The IMF Financial Stability Review: Chapter 3

It is with a heavy heart that I return to the IMF Financial Stability Review. There is an awful lot in chapter 3, and it is worth reading carefully even if on first glance it seems to be forbiddingly dry.

Chapter 3 of the IMF report begins with a fairly stark admission:

The speed and extent of the transition from “market” illiquidity to “funding” illiquidity, and their subsequent interaction, was remarkable and
required unprecedented intervention by mature market central banks to meet banks’ liquidity needs. As a result, important questions arise concerning the extent to which new financial instruments have increased the financial system’s vulnerability to liquidity events and the adequacy of the tools central banks have at their disposal to address such disruptions.

This is true, and I find the distinction between market liquidity (the ease with which one can liquidate a position in an asset without appreciably altering its price) and funding liquidity (the ease with which one can borrow money possibly against collateral) helpful. However it is worth pointing out that the central banks at first had no idea of the magnitude of the funding markets' needs. Remember the Bank of England announcing additional funding of £5B with a great fanfare? Yet a single decent sized SIV or conduit was tens of billions. Is it any wonder that when these came back on balance sheet the banking system needed hundreds of billions of funding.

Next something that we need to take with a pinch of salt:

Given the inherent complexity of managing liquidity risk, bank regulators have adopted a diverse approach.

I guess doing nothing very much in an agitated fashion might count as diversity.

The report points out a couple of interesting phenomema relating to funding liquidity.

Events since July 2007 have revealed weaknesses in funding liquidity management. First, banks tended to hoard liquidity during the period of systemic stress. [...] Second, liquidity-stressed banks were reluctant to use central bank standing facilities or the discount window for reputational reasons.

Hoarding liquidity is clearly bad for the system but no one has a convincing way of making this particular horse drink. The best we have so far is making liquidity cheaper for everyone in the hope that that will restore confidence.

Squeezes in funding liquidity can give risk to market illiquidity:

Runs on markets can occur when there is an increased likelihood of a deterioration in funding conditions, leading to a simultaneous attempt to sell assets by a number of investors. Faced with the decision to sell immediately or wait, speculative investors have to take into account that they could be hit by an unexpected need to sell before asset values recover from fire-sale conditions. The risk of eventual forced selling at a lower price causes a rush to the exit.

Knowing that you will be able to fund an asset therefore reduces the rush for the exit: hence the FED's TSLF and the Bank's SLF.

The IMF points out that liquidity risk might be getting worse. Reasons this might be true include:

• The growth in securitized lending and credit risk transfer mechanisms [...which] has reduced the illiquidity of banks’ asset holdings on average, but made access to liquidity more dependent on market conditions.
  
• The emergence of new complex instruments that are difficult to value and appear prone to illiquidity in times of stress. [I would add here too the use of fair value triggers for sale, for instance in the definition of default of a SIV or conduit.]
  
• The increasing dependence of market liquidity on hedge fund activity. While hedge funds have added generally to market liquidity, their increasing importance means that overall market liquidity often relies on their ability to leverage themselves, which is in turn affected by market volatility determining margining requirements.
  
• The provision of emergency liquidity support, which remains tied to national currencies and payment systems, has not kept pace with the internationalization of financial institutions’ treasury operations.

All of this suggests that firms need to be more aware of liquidity risks, more thorough in their quantification, and more prudent in their management. The IMF concludes:

Firms need to factor in more severe liquidity gapping and correlation jumps in their market risk models and stress tests, making sure that these are well tailored to firms’ particular circumstances and positions...More severe stress testing of funding liquidity should be adopted, taking into account the possible closure of multiple wholesale markets (both secured and unsecured) and wide-spread calls on liquidity commitments, taking into account commitments to off-balance-sheet entities.

Indeed. Stress testing is not quantatively sophisticated - the scenarios chosen are often fairly arbitrary, as is the estimate of their impact - but it is a vital estimate of the impact of a major event.

Where market liquidity can be measured robustly, a liquidity adjustment to market risk measures can be helpful, and its disclosure can usefully focus attention on liquidity risk, especially in “normal” conditions.

Remember though that the 1996 Market Risk Amendment to Basel 1 (defining regulatory conditions for the use of VAR models) sets not just a minimum but also a de facto maximum standard for market risk models. Why have a liquidity adjusted VAR with higher capital estimates than your peers? Regulators need to permit a much wider variety of market risk capital estimates and to raise the bar significantly on VAR.

Finally, a sobering observation from a public policy perspective.

The cost of insurance against liquidity events appears to have shifted from the private toward the public sector.

I'm not sure 'cost of' is the right phrase. 'Responsibility for' perhaps. But certainly Central Banks are finding themselves increasingly concerned with the explicit management of liquidity premiums as well as of rates. They certainly need to get used to this idea and to develop better tools for it.