macroprudential policy implementation in europe session 4 ... · • article 105 of directive...

Macroprudential Policy Implementation in Europe

Session 4: Liquidity Instruments and Systemic Liquidity

Michael Wedow

17-19 October 2018

1. Motivation and rationale

2. Microprudential liquidity requirements

3. Macroprudential perspective

1. Concept of systemic liquidity

2. Available instruments in the CRR/CRD

3. Monitoring systemic liquidity risk

4. Liquidity measures for non-banks and markets

Overview

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Overview

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Reaction to the financial crisis

• Dry up of financial markets made public liquidity support paramount

• Central bank balance sheets expanded substantially

– CBs lowered policy rates,

– More frequent auctions,

– Reduced reserve requirements,

– Used non-standard measures e.g. broadening collateral,

– Changed to fixed rate full allotment 15 October 2008

– Outright asset purchases,

– Liquidity facilities for non-banks (FED for MMFs and AIG)

• Public sector measures

– Increase in deposit guarantees,

– Government guaranteed bonds

Motivation and Rationale

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Motivation and Rationale

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Overview

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Lessons learnt from the Financial Crisis

• Buoyant asset markets and extremely low funding costs before crisis

• Excessive reliance on vulnerable sources of liquidity i.e. short-term

wholesale funding

• Excessive maturity transformation created a mismatch between asset

liquidity and contractual maturity of liabilities

• Banks were vulnerable to sudden dry ups of market liquidity

International response to the liquidity crisis

• BCBS (2008) Principles for Sound Liquidity Risk Management and

Supervision

• Two microprudential liquidity requirements: Liquidity Coverage Ratio

(LCR) and the Net Stable Funding Ratio (NSFR)

Microprudential liquidity requirements

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Liquidity Coverage Ratio

• Objective: promote short term resilience of banks’ liquidity risk

profile (provide central banks time to respond)

Liquidity Coverage Ratio =𝐻𝑖𝑔ℎ 𝑄𝑢𝑎𝑙𝑖𝑡𝑦 𝐿𝑖𝑞𝑢𝑖𝑑 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑠> 100%

• High quality Liquid Asset – various levels 1, 2 (A and B)

subject to different haircuts

• Net cash outflows are calibrated over a 30 day stress scenario

• The meaning of Net: Outflows-Inflows with a minimum of at

least 25% outflows (outflow cap)


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Status Quo in EU

• Implemented in October 2015 at 60%, phased in until reaching

100% in 2018

• End 2016, the average LCR across banks was 139%; majority of

banks meet the LCR


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Some issues for deliberation

• Central bank operations: receive a preferential treatment – 0% outflow

factor

• HQLA central bank eligible: necessary but not sufficient

• Unwind mechanism: ensures that caps for HQLA are met, incl. central

bank operations

• Cross-border liquidity waivers: Important for financial integration but

subject to significant obstacles

• Unsecured vs. secured funding: unsecured funding seen as less stable

• Characteristics of deposits: covered deposits always more stable but

what makes a deposit less stable

• Jurisdictions with insufficient HQLA: Alternative Liquidity Approaches


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Net Stable Funding Ratio

• Objective: reduce funding risk i.e. fund activities with sufficiently

stable sources of funding over a 1 year horizon

Net Stable Funding Ratio =𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑆𝑡𝑎𝑏𝑙𝑒 𝐹𝑢𝑛𝑑𝑖𝑛𝑔

𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑆𝑡𝑎𝑏𝑙𝑒 𝐹𝑢𝑛𝑑𝑖𝑛𝑔> 100%

• Available Stable Funding relates to liabilities weighted by factors

reflecting their contractual maturity and market liquidity (HQLA)

• Required Stable Funding relates assets and their perceived

market liquidity (encumbrance)


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Status Quo in EU

• Discussion ongoing in triologues – possible implementation in

2021

• BCBS NSFR to become minimum standard in 2018

• End 2017, average NSFR 113.5%


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Some issues for deliberation

• Important interactions with other parts of reform package e.g.

capital framework and MREL

• Possible EU deviations from Basel NSFR

• Impact of Longer Term Central Bank operations on the NSFR


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Other instruments to address liquidity risk

• Pillar 2 liquidity requirements: e.g. to cover time horizons other

than LCR and NSFR

• Loan to Deposit/Asset Ratio: (ESRB, 2014) and Lallour and Mio

(2016)

• Price based measures: Perotti (2011) proposes a Pigovian tax on

short term assets

• Nicoletti-Altimari and Salleo (2010) propose contingent bonds

• Complementarity vs Substitutability of capital and liquidity:

e.g. US GSIB framework

• Some EU countries already had liquidity requirements in place

before the crisis while others have introduced new requirements

similar to LCR and NSFR concepts

– Hungary: ▪ Mortgage Funding Adequacy Ratio

▪ Foreign Exchange Funding Adequacy Ratio


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Overview

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Why is a macroprudential perspective warranted?

• Microprudential requirements fail to account for systemic liquidity

aspects

– Idea behind LCR is that banks can liquidate in markets – feasibility when many

banks pursue this is questionable – may lead to fire sales or market dry ups

– Difference in systemic liquidity footprint of different banks not acknowledged

• Central bank lender of last resort function remains key for managing

liquidity crisis

– LOLR not forward looking i.e. addresses risks only when they materialise

Provides some justification for macroprudential perspective for

liquidity

Macroprudential perspective

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Concept of systemic liquidity (ECB OP 214)

• IMF(2011) defines systemic liquidity risk as the “risk of simultaneous

liquidity difficulties at multiple financial institutions”

• Disrupting functioning of financial intermediation and impair the

provision of credit to the real economy, warranting the intervention of

the central bank.

• Houben et al. (2015), four main features:

(i) it is conditioned by the phase of the financial cycle and as a result is an

endogenous concept;

(ii) it is characterised by a liquidity illusion effect in the upswing phase of the

financial cycle;

(iii) it is driven by the interconnectedness within the financial sector and

financial markets, which amplifies the consequences of liquidity shortfalls;

and

(iv) it is highly correlated with capital leverage


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Time dimension

• Abundant liquidity increases liquidity risk taking

• Liquidity illusion affects both sides of the balance sheet leading to increased

liquidity leverage

• Systemic liquidity risk increases throughout the financial system (endogenously)

and materialises when liquidity illusion evaporates


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Cross-sectional dimension

• Markets characterised by centralised networks with liquidity hubs i.e.

dealer banks/market makers

• Liquidity shortages at hubs can disrupt flow of liquidity through the

system and impair market functioning/liquidity

• Central liquidity providers might not take into account externality of

their liquidity risk taking behaviour

• Contagion can spread via direct interconnectedness and indirect

contagion e.g. common exposures, information spillovers, margin calls

and haircuts


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Available Instruments in the CRR/CRD – Art. 458

• Article 458 of Regulation (EU) No 575/2013 provides the legal basis

for introducing macroprudential liquidity instruments:

“Where the authority … identifies changes in the intensity of macroprudential or systemic risk in

the financial system … and which that authority considers would better be addressed by means of

stricter national measures…”

• Broad view: National measures do not have to be based on the existing liquidity requirements

in Part Six, as long as the designated or competent authority can provide

evidence that existing measures are not adequate to address the current

increase in systemic liquidity risk.

• Narrow view: Limits the scope of national measures to the existing liquidity requirements in Part

Six of the CRR (i.e. LCR and NSFR).

⟹ Majority of TFSL supports the broad view

• Limitation: National measures can be adopted for a period of up to two years.


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Available Instruments in the CRR/CRD – National Law

• National law can play a role in setting liquidity requirements

• However, its interaction with the European regulatory framework is

unclear

• Article 413 CRR asserts that Member States can “maintain or

introduce national provisions in the area of stable funding

requirements before binding minimum standards for net stable funding

requirements” are put in place.

• However, it states nothing regarding the possibility of national law

after this implementation.

• It is unclear whether national laws could introduce specific

macroprudential tools regarding the regulation of liquidity risk, or

whether this regulation should be limited to existing LCR and NSFR


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Available Instruments in the CRR/CRD – Pillar 2

• Article 103 of Directive 2013/36/EU: to introduce measures at a

national level if competent authorities determine that institutions with

similar risk profiles (Article 97) are exposed to similar risks or pose

similar risks to the financial system (systemic liquidity risk is included

in the definition of “risks”).

• Article 105 of Directive 2013/36/EU: a proposed liquidity requirement

under this article is intended to capture liquidity risks to which an

institution is or might be exposed, taking into account (among others)

systemic liquidity risk that threatens the integrity of the financial

markets of the Member State concerned.

• Main problem: If the EC decides to separate Pillar 2 measures and

macro-prudential tools, national authorities will no longer be able to

use Article 103 and 105 CRD for macro-prudential purposes -> Article

458 CRR will have to be enhanced.


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How material is systemic liquidity risk? Need a monitoring

framework

⟹ Dashboard containing 20 indicators for assessing the materiality of

systemic liquidity risk.

The decision to include indicators was guided by four criteria:

(i) Systemic liquidity: Does the indicator capture systemic liquidity and specifically

endogeneity, interconnectedness and concentration?

(ii) Scope: How much of the financial system does the indicator cover?

(iii) Crisis signaling: Would the indicator have been useful to signal past stress

events?

(iv) Data availability: Can the indicator be built for all countries and does it include a

time series?


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Dashboard


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Dashboard – Caveats

• Time series for many indicators are limited (mostly since 2014Q4) –

constrains empirical assessment e.g. for predicting crisis

• COREP and FINREP for some countries apparently unreliable

• Not all markets and financial entities can be captured with meaningful

indicators due to data limitations e.g. derivatives and repo market or CCP

and investment firms

• At this stage use dashboard for monitoring purposes rather than a risk

assessment

• Experience with liquidity scoreboard needs to be gained and

dashboard/risk assessment may need to be updated and revised


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Overview

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Investment funds

• FSB and ESRB concerns about liquidity risks in investment funds and called for

exploration of the role of macroprudential authorities

• ECB FSR: funds increased their risk-taking by investing in less liquid assets and

offering shorter-term redemptions

What instruments are available?

• AIFMD appropriate liquidity management systems and effective procedures to

account for liquidity profile and the redemption policy of each fund.

• UCITS IV Directive sets detailed list of eligible assets, requires funds to invest in

liquid assets, and expects the ability to demonstrate that liquidity management

processes are in place.

• MMF regulation stipulate requirements for a fixed share of daily and weekly

maturing assets to reduce liquidity risks

ECB (2018): suspension of redemptions constitutes a valuable crisis

management instrument; redemption duration restrictions could be explored

further with the aim of improving the resilience of funds

Liquidity instruments for non-banks and markets

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Circuit breakers

• MifidII: trading venues to temporarily halt or constrain trading if there is a

significant price movement in a financial instrument

Trading halts

• Mechanisms that interrupt continuous trading

• Trading switches from continuous trading to a call auction

Liquidity instruments for non-banks and markets

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• Macroprudential framework for liquidity much less developed than

for capital

• Similar instruments as for capital may be needed

• Already some use of liquidity instruments for macroprudential

purposes e.g. FX risks or systemic banks

• Activation challenging given lack of reliable indicators

• Activation via Art. 458 cumbersome, legal certainty needed

• Monitoring of systemic liquidity risk hampered by lack of reliable

indicators

Conclusion

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