Liquidity and Transparency in Bank Risk Management Lev Ratnovski Bank of England & University of Amsterdam

2June 2007Ratnovski: Liquidity and Transparency 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

3June 2007Ratnovski: Liquidity and Transparency Liquidity and Transparency Two ways to manage liquidity risk:  Liquidity buffer of short-term assets  Transparency mechanisms that facilitates communication of solvency info  enable refinancing Both - strategic ex-ante decisions Optimal choices, interaction, policy implications

4June 2007Ratnovski: Liquidity and Transparency 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

5June 2007Ratnovski: Liquidity and Transparency 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

6June 2007Ratnovski: Liquidity and Transparency 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

7June 2007Ratnovski: Liquidity and Transparency Policy Solvency is not enough  Asymmetric info  Liquidity risk Liquidity regulation  If incorrect, can compromise transparency  Extra emphasis on transparency beneficial

8June 2007Ratnovski: Liquidity and Transparency 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

9June 2007Ratnovski: Liquidity and Transparency 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. 1–s 0 w.p. s (s small) A bank does not borrow more than 1 at date 0

10June 2007Ratnovski: Liquidity and Transparency Intermediate Refinancing – date 1 Random withdrawal, L<1 or 1 w.p. ½  Uninformed depositors  Maturing term liabilities Noisy solvency signal  Fundamentals: solvent 1–s, insolvent s solvent  Probability 1–s–q: correct signal “solvent” Outsiders willing to refinance possibly insolvent  Probability s+q: “possibly insolvent” High posterior insolvency s /(s+q) > s Outsiders unwilling to refinance, incl q solvent banks

11June 2007Ratnovski: Liquidity and Transparency 1–s–qsq InsolventSolvent 1–s Positive signal, known solvent Solvent, but unable to refinance Negative signal, pooled together s

12June 2007Ratnovski: Liquidity and Transparency 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 t<1  Partial insurance against any shocks

13June 2007Ratnovski: Liquidity and Transparency Transparency Effectiveness t  Probability of successful communication  Exogenous to bank’s decision Determinants  Financial development  Market size / liquidity  Other banks – externalities (Admati and Pfheiderer, 2000) or coordination

14June 2007Ratnovski: Liquidity and Transparency 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

15June 2007Ratnovski: Liquidity and Transparency Distortion Banks are leveraged  Can under-invest in both liquidity and transparency Alternative set-ups possible (LOLR rents or systemic externalities)

16June 2007Ratnovski: Liquidity and Transparency Regulation Liquidity is verifiable  impose ratios Transparency  ? Multi-tasking Liquidity requirements can compromise transparency choices  Impose “too much” liquidity on transparent banks, get liquidity only & exposure to larger shocks

17June 2007Ratnovski: Liquidity and Transparency Contribution Novel model of liquidity risk Closest: Chari and Jagannathan, 1988  Consumer runs under asymmetric information  Uninformed observe a withdrawal May be not information-based Amplification of liquidity withdrawals  No refinancing Our approach  Wholesale funding under asymmetric information  Downplay withdrawals: Known 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

18June 2007Ratnovski: Liquidity and Transparency 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

19June 2007Ratnovski: Liquidity and Transparency Main results Banks may combine liquidity buffers and transparency investments in risk mgmt Liquidity fully insures small shocks; Transparency partially all shocks Both may be compromised by leverage; Regulation complicated by multitasking Lessons for liquidity regulation  If incorrect, can compromise transparency  Important that thoroughly designed  May require extra emphasis on transparency

20June 2007Ratnovski: Liquidity and Transparency 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