Last week, the banks won but financial stability lost. Heavy lobbying undermined G20 support for proposals by the Basel Committee to plug a major gap in banking regulation. Measures such as “liquidity buffers” were challenged. Yet these are the sort necessary to contain “liquidity risk” – the inability of financial institutions to refinance their positions in times of distress. This failure was a major flaw in the international policy framework known as Basel II.
The devastating consequences of unstable funding have been clear for all to see. When subprime losses appeared, uninsured wholesale funding evaporated rapidly, forcing fire sales and huge price falls which in turn reinforced panic (Gorton 2009). This created unnecessary propagation from the US market to the whole world. In the end, the panic stopped only when central banks stepped in to provide a substitute to the short-term wholesale-market funding, and state guarantees reassured other investors.
Yet while liquidity buffers would indeed have been costly for banks, these costs are justified by social economic losses avoided. Indeed it is critical that such costs be born in good times, to produce proper incentives and avoid socialising losses in bad times.
At the heart of the problem was the inability for regulators to keep up. Many large banks changed the way they did business, regulators did not. Traditionally, banks relied more on stable funding sources such as bonds and bank deposits that benefited from deposit insurance. In recent decades, major trends shifted incentives to expand short-term funding in the wholesale credit market, reducing risk bearing for many investors.
This process accelerated in the last decade, thanks to the unlimited availability of repo funding for securitisation. The overnight swapping of cash for securities (including opaque mortgage backed securities) grew explosively. While no one seems to have a proper measure of how large this was, even conservative BIS estimates suggests a boost from $3 trillion to $7 trillion in the three years preceding the September 2008 crash.
Combined with the decline in capital ratios, the net result has been an accelerated collapse in funding maturity, and more generally in stable funding sources. Bear Stern, for example, had an average funding maturity of 7 days prior to collapse (and a loans-to-capital leverage ratio of 30). Lehman Brothers funded its immense proprietary trading with an average maturity of 3 days.
Change in short-term bank funding sources
What caused the collapse in funding maturity? There is consensus that the rise in short-term leverage of banks and shadow banks in the 2000s was fuelled by abundant liquidity. But even if bankers had an incentive to borrow short term, where did the massive supply come from? Two factors played a role: global imbalances and regulatory failure.
Sustained current-account imbalances meant a shift in wealth from lower-savings to higher-savings countries (the stock of reserves held by the large surplus nation amounts to a few trillion dollars). A large part of this surplus was invested with a clear preference for safe dollar assets, mostly short term. US capital inflows sought safe assets, US credit expansion targeted riskier assets.
A second boost to short-term wholesale funding came from regulatory neglect of the shadow banking system. Money market mutual funds, which invest only in short-term paper, gained market share from banks by offering low cost demandable deposits, even though they had no access to central bank liquidity support. In the end they were also bailed out, so it turned out that they, like the banks they were competing with, were insured even though they had escaped paying for deposit insurance.
The final step in creating massive quasi money came as the financial industry successfully lobbied for a set of unique exceptions to bankruptcy law for secured financial credit and derivatives from 2002 to 2005, both in the US and the EU. The result of this major, yet poorly understood, legal change was to allow an escape route from insolvency. The result was an explosion in derivatives and overnight credit volumes. This gave the final boost to supply of secured short-term funding and led to the veritable explosion in volume of derivatives in 2003 to 2007.
Impact on private incentives to monitor bank investment strategies
To fully appreciate the effect of these shifts, we need to understand not just their effect on panics, but also on lending quality. The critical problem with short-term funding was that it imposed no discipline on the borrowing intermediaries. Its suppliers are guaranteed such a rapid exit that they never bear any risk arising from borrowing banks’ investment decisions – regardless of how poor those decisions are.
The significant expansion in consumer and mortgage lending could not have occurred, had the funding come from longer-term investors that had an interest in monitoring its credit quality. Cheap and unlimited funding was the fuel – the steroids, so to speak – that enabled bankers to scale up uninformed carry trades. These, in turn, allowed them to book large risk premia as profits, thus generating large bonuses and dividends. When the panic struck, most losses were shouldered by stable investors and taxpayers.
Short-term funding had two effects on risk. Ex ante, it reduced the fraction of actively monitoring intermediaries, enabling lax credit choices. Ex post, it increased the speed of liquidity runs, especially since wholesale flows are not insured and are already packaged for rapid mass exit.
Incentives encouraged short-term funding
In theory, other investors – e.g. bank shareholders – should compensate by increasing private monitoring. After all, the higher profitability that comes with cheaper, easy-exit borrowing also comes with great risk of capital losses.
Yet this did not happen. Some investors were insured, others relied on vigilance by intermediaries with conflicted incentives such as advisors, issuers, and traders.
- Bankers took huge gambles with this cheap, unlimited funding, booked the risk premia as profits and distributed them.
- Regulators and investors did not understand financial innovations nor bankruptcy exceptions.
In the end, both the private and public financial governance system failed to monitor credit assessment. At best, none was playing a gate-keeping role for risk creation, and in some cases, clever bankers actively played the game for their own trading profit.
In the medium term, restoring financial stability will require that investors bear potential losses, in order to restore incentives for monitoring. This requires they accept the funding of intermediaries with longer term claims. Investors unwilling to take risks who seek time priority at all cost must pay for the privilege, just as in the past when checking accounts paid no interest.
A natural tool to achieve this would be liquidity-risk charges, levied on uninsured short-term liabilities. There is a good analogy with the insurance premia banks paid for the government insurance on their deposits. This insurance stabilised this short-term funding sources (and the financial system). Liquidity-risk charges are the correspondent for short-term funding raised in wholesale credit markets. These would act as a Pigouvian tax incentive to contain the negative externality associated with liquidity runs and reduced monitoring (Perotti and Suarez 2009). Taxation of unstable funding would limit systemic risk without suffocating or segmenting financial intermediation, a regression which modern, leveraged economies cannot easily afford.
Liquidity risk charges would have three functions:
- They would give direct incentives to increase funding maturity, and thus increased monitoring.
- They could be used as macro prudential tools to increase the cost of rapid credit expansion in exuberant times.
- They would charge any intermediaries (thus not only banks) for the direct and indirect fiscal costs that unstable funding choices may impose on the rest of the economy.
Liquidity-risk charges are a novel concept, though solidly rooted in the academic consensus on the propagation risk caused by short-term funding (Brunnermeier 2008, Khrishnamurti 2009).
Introducing new tools always raises concerns, yet there are precedents. Evidence suggests that charges on short-term inflows, used in several countries such as Chile, succeeded in increasing funding maturity. A recent IMF staff position paper on the experience of capital controls in emerging countries facing sizeable inflows concedes that creating frictions for hot money is at times indispensable for financial stability (Ostry et al. 2010).
Government attention is now focused on restoring investor confidence. But future financial stability requires more than a ‘pause in panic’. We need to reverse the dramatic slide of the financial system towards unstable funding – a trend which holds a gun to the heads of governments and central banks.
To avoid inflationary money creation, decisive action is needed to support a safe-exit option for the huge liquidity support from central banks. Public liquidity was provided to replace the private, short-term wholesale funding that evaporated with the crisis. Private funding needs to make a return. But the form of this private funding must be one that can bear risk – as a proper financial system should do – rather than merely carry on shifting any losses to the public purse.
Finally, each individual bank needs help to restore funding stability. Without a serious push from regulators, it is hard for any bank to move against the tide of more easily available, unreliable funding. We need a major shift among bank investors, not just bankers, to restore solid foundations.
Brunnermeier, Markus (2009), “Deciphering the Liquidity and Credit Crunch 2007-08”, Journal of Economic Perspectives, 23(1):77-100.
Gorton, Gary (2009), “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007”, paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference, May.
Gorton, Gary and George Pennacchi (1990), “Financial Intermediaries and Liquidity Creation”, The Journal of Finance, 45(1):49-71
IMF (2010), "Capital Inflows: The Role of Controls", IMF staff position note, February.
Perotti, Enrico (2010), “Tax banks to discourage systemic-risk creation, not to fund bailouts”, VoxEU.org, 19 February.
Perotti, Enrico and Javier Suarez (2009a), “Liquidity Insurance for Systemic Crises”, CEPR Policy Insight 31, February.
Perotti, Enrico and Javier Suarez (2009b), “Liquidity Risk Charges as a Macro prudential Tool”, CEPR Policy Insight 40, November.