Featured Product

    FED Paper Suggests Regulating Liquidity Risk at Macro-Prudential Level

    November 25, 2019

    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
    Related Articles
    News

    EBA Clarifies Use of COVID-19-Impacted Data for IRB Credit Risk Models

    The European Banking Authority (EBA) published four draft principles to support supervisory efforts in assessing the representativeness of COVID-19-impacted data for banks using the internal ratings based (IRB) credit risk models.

    June 21, 2022 WebPage Regulatory News
    News

    EP Reaches Agreement on Corporate Sustainability Reporting Directive

    The European Council and the European Parliament (EP) reached a provisional political agreement on the Corporate Sustainability Reporting Directive (CSRD).

    June 21, 2022 WebPage Regulatory News
    News

    PRA Consults on Model Risk Management Principles for Banks

    The Prudential Regulation Authority (PRA) launched a consultation (CP6/22) that sets out proposal for a new Supervisory Statement on expectations for management of model risk by banks.

    June 21, 2022 WebPage Regulatory News
    News

    EC Regulation Amends Standards for Calculating Credit Risk Adjustments

    The European Commission (EC) published the Delegated Regulation 2022/954, which amends regulatory technical standards on specification of the calculation of specific and general credit risk adjustments.

    June 21, 2022 WebPage Regulatory News
    News

    BIS Hub Updates Work Program for 2022, Announces New Projects

    The Bank for International Settlements (BIS) Innovation Hub updated its work program, announcing a set of projects across various centers.

    June 17, 2022 WebPage Regulatory News
    News

    EIOPA Issues Cyber Underwriting Proposal, Statement on Open Insurance

    The European Insurance and Occupational Pensions Authority (EIOPA) published two consultation papers—one on the supervisory statement on exclusions related to systemic events and the other on the supervisory statement on the management of non-affirmative cyber exposures.

    June 17, 2022 WebPage Regulatory News
    News

    US Senate Members Seek Details on SEC Proposed Climate Disclosure Rule

    Certain members of the U.S. Senate Committee on Banking, Housing, and Urban Affairs issued a letter to the Securities and Exchange Commission (SEC)

    June 16, 2022 WebPage Regulatory News
    News

    EIOPA Consults on Review of Securitization Framework in Solvency II

    The European Insurance and Occupational Pensions Authority (EIOPA) published a consultation paper on the advice on the review of the securitization prudential framework in Solvency II.

    June 16, 2022 WebPage Regulatory News
    News

    UK Authorities Issue Regulatory and Reporting Updates for Banks

    The Prudential Regulation Authority (PRA) issued a statement on PRA buffer adjustment while the Bank of England (BoE) published a notice on the statistical reporting requirements for banks.

    June 15, 2022 WebPage Regulatory News
    News

    BCBS Issues Climate Risk Principles while HKMA Expresses Its Support

    The Basel Committee on Banking Supervision (BCBS) issued principles for the effective management and supervision of climate-related financial risks.

    June 15, 2022 WebPage Regulatory News
    RESULTS 1 - 10 OF 8280