consequence is that, if the liabilities of a group of banks increases above trend value, the required liquidity buffer increases more than proportionally.

Although this may seem prudent and an adequate answer to the systemic nature of the liquidity crisis (as perceived by the authors), this approach is only slightly more advanced than the LCR.

Cash flows in time

Both ratios, however, suffer from a naive view on liquidity risk management because they fail to translate the balance sheet into operational cash flows in time. After this translation, cash inflows and cash outflows are presented per maturity bucket. If, in any bucket, the cash outflow exceeds the cash inflow, there is a liquidity gap.

The best measure for the required liquidity buffer is the cumulative operational liquidity gap. Of course, this gap should be based on stressed conditions (as each buffer requirement is based on a stress scenario, that’s what buffer are for), such as a stressed outflow of savings and stressed haircut values.

These stressed values can be based on both an idiosyncratic stress scenario and a bank-wide scenario. Bank-wide scenarios can comprise the same ingredients that the authors describe in their analysis of the systemic liquidity crisis (basically a ‘loss spiral’ leading to fire sale of assets).

It is important to realize that both the operational cash flows and the instruments that are used for the liquidity buffer have maturities. An investment strategy for the liquidity buffer should be developed so that this buffer generates liquidity in times when the operational cash flows show a (cumulative) gap.

The SLAR system that is proposed in the IMF Working Paper fails to acknowledge that the liquidity risk that is inherent in an increase in a long-term liability is fundamentally different from an increase in a short-term liability.

Buffer optimization

The paper also fails to acknowledge that buffers should rather be optimized than maximized. Excessive liquidity buffer requirements endanger a bank’s long term profitability and its attractiveness for both shareholders and (other) investors. This can also impact its external rating. Hence, an excessive macroprudential liquidity buffer requirement could even be procyclical rather than countercyclical.

To conclude: the ratio in the IMF Working Paper disregards liquidity risk management with the help of cash flows in time and it could even by procyclical where it is meant to be countercyclical.

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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