FED Paper Suggests Regulating Liquidity Risk at Macro-Prudential Level
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.
Related Links
Keywords: Europe, Americas, US, Banking, Liquidity Mismatch, Systemic Risk, Macro-Prudential Framework, Basel III, Liquidity Transformation Risk, Research, FED
Featured Experts
María Cañamero
Skilled market researcher; growth strategist; successful go-to-market campaign developer
Blake Coules
Across 35 years in banking, Blake has gained deep insights into the inner working of this sector. Over the last two decades, Blake has been an Operating Committee member, leading teams and executing strategies in Credit and Enterprise Risk as well as Line of Business. His focus over this time has been primarily Commercial/Corporate with particular emphasis on CRE. Blake has spent most of his career with large and mid-size banks. Blake joined Moody’s Analytics in 2021 after leading the transformation of the credit approval and reporting process at a $25 billion bank.
Nicolas Degruson
Works with financial institutions, regulatory experts, business analysts, product managers, and software engineers to drive regulatory solutions across the globe.
Previous Article
Sam Woods of PRA Speaks About Style of Regulation in UK After BrexitRelated Articles
BIS and Central Banks Experiment with GenAI to Assess Climate Risks
A recent report from the Bank for International Settlements (BIS) Innovation Hub details Project Gaia, a collaboration between the BIS Innovation Hub Eurosystem Center and certain central banks in Europe
Nearly 25% G-SIBs Commit to Adopting TNFD Nature-Related Disclosures
Nature-related risks are increasing in severity and frequency, affecting businesses, capital providers, financial systems, and economies.
Singapore to Mandate Climate Disclosures from FY2025
Singapore recently took a significant step toward turning climate ambition into action, with the introduction of mandatory climate-related disclosures for listed and large non-listed companies
SEC Finalizes Climate-Related Disclosures Rule
The U.S. Securities and Exchange Commission (SEC) has finalized the long-awaited rule that mandates climate-related disclosures for domestic and foreign publicly listed companies in the U.S.
EBA Proposes Standards Related to Standardized Credit Risk Approach
The European Banking Authority (EBA) has been taking significant steps toward implementing the Basel III framework and strengthening the regulatory framework for credit institutions in the EU
US Regulators Release Stress Test Scenarios for Banks
The U.S. regulators recently released baseline and severely adverse scenarios, along with other details, for stress testing the banks in 2024. The relevant U.S. banking regulators are the Federal Reserve Bank (FED), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).
Asian Governments Aim for Interoperability in AI Governance Frameworks
The regulatory landscape for artificial intelligence (AI), including the generative kind, is evolving rapidly, with governments and regulators aiming to address the challenges and opportunities presented by this transformative technology.
EBA Proposes Operational Risk Standards Under Final Basel III Package
The European Union (EU) has been working on the final elements of Basel III standards, with endorsement of the Banking Package and the publication of the European Banking Authority (EBA) roadmap on Basel III implementation in December 2023.
EFRAG Proposes XBRL Taxonomy and Standard for Listed SMEs Under ESRS
The European Financial Reporting Advisory Group (EFRAG), which plays a crucial role in shaping corporate reporting standards in European Union (EU), is seeking comments, until May 21, 2024, on the Exposure Draft ESRS for listed SMEs.
ECB to Expand Climate Change Work in 2024-2025
Banking regulators worldwide are increasingly focusing on addressing, monitoring, and supervising the institutions' exposure to climate and environmental risks.
