Gianni De Nicolò International Monetary Fund and CESifo The views expressed in this presentation are exclusively those of the author and do not necessarily represent those of the IMF or IMF policy.

Three key questions What are the market failures that may justify liquidity regulation? Is liquidity regulation a necessary complement to other policies, such as capital requirements, prompt corrective action, or public provision of liquidity, such as LOLR facilities? What are the potential costs of liquidity regulation?

Outline 1. A brief review of the market failures that can trigger liquidity crises 2. Policies that can mitigate market failures: LOLR policies, capital requirements, liquidity requirements. 3. Available estimates of the cost of envisioned Basel III liquidity requirements 4. Answer to the three key questions

1. Market failures Diamond and Dybvig (1983) role for banks: Banks’ maturity transformation is welfare-enhancing (funds are channeled to higher return long-term investments rather than to lower return short-term assets). Banks provide depositors insurance against unexpected liquidity needs (improved economy’s risk-sharing opportunities). Banks are fragile as they are exposed to panics and/or information-based runs. A (liquidity) crisis impairs banks’ welfare-enhancing maturity transformation and risk-sharing services.

1. Market failures De Nicolò (1996) : no liquidity crisis if banks offer (almost ) complete deposit contracts (payoffs contingent on the occurrence of premature withdrawals of subsets of depositors) Allen and Gale (1998): liquidity crises can be part of an optimal arrangement even if deposit contracts are incomplete (changes in repayment terms following bank failures make the deposit contract effectively contingent on the realization of the “crisis” states).

1. Market failures Allen and Gale (2004a, 2004b) : If markets are incomplete, a liquidity crisis would force intermediaries to undertake fire sales of their long-term assets to honor debt holder claims. As a result, prices of long-term assets would fall below their fundamental values, leading to inefficient “fire-sales”, which would further threaten intermediaries’ ability to repay debt, thus leading to their insolvency. A key source of market failures is the incompleteness of financial markets.

1. Market failures Brunnermeier and Pedersen (2009), Brunnermeier and Sannikov (2014). Technological liquidity: degree of reversibility of investment in physical capital. Market liquidity : degree to which physical capital, or claims on its payoffs, can be traded with limited impact on their prices. Funding liquidity: related to maturity structure of debt and the sensitivity of the margins required for collateralized debt to variations in the value of collateral.

1. Market failures Liquidity crises arise from the interaction of liquidity mismatches between the technological and market liquidity on banks’ asset side, and the funding liquidity on banks’ liability side. Unexpected shocks leading to a fall in funding liquidity induces banks to recur to fire sales, which in turn cause a reduction in market liquidity of their assets. When banks’ assets are used as collateral for banks access to funding, decreased market liquidity and tighter funding liquidity amplify each other.

1. Market failures Summing up: Intermediaries’ investment and funding decisions fail to internalize the price effects and the amplification loops (fire sales externalities) leading to a liquidity crisis. Absent corrective policies, financial intermediaries take on excessive asset return risk and excessive liquidity mismatches, exposing themselves to excessive default and liquidity (rollover) risks.

2. Policies: Bhattacharya and Gale (1987): banks reliance on the liquidity provided by an interbank market leads them to under-invest in liquid assets. A central bank can design access to the LOLR if banks’ asset choices can be perfectly monitored. If they are not, access to the LOLR will need to be designed so as to prevent banks from free-riding on the liquidity facility (second best).

2. Policies: Rochet and Vives (2004): examine the role of LOLR policies, prompt corrective action, and liquidity requirements. Prompt corrective action is a necessary component of an efficient LOLR arrangement. Liquidity requirements can indeed prevent liquidity crises, but they are too costly in terms of forgone investment opportunities

2. Policies Stein (2012) : central bank policies in the presence of fire- sale externalities. A LOLR policy can be successfully implemented to stem the adverse effect of the liquidity crisis. In contrast to Rochet and Vives (2004), the LOLR might be more costly than liquidity regulation because of the need of tailoring ex-post interventions selectively due to the difficulty of distinguishing illiquidity from insolvency.

2. Policies Farhi and Tirole (2012): the efficiency of a LOLR policy depends on whether a central bank commits ex-ante to an incentive compatible set of rules determining banks’ access to liquidity facilities. If the terms of LOLR liquidity provision are perceived to be stringent, then each bank has the incentive to hold higher levels of short-term liquid assets or issue less short-term debt. However, a stringent LOLR policy set ex-ante might be expected by banks to turn more lenient in a liquidity crisis through the expansion of access to LOLR facilities.

2. Policies LOLR summing up: Need to design LOLR policies that integrate ex-ante regulatory tools capable of mitigating moral hazard and inducing banks to internalize fire sales externalities.

2. Policies Key objective: controlling bank default risk ex-ante. A classical regulatory instrument: capital regulation. There is a consensus about the rationales of capital regulation, but not yet a consensus about what an optimal design of capital requirements might be (see e.g. De Nicolò, 2015). Are liquidity requirements a necessary complement to capital regulation?

2. Policies Admati et al. (2013) suggest that capital requirements might be a substitute for liquidity requirements because:  Adequate bank capital would reduce the risk of information-based runs leading to liquidity crises.  Capital requirements would lower the cost of providing LOLR assistance by reducing the cost of distinguishing illiquidity from insolvency.  The social costs of capital regulation would be lower than those associated with liquidity requirements, by avoiding forcing banks to hold excessive levels of liquid assets. This mirrors the conclusion of Rochet and Vives (2004).

2. Policies De Nicolò, Gamba and Lucchetta (2014): a welfare and quantitative evaluation of capital requirements, liquidity requirements, and prompt corrective action in an infinite horizon model. Adding liquidity requirements to capital requirements reduces bank lending, efficiency, and welfare. A policy of prompt corrective action imposing capital requirements contingent on observed bank capitalization dominates standard non-contingent capital and liquidity requirements in terms of bank efficiency and welfare.

3. Costs of Basel III liquidity requirements Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NFSR) are predicted to have significant effects on bank business models and money markets The current consensus in the regulatory community is that these liquidity requirements have two key benefits: A. they give policy makers sufficient time to assess banks’ liquidity positions and arrange appropriate responses in times of stress, and B. force banks to maintain precautionary liquidity cushions limiting liquidity mismatches and funding liquidity risk. Yet, an assessment of the cost of these requirements on bank lending and real activity is still uncertain

3. Costs of Basel III liquidity requirements Based on a variety of models developed at central banks, MAG (2010) and Angelini et al. (2011) estimate a relatively small negative impact of liquidity requirements on lending and real activity. However, IIF (2011) and EBA Banking Stakeholder Group (2014) estimate significantly larger negative effects. De Nicolò, Gamba and Lucchetta (2014): the negative impact of liquidity requirements on lending, bank efficiency and welfare is relatively large.

Answers to the three key questions What are the market failures that may justify liquidity regulation? Broad consensus Is liquidity regulation a necessary complement to other policies, such as capital requirements, prompt corrective action, or provision of liquidity (LOLR)? No consensus yet What are the potential costs of liquidity regulation? No consensus yet