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Liquidity and Transparency in Bank Risk Management

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Liquidity and Transparency in Bank Risk Management Lev Ratnovski Bank of England & University of Amsterdam – PowerPoint PPT presentation

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Title: Liquidity and Transparency in Bank Risk Management


1
Liquidity and Transparencyin Bank Risk Management
  • Lev Ratnovski
  • Bank of England University of Amsterdam

2
Liquidity Risk
  • A solvent bank cannot refinance
  • Stylized facts (recent events)
  • Solvency concerns
  • 1991, Citibank and Standard Chartered (HK)
  • 1998, Lehman Brothers
  • 2002, Commerzbank
  • Strain in wholesale finance
  • 2006, BAWAG, 5 retail withdrawals

3
Liquidity and Transparency
  • Two ways to manage liquidity risk
  • Liquidity
  • buffer of short-term assets
  • Transparency
  • mechanisms that facilitates communicationof
    solvency info ? enable refinancing
  • Both - strategic ex-ante decisions
  • Optimal choices, interaction, policy implications

4
Strategic Transparency
  • Invest today into ability to borrow tomorrow
  • Transparency ex-ante
  • Disclosure ex-post info release
  • Uncertain credibility / effectiveness
  • Examples
  • Subordinated debt
  • Risk management / external oversight
  • Streamlining LCFIs
  • Commitment to credible disclosure
  • Citicorp 1987 provisions 3bn, positive reaction

5
Strategic Transparency
  • Imperfect
  • Country determinants
  • Industry effects externalities / coordination
  • Many everyday beneficial effects
  • Better screening / monitoring
  • Lower funding costs
  • Most pronounced in unforeseen shocks
  • Highest asymmetric information

6
Main results
  • Banks can combine liquidity and transparency in
    risk management
  • Liquidity small shocks, complete
  • Transparency all shocks, partial
  • Banks may under-invest in both
  • Leverage (or LOLR or externalities)
  • Regulation complicated by multitasking
  • Liquidity requirements can compromise
    transparency choices

7
Policy
  • Solvency is not enough
  • Asymmetric info ? Liquidity risk
  • Liquidity regulation
  • If incorrect, can compromise transparency
  • Extra emphasis on transparency beneficial

8
Set-up
  • Liquidity risk driven by asymmetric information
  • Wholesale refinancing for known solvent banks
  • Bank has a valuable long-term project
  • Small probability of 0 return
  • Does not prevent initial funding
  • Intermediate refinancing
  • Exogenous random withdrawal
  • Most states bank confirmed solvent,investors
    willing to refinance
  • Risk negative signal (possible for a solvent
    bank), no refinancing

9
Economy
  • Multiple competitive investors
  • Endowed with money
  • Lend at 1 risk-free interest
  • A bank with an investment project
  • Date 0 Investment
  • Date 1 Refinancing
  • Date 2 Returns,
  • per unit invested X w.p. 1s
  • 0 w.p. s (s small)
  • A bank does not borrow more than 1 at date 0

10
Intermediate Refinancing date 1
  • Random withdrawal, Llt1 or 1 w.p. ½
  • Uninformed depositors
  • Maturing term liabilities
  • Noisy solvency signal
  • Fundamentals solvent 1s, insolvent s
  • Probability 1sq correct signal solvent
  • Outsiders willing to refinance
  • Probability sq possibly insolvent
  • High posterior insolvency s /(sq) gt s
  • Outsiders unwilling to refinance, incl q solvent
    banks

11
Insolvent
Solvent 1s
s
Negative signal,pooled together
Positive signal, known solvent
1sq
s
q
Solvent,but unableto refinance
12
Hedging
  • Liquidity buffer
  • Invest L into short-term assets
  • Covers small outflows internally
  • Not suitable for large outflows
  • Complete insurance against small shocks
  • Transparency
  • Invest T to establish communication mech-ms
  • Helps resolve uncertainty, refinance any shocks
  • Effective only with probability tlt1
  • Partial insurance against any shocks

13
Transparency
  • Effectiveness t
  • Probability of successful communication
  • Exogenous to banks decision
  • Determinants
  • Financial development
  • Market size / liquidity
  • Other banks externalities (Admati and
    Pfheiderer, 2000) or coordination

14
Optimal choices
  • Liquidity and transparency are costly hedges
  • When costs are sufficiently low
  • Banks can optimally combine liquidity and
    transparency in risk management
  • Liquidity small shocks, complete
  • Transparency large shocks, partial

15
Distortion
  • Banks are leveraged ?
  • Can under-invest in bothliquidity and
    transparency
  • Alternative set-ups possible(LOLR rents or
    systemic externalities)

16
Regulation
  • Liquidity is verifiable ? impose ratios
  • Transparency ? ?
  • Multi-tasking
  • Liquidity requirements can compromisetransparency
    choices
  • Impose too much liquidity on transparent
    banks,get liquidity only exposure to larger
    shocks

17
Contribution
  • Novel model of liquidity risk
  • Closest Chari and Jagannathan, 1988
  • Consumer runs under asymmetric information
  • Uninformed observe a withdrawalMay be not
    information-basedAmplification of liquidity
    withdrawals
  • No refinancing
  • Our approach
  • Wholesale funding under asymmetric information
  • Downplay withdrawalsKnown solvent can
    refinance, Goodfriend and King, 1988
  • Refinancing problem Imprecise info of informed
    investors
  • How to prove solvency?
  • Liability-side liquidity risk, but no bank runs
  • Reflects flight to quality

18
  • Is cash negative debt?
  • Acharya at al., 2006 future access to finance is
    uncertain
  • Financial constraints
  • Kashyap and Stein, 2000 Paravisini, 2006
  • Jointly determined by liquidity and transparency
  • Empirical implications

19
Main results
  • Banks may combine liquidity buffers and
    transparency investments in risk mgmt
  • Liquidity fully insures small shocksTransparency
    partially all shocks
  • Both may be compromised by leverageRegulation
    complicated by multitasking
  • Lessons for liquidity regulation
  • If incorrect, can compromise transparency
  • Important that thoroughly designed
  • May require extra emphasis on transparency

20
Main results
  • Banks can combine liquidity and transparency in
    risk management
  • Banks may under-invest in both
  • Regulation is complicated by multitasking
  • Lessons for liquidity regulation
  • Solvency regulation not enough
  • Incorrect liquidity requirements can compromise
    transparency choices
  • Additional emphasis on transparency beneficial
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