30 April 2011

IMF on Systemic Liquidity Risk & Observer’s Comments

In its April 2011 Global Financial Stability Report IMF devotes the entire chapter to the issue of systemic liquidity risk, the risk that multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding through widespread dislocations of money and capital markets. While IMF seems to say and do quite a lot, it continues to ignore the root causes of the problem.

More specifically, IMF’s key messages are:
* Basel III liquidity rules (first of all, the Liquidity Coverage Ratio, LCR, and the Net Stable Funding Ratio, NSFR) are good at the level of individual banks, but because they target only individual banks, they can play only a limited role in addressing systemic liquidity risk concerns.
* More needs to be done to develop macroprudential techniques to measure and mitigate systemic liquidity risks.
* It is important to have a macroprudential tool that would allow for a more effective private-public burden sharing on systemic liquidity risk management (such as a macroprudential capital surcharge, fee, tax, insurance premium, or some other instrument).
* Regulators and supervisors need more data and information from banks; data disclosure practices on liquidity risk need to be improved.
* Also, nonbank financial institutions that contribute to systemic liquidity risk should receive more oversight and regulation.

IMF also suggests three separate methods for measuring systemic liquidity risk and an institution’s ongoing contribution to it. The use of those techniques is told to establish an objective basis on which to charge an institution for the externality it imposes on the financial system.
* The first method is called Systemic Liquidity Risk Index (SLRI). Basically the SLRI is a time series prediction of a common factor that best explains the violations from various arbitrage relationships such as Covered Interest Parity (CIP).
* The second methodology means the development of a Systemic Risk-Adjusted Liquidity Model (SLR model). The work involves three steps: (1) deriving a daily measure of the NSFR at market prices, (2) determining the expected losses from liquidity risk for an individual institution, and (3) deriving systemic (aggregate) expected losses for all sample firms.
* The third proposed approach is Systemic Liquidity Risk Stress Testing (ST) Framework. The approach proceeds in four stages: (1) modelling of the financial and economic environment; (2) credit risk modelling; (3) systemic solvency risk modelling; and (4) systemic liquidity risk modelling.

When we look at the proposed methods and techniques a bit more closely, several conclusions on regulatory approach can be drawn. Some examples follow.

Regulators intend to maintain the status quo in the design of financial system despite of its limitations. The aim of all the new regulatory developments is a more sustainable but not a sustainable financial system. It should be obvious that in long term systemic liquidity risk can only increase if money continues to be debt, debts continue to exceed the outstanding money amount and this gap continues to increase because of the very design of financial system and financial instruments. The only steps towards greater resilience are improved ability to transfer assets and liabilities from one part of the financial system to another and (maybe) increased trustworthiness of financial institutions in the eyes of households and businesses (as a result of greater supervision).

The role and importance of public authorities is intended to be permanently increased not only as supervisors and regulators of financial system, but as parts of financial system itself. For reference consider the built-in assumptions that public authorities provide an implicit guarantee for bank liabilities (it is called “the contingent claims analysis (CCA) approach”).

Regulators strive towards greater complexity and seem to think that more complex means more advanced which means better. Note that soon we will have a risk adjusted Net Stable Funding Ratio not just a Net Stable Funding Ratio with supervisory weights on different assets and liabilities. A clear implication for that is the use of market-implied NSFR in SLR model. This may be the way for banks to “soften” the Basel III liquidity requirements.

There is great reliance on market prices and market behaviour in the three suggested methods. IMF staff seems not to be bothering with thinking about the considerations behind market behaviour and whether reliance on market-based indicators is reasonable or not (as markets tend to be emotional rather than reasonable).

My main question is: does IMF really believe that regulators or banks or IMF staff or anyone else is able to measure the systemic liquidity risk precisely enough, or it’s just another show meant for calming down the public? At least until there is no broader acknowledgement of the real problems in the design of financial system and the very principles of money creation, I tend to think the later. It should be understood that if theorists and analysts are working within the current framework and prevailing paradigm, they cannot make any real progress in solving the issues but only make things increasingly complex (which also means that the system itself gets increasingly expensive).

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