Where danger lurks
Olivier Blanchard 03 October 2014
Before the 2008 crisis, the mainstream worldview among US macroeconomists was that economic fluctuations were regular and essentially self-correcting. In this column, IMF chief economist Olivier Blanchard explains how this benign view of fluctuations took hold in the profession, and what lessons have been learned since the crisis. He argues that macroeconomic policy should aim to keep the economy away from ‘dark corners’, where it can malfunction badly.
Until the 2008 global financial crisis, mainstream US macroeconomics had taken an increasingly benign view of economic fluctuations in output and employment. The crisis has made it clear that this view was wrong and that there is a need for a deep reassessment.
The benign view reflected both factors internal to economics and an external economic environment that for years seemed indeed increasingly benign.
Macroeconomic policy Monetary policy
macroeconomics, global crisis, great moderation, rational expectations, nonlinearities, fluctuations, business cycle, monetary policy, inflation, bank runs, deposit insurance, sudden stops, capital flows, liquidity, maturity mismatch, zero lower bound, liquidity trap, capital requirements, credit constraints, precautionary savings, housing boom, Credit crunch, unconventional monetary policy, fiscal policy, sovereign default, diabolical loop, deflation, debt deflation, financial regulation, regulatory arbitrage, DSGE models
Finance at the speed of light: Is faster trading always better?
Marius Zoican 20 September 2014
Technological advances in equity markets entered the spotlight following the Flash Crash of May 2010. This column analyses the advantages and disadvantages of algorithmic and high-frequency trading. Ever-faster exchanges do not always improve liquidity. Following a speed upgrade in the Nordic equity markets, effective spreads posted by high-frequency traders increased by 32%.
Few activities embraced the computer age so actively as trading. Loud and hectic pits have been progressively replaced by silent computer server rooms. Transactions are no less dynamic for it, however. A London-based trader can buy stocks in Frankfurt within just 2.21 milliseconds.1 Light needs 2.12 milliseconds to travel the same distance. Welcome to the age of algorithmic and high-frequency trading!
high-frequency trading, algorithmic trading, technology, liquidity, spreads, price discovery, adverse selection, exchanges, competition-stability trade-off
Shadow banking and the economy
Alan Moreira, Alexi Savov 16 September 2014
The prevailing view of shadow banking is that it is all about regulatory arbitrage – evading capital requirements and exploiting ‘too big to fail’. This column focuses instead on the tradeoff between economic growth and financial stability. Shadow banking transforms risky, illiquid assets into securities that are – in good times, at least – treated like money. This alleviates the shortage of safe assets, thereby stimulating growth. However, this process builds up fragility, and can exacerbate the depth of the bust when the liquidity of shadow banking securities evaporates.
Shadow banking, what is it good for? At the epicentre of the global financial crisis, shadow banking has become the focus of intense regulatory scrutiny. All reform proposals implicitly take a stance on its economic value.
According to the prevailing regulatory arbitrage and neglected risks views, it doesn’t have any – shadow banking is about evading capital requirements, exploiting ‘too big to fail’, and marketing risky securities as safe to unwitting investors. The right response is to bring shadow banking into the regulatory and supervisory regime that covers insured banks.
Financial markets Global crisis Macroeconomic policy
shadow banking, banking, financial crisis, global crisis, regulatory arbitrage, liquidity transformation, financial stability, externalities, collateral, business cycle, financial regulation, financial fragility, liquidity, liquidity crunch
Persistent noise, investors’ expectations, and market meltdowns
Giovanni Cespa, Xavier Vives 22 April 2014
Since capital flows to and from hedge funds are strongly related to past performance, an exogenous liquidity shock can trigger a vicious cycle of outflows and declining performance. Therefore, ‘noise’ trades – usually thought of as erratic – may in fact be persistent. Based on recent research, this column argues that there can be multiple equilibria with different levels of liquidity and informational efficiency, and that the high-information equilibrium can under certain conditions be unstable. The model provides a lens through which to interpret the ‘Quant Meltdown’ of August 2007 and the recent financial crisis.
The recent financial crisis has revived interest in the question of what triggers crashes and meltdowns in financial markets. An important reason for abrupt and large price dislocations is the lack or ‘slow motion’ of arbitrage capital (Duffie 2010) that weakens the risk-bearing capacity of liquidity providers.
We suggest that there is an alternative explanation based on expectations dynamics in the presence of persistent market noise.
In the market:
liquidity, financial crises, asset prices, noise trading, informational efficiency
Recent studies reinforce the case for the Liquidity Coverage Ratio
Stefan W Schmitz, Heiko Hesse 28 February 2014
Europe aims to implement Liquidity Coverage Ratio regulation by the end of 2014. This column discusses recent evidence on its impact. It finds that EU banks have not adjusted by reducing lending to the real economy, to SMEs, or to trade finance. Despite this adjustment, substantial liquidity risk exposure remains. Overall, the benefits of the LCR outweigh the costs by far.
With the underpricing of liquidity risk prior to the crisis, a return to the same pre-crisis liquidity pattern is not expected. There is widespread consensus that banks’ extensive pre-crisis reliance on deep and broad unsecured money markets is to be avoided in the future (see e.g. IMF 2013). Creating substantial liquidity buffers across the board is the explicit aim of a number of regulatory responses to the crisis, such as the CEBS Guidelines on liquidity buffers (CEBS 2009) and the LCR.
EU institutions Financial markets
A call for liquidity stress testing and why it should not be neglected
Clemens Bonner 06 February 2014
Liquidity risks can be a primary source of bank failures. As such, there are arguments not to rely on a single metric for providing supervision. This column describes research on detailed cases of failed and near-failed institutions, which helps highlight gaps in current practices of liquidity stress testing. It also gives guidance on how to design liquidity stress tests. Deposit insurance coverage, the heterogeneity of lending commitments, distinction between different types of repos, committed facilities, and derivative transactions should receive increased attention when designing liquidity stress tests.
The recent financial crisis has shown that neglecting liquidity risks comes at substantial costs. In order to reinforce banks’ resilience to liquidity risks, the Basel Committee on Banking Supervision (BCBS) proposed the introduction of two harmonised liquidity standards:
- The liquidity coverage ratio; and
- The net stable funding ratio.
While the implementation of harmonised liquidity regulation across the globe is a unique and necessary step for supervision, one single metric cannot provide a complete picture of an institution’s liquidity risk profile.
liquidity, banks, stress tests
The determinants of banks’ liquidity buffers and the role of liquidity regulation
Clemens Bonner, Iman van Lelyveld, Robert Zymek 01 November 2013
What are the determinants of banks’ liquidity holdings and how are these reshaped by liquidity regulation? Based on a sample of 7,000 banks in 30 OECD countries, this column argues that banks’ liquidity buffers are determined by a combination of both bank- and country-specific variables. The presence of liquidity regulation substitutes for most of these determinants while complementing the role of size and institutions’ disclosure requirements. The complementary nature of disclosure and liquidity requirements provides a strong rationale for considering them jointly in the design of regulation.
Until recently, liquidity risk was not the main focus of banking regulators. However, the 2007–2009 crisis showed how rapidly market conditions can change, exposing severe liquidity risks for some institutions. Although capital buffers were effective in reducing liquidity stress to some extent, they were not always sufficient. In the light of this, efforts are underway internationally as well as in individual countries to establish or reform existing liquidity risk frameworks – most notably the proposals by the Basel Committee on Banking Supervision (BCBS 2013).
Financial markets Microeconomic regulation
transparency, liquidity, regulation, banking, Too big to fail, disclosure
The impact of liquidity regulation on monetary-policy implementation
Clemens Bonner, Sylvester Eijffinger 14 October 2013
Liquidity requirements like the Basel III Liquidity Coverage Ratio are aimed at reducing banks’ reliance on short-term funding. This may have implications for the implementation of monetary policy, which usually operates through short-term interbank interest rates. This column looks at how banks reacted to the Dutch quantitative liquidity requirement. The authors conclude that liquidity requirements will only reduce overnight interest rates if they cause an aggregate liquidity shortage.
In response to the recent financial crisis, the Basel Committee on Banking Supervision has drafted a new regulatory framework (henceforth Basel III) with the aim to achieve a more robust banking system. While it also tightens the existing requirements for capital, the proposal stands out as it is the first to attempt harmonised liquidity regulation across the globe. Specifically, the framework includes the short-term Liquidity Coverage Ratio (Liquidity Coverage Ratio) and the long-term Net Stable Funding Ratio.
Financial markets Monetary policy
monetary policy, liquidity, financial regulation, BASEL III, liquidity coverage ratio
Enhancing the global financial safety net through central-bank cooperation
Edwin M. Truman 10 September 2013
Should we expect more global financial crises? This column argues that we should. Global financial crises are far from being a thing of the past because they are often caused by buildups of excessive domestic and foreign debt. To successfully address them and to limit negative spillovers, we need coordinated actions that prevent a contraction in global liquidity. Unless we establish this more robust, coordinated global financial safety net centred on central banks (which is where the money is), we may end up being incapable of addressing inevitable future crises.
The prospect that the Federal Reserve will soon ease off on its purchases of long-term assets has increased financial-market uncertainty and contributed to a retrenchment in global capital flows. This turbulence has revived discussion of the need to enhance the global financial safety net –i.e. the set of arrangements to provide international liquidity to countries facing sharp reversals in capital inflows despite following sound economic and financial policies.1
The dominant lessons from the financial crises of the past decade are:
Global crisis International finance
Central Banks, liquidity, banking, debt
Global factors in capital flows and credit growth
Valentina Bruno, Hyun Song Shin 07 June 2013
‘Global liquidity’ focuses on the role of cross-border banking in the international transmission of financial conditions. This column argues that when global banks apply more lenient conditions on national banks by supplying wholesale funding, national banks transmit the more lenient conditions to their borrowers through greater availability of local credit. Researchers and policymakers would do well to recognise the role of global liquidity as a key concept in international finance.
It is a cliché that the world has become more connected, but the financial crisis and the boom that preceded it have focused attention on the global factors behind credit growth and capital flows. Calvo, Leiderman and Reinhart (1993, 1996) famously distinguished the global ‘push’ factors for capital flows from the country-specific ‘pull’ factors, and the Bank for International Settlements report on global liquidity (the ‘Landau report’) has highlighted the role of cross-border banking in the transmission of financial conditions (BIS 2011).