ABSTRACT
Although financial crises can be triggered by many reasons, the propagation of a crisis often follows the liquidity channel. In the downturn, the financial intermediaries, or the banks, whose business model is featured by investing on the high yield and risky long assets funded by the short-term debts, immediately feels the stress from liquidity, i.e., the difficulty in raising short-term funds to roll over their long-term investments. As argued in Chapter 3, liquidity is the key to understanding financial crises. But also it may play a pivotal role in the rules preventing the market crunch. To cushion the market shocks and cut off the propagation of crisis, in banking regulation the most straightforward solution is to have some obligatory liquidity buffer in the banking sector. The buffer should be thick enough to meet the demand shocks; the interbank market should be resilient enough for the banks to borrow and lend even when the market is under stress; and the buffer should be “liquid” enough so that it can be easily converted to fulfill the banks’ instantaneous demand for cash without losing much value in the conversion. The level of regulatory liquidity requirement certainly depends on the liquidity risk. The safest case is to require all the banks to hold so much liquid assets
that they are able to meet the demand in all contingencies. Of course this eliminates all the liquidity crises, but is not optimal since holding liquid assets implies giving up the high yields from the illiquid assets. The investors will be better off if the banks are allowed to take some risk under certain contingencies. However, allowing the banks to take risks implies that they may fail in some states of the world. The bank failure is obviously costly and should be avoided; therefore, the optimal liquidity regulation needs to be companioned by the active intervention of the regulator – usually the central bank. The central bank in this case plays a role as the lender of last resort facilitating the liquidity provision to ease the market stress, known as “the Bagehot principle” such that in the crisis the central bank should lend freely – at penalty interest rates, though – to anyone who could offer good assets as collateral. But the central bank intervention opens another source of trouble, since the regulated banks actively respond to regulation and undo the regulatory policies. Because bank failure is costly, when there is a pure liquidity problem it is always optimal to bail out all the banks ex post even if some of them do not follow the liquidity requirement ex ante. Anticipating such “Greenspan put,” the banks will coordinate on excess risk taking without observing any of the liquidity requirements. The moral hazard thus endogenously arises as the banks’ response to regulation. The episodes from the current crisis shed much light on this issue. For quite some time before the crisis started in mid-2007, at least a few market participants had the feeling that financial markets have been susceptible to excessive risk taking, encouraged by extremely low risk spreads. There was the notion of abundant liquidity, stimulated by a “savings glut”, by an “investment drought,” or by central banks running too-loose monetary policies. In that context, some brave economists warned against the rising risk of a liquidity squeeze which might force central banks to ease policy again (compare, for example, “A fluid concept,” The Economist, February 2007). Frequently it was argued that it was exactly the anticipation of such a central bank reaction which encouraged further excessive risk taking: the belief in “abundant” provision of aggregate liquidity might have resulted in overinvestment in activities creating systemic risk. Afterwards, following the turmoil on financial markets, there has been a strong debate about the adequate policy response. Some have warned that central bank actions may encourage dangerous moral hazard behavior of market participants in the future. Others instead criticized central banks for responding far too cautiously. The most prominent voice has been Willem Buiter, who – jointly with Ann Sibert – right from the beginning of the crisis in August 2007 strongly pushed the idea that in times of crises, central banks should act as market maker of last resort (see Buiter and Sibert 2007). As an adaptation of the Bagehot principles to modern times with globally integrated financial systems, central banks should actively purchase and sell illiquid private-sector securities and so play a key role in assessing and pricing credit risk. In his Financial Times blog “Maverecon,” Willem Buiter stated the intellectual arguments behind such a policy very clearly on December 13, 2007:
Liquidity is a public good. It can be managed privately (by hoarding inherently liquid assets), but it would be socially inefficient for private banks and other financial institutions to hold liquid assets on their balance sheets in amounts sufficient to tide them over when markets become disorderly. They are meant to intermediate short maturity liabilities into long maturity assets and (normally) liquid liabilities into illiquid assets. Since central banks can create unquestioned liquidity at the drop of a hat, in any amount and at zero cost, they should be the liquidity providers of last resort, both as lender of last resort and as market maker of last resort. There is no moral hazard as long as central banks provide the liquidity against properly priced collateral, which is in addition subject to the usual “liquidity haircuts” on this fair valuation. The private provision of the public good of emergency liquidity is wasteful. It’s as simple as that.
