Liquidity Risk, Liquidity Management, And Liquidity Policies

During the 2007-09 financial crisis, banks experienced widespread funding shortages, with shortfalls even hindering adequately capitalized banks. The Federal Reserve responded to the funding shortages by creating liquidity backstops to insulate the real economy from the banking sector’s liquidity crisis. The regulatory reforms initiated by the Dodd-Frank Act and Basel III introduced systematic liquidity risk management into bank regulations.

In the past year, research economists from the Federal Reserve Bank of New York have undertaken a number of research projects to further the conceptual and empirical understanding of banks’ role in liquidity creation and to guide the design of arrangements to minimize the impact of liquidity shortages on financial stability and the real economy. On the Liberty Street Economics blog this week, we will publish a series of posts summarizing this work. This post provides an overview of the research projects. 

In “Depositor Discipline of Risk-Taking by U.S. Banks,” Stavros Peristiani and João Santos examine how depositors responded to the amplified risks of bank failure over the last three decades, motivated by the large rise in the number of bank failures since the 2007-09 financial crisis. The authors show that uninsured depositors discipline troubled banks by withdrawing their funds well in advance of bank failures. Focusing on the recent financial crisis, the authors find that banks experienced an outflow of uninsured time deposits after the near-failure of Bear Stearns and bankruptcy of Lehman Brothers. Depositors became less risk sensitive after the Federal Deposit Insurance Corporation (FDIC) introduced the Transaction Guarantee Account Program in October 2008, which raised the maximum deposit insurance limit from $100,000 to $250,000. 

In “The Liquidity Stress Ratio: Measuring Liquidity Mismatch on Banks’ Balance Sheets,” Dong Beom Choi and Lily Zhou present a liquidity stress indicator that measures the potential for illiquidity in the banking sector. They note that while maturity transformation—funding long-term assets with short-term liabilities—is a key function of banks, this liquidity mismatch exposes banks to liquidity risk. This risk was clearly demonstrated in the 2007-09 financial crisis when banks’ funding liquidity dried up and their market liquidity evaporated. Since the crisis, liquidity risk management has become one of the top priorities for regulators. Choi and Zhou introduce the Liquidity Stress Ratio as a new measure of liquidity mismatch, analyze how it has evolved for large banks, and study the correlation between the Liquidity Stress Ratio and key bank characteristics over time. 

In “Liquidity Policies and Systemic Risk,” Tobias Adrian and Nina Boyarchenko provide a conceptual framework to evaluate the impact of liquidity requirements on economic growth, the creation of systemic risk, and household welfare. The framework incorporates liquidity requirements and capital requirements, thus allowing the study of trade-offs and complementarities between these regulatory tools. The authors find that liquidity requirements are a useful complement in preventing systemic banking crises, as tighter liquidity requirements constrain the risk-taking of banks, with little impact on consumption growth. In contrast, tighter capital requirements tend to lower consumption growth through their effect on the cost of credit. From policymakers’ point of view, the trade-off between real growth and lower systemic risk is thus more favorable for liquidity requirements than for capital requirements. 

In “How Liquidity Standards Can Improve Last Resort Lending Policies,” João Santos and Javier Suarez consider a model in which banks vulnerable to liquidity crises may receive support from the lender of last resort. Higher liquidity standards, though costly to banks, give the lender of last resort more time to find out the systemic implications of denying support to the banks in trouble. By modifying banks’ prospects of being supported in a crisis, liquidity standards affect banks’ adoption of precautions against a crisis. The authors show that this effect is positive when banks are ex ante perceived to be systemically important and discuss implications for the liquidity regulation and lender-of-last-resort policies. 

In “On Fire-Sale Externalities, TARP Was Close to Optimal,” Fernando Duarte and Thomas Eisenbach examine fire-sale externalities across banks due to an adverse shock. Fire-sale externalities occur when many large and levered banks suffer heavy losses and must quickly sell assets to reduce their leverage. In such a circumstance, the market prices of the assets sold decline, at least temporarily. As a result, other financial institutions that happen to hold the same assets will experience losses through no fault of their own—a negative fire-sale externality. In their research, the authors show that the vulnerability to fire-sale externalities was high during the crisis and that the capital injections of the government’s Troubled Asset Relief Program (TARP) helped reduce it considerably.