FED Paper Suggests Regulating Liquidity Risk at Macro-Prudential Level

By Regulatory News

November 25, 2019

Basel III, Basel Liquidity Compliance, Systemic Risk

FED published a paper that examines whether banks strategically incorporate their competitors’ liquidity mismatch policies when determining their own and the impact of these collective decisions on financial stability. Using a novel identification strategy that exploits the presence of partially overlapping peer groups, the author shows that liquidity transformation activity of banks is driven by that of the peers. These correlated decisions are concentrated on the asset side of riskier banks and are asymmetric, with mimicking occurring only when competitors take more risk. Accordingly, this strategic behavior increases default risk of banks, along with the overall systemic risk, highlighting the importance of regulating liquidity risk from a macro-prudential perspective.

This paper examines the extent to which banks’ liquidity transformation activities are affected by the choices of their competitors and the impact of these collective risk-taking decisions on financial stability. Using a sample of 1,584 commercial banks operating in the Organisation for Economic Cooperation and Development (OECD) countries from 1999 to 2014 and the Berger and Bouwman (2009) liquidity creation measure to capture banks’ liquidity transformation activity, the author shows that financial intermediaries follow the liquidity mismatch policies of their competitors when determining their own. This strategic behavior is driven by liquidity created on the asset side, of which lending is a key component, and is concentrated in ex ante riskier banks.

With respect to the consequences of such strategic behavior for the financial system, the paper notes that the response of individual banks to the liquidity mismatch choices of competitors is asymmetric, with individual banks mimicking their peers only when competitors increase liquidity transformation risk. The author also shows that peer effects in financial institutions’ liquidity mismatch policies increase both individual banks’ default risk and overall systemic risk. This effect is both statistically and economically significant, highlighting the importance of explicitly regulating systemic liquidity risk from a macro-prudential perspective. While the Basel III liquidity requirements, combined with improved supervision, should help to strengthen individual banks’ funding structure and thus enhance banking sector stability, these liquidity standards are fundamentally micro-prudential in nature.

Despite the proposals for macro-prudential liquidity regulation such as time-varying liquidity coverage ratio and net stable funding ratio, or a macro-prudential liquidity buffer where each bank would be required to hold assets that are systemically liquid, policymakers and regulators have yet to establish a concise macro-prudential framework that mitigates the possibility of a simultaneous liquidity need by financial institutions. Since information spillovers are a defining characteristic of panics due to financial agents’ imperfect knowledge regarding common exposures and given that these information spillovers between banks do occur, a static and time-invariant micro-prudential liquidity requirement that mainly depends on individual banks’ idiosyncratic risk may not be suitable to prevent a systemic liquidity crisis.

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Keywords: Europe, Americas, US, Banking, Liquidity Mismatch, Systemic Risk, Macro-Prudential Framework, Basel III, Liquidity Transformation Risk, Research, FED

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