Liquidity Policies And Systemic Risk

This post is the fifth in a series of six Liberty Street Economics posts on liquidity issues.

One of the most innovative and potentially far-reaching consequences of regulatory reform since the financial crisis has been the development of liquidity regulations for the banking system. While bank regulation traditionally focuses on requiring a minimum amount of capital, liquidity requirements impose a minimum amount of liquid assets. In this post, we provide a conceptual framework that allows us to evaluate the impact of liquidity requirements on economic growth, the creation of systemic risk, and household welfare. Importantly, the framework addresses both liquidity requirements and capital requirements, thus allowing the study of trade-offs and complementarities between these regulatory tools. The reader will find a more detailed discussion in our recent staff report “Liquidity Policies and Systemic Risk.”

Motivation

During the initial phase of the 2007-09 financial crisis, many banks experienced funding shortages because they did not manage their liquidity prudently, despite maintaining adequate capital levels. Funding liquidity dried up quickly, leading to stress in short-term funding markets. The rapid reversal in market conditions illustrated how quickly liquidity could evaporate, and how important liquidity management was for the functioning of the financial system. This experience motivated the Basel Committee on Banking Supervision to develop the Liquidity Coverage Ratio (LCR). In its explanationof the LCR, the Basel Committee writes that the objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks by ensuring that banks have an adequate stock of liquid assets that can be used to meet liquidity needs for a thirty-day stress scenario. The LCR thus constrains financial institutions to provision against shocks to unstable sources of funding by holding a minimum amount of liquid assets. This reverses the logic that is used for setting capital requirements, in which a minimum amount of capital is held as protection against shocks to the risky assets on banks’ balance sheets, as is illustrated in the stylized balance sheet below: