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.
Keywords: Europe, Americas, US, Banking, Liquidity Mismatch, Systemic Risk, Macro-Prudential Framework, Basel III, Liquidity Transformation Risk, Research, FED
Previous ArticleFDIC Publishes Fall 2019 Issue of Supervisory Insights
The European Banking Authority (EBA) published the final guidelines on the monitoring of the threshold and other procedural aspects on the establishment of intermediate parent undertakings in European Union (EU), as laid down in the Capital Requirements Directive (CRD).
In a recent Market Notice, the Bank of England (BoE) confirmed that green gilts will have equivalent eligibility to existing gilts in its market operations.
The Financial Conduct Authority (FCA) published the policy statement PS21/9 on implementation of the Investment Firms Prudential Regime.
The European Banking Authority (EBA) proposed regulatory technical standards that set out criteria for identifying shadow banking entities for the purpose of reporting large exposures.
The Board of the International Organization of Securities Commissions (IOSCO) proposed a set of recommendations on the environmental, social, and governance (ESG) ratings and data providers.
The European Securities and Markets Authority (ESMA) published recommendations from the Working Group on Euro Risk-Free Rates (RFR) on the switch to risk-free rates in the interdealer market.
The European Commission (EC) announced plans to defer the application of 13 regulatory technical standards under the Sustainable Finance Disclosure Regulation (2019/2088) by six months, from January 01, 2022 to July 01, 2022.
The European Insurance and Occupational Pensions Authority (EIOPA) proposed to amend the supervisory statement on supervision of run-off undertakings that are subject to Solvency II regulation.
The Bank of England (BoE) published a consultation paper on approach to setting minimum requirement for own funds and eligible liabilities (MREL), an operational guide on executing bail-in, and a statement from the Deputy Governor Dave Ramsden.
The European Banking Authority (EBA) is seeking preliminary input on standardization of the proportionality assessment methodology for credit institutions and investment firms.