- The public policy case for regulation is very weak. The two arguments raised for regulating liquidity are flawed and I will address them in my submission.
- The diversity of business models in the NBDT sector make a diverse range of liquidity management policies appropriate, including definitions, indicators and levels of liquidity risk. This makes the option of 'Prescribing a measurement framework' inappropriate.
- Imposing quantitative liquidity requirements would be ineffective, or competitively non-neutral, and/or overly complex, and this option should be decisively rejected.
- The particular quantitative liquidity requirements and indicators presented in the consultation document as an illustration from the regulations for registered banks, are flawed and inappropriate for the NBDT sector. I will criticise these indicators in my submission.
During this period [of stress], finance companies within the consumer financing sector have shown some success in their ability to meet deposit outflows with matching maturities of their loan book. However, finance companies within the property financing sector have been more vulnerable to liquidity shortfalls as their loan book assets have proven to be highly illiquid in a stressed market. Saving institutions have generally held high levels of depositor confidence and accordingly liquidity has been managed by the reliance on high levels of reinvestment.
- Where the institution's solvency and asset quality are not in question, there is no need for high levels of liquid assets or long term funding, because the institution can retain the confidence of its depositors, experiences no runs, and is able to roll over its liabilities in the normal course of business.
- Where the institution's solvency or asset quality are in question, even high levels of liquid assets or long term funding are ineffective in preventing runs and the demise of the institution, they just slow them down a little.
'(a) promoting the maintenance of a sound and efficient financial system; or
(b) avoiding significant damage to the financial system that could result from the failure of a deposit taker'?
'The main argument here is that the failure of a deposit taker in benign times due to a sudden large liquidity shock could significantly affect confidence in similar entities. A deposit taker’s management would not typically factor this public cost into their decision on how much to spend on liquidity protection, and as a result prescription of liquidity requirements could provide reasonable comfort that the degree of liquidity risk would be lower than it would be without intervention.'
But bank failures were almost never contagious, or prone to spread to sound banks, for several reasons. Each bank tried to maintain an identity distinct from its rivals, and was able to do so when it was not compelled by any regulation to hold a similar asset portfolio. Depositors then had no reason to infer from troubles at one bank that the next bank was in trouble. Banks were generally well capitalized, so that fear of insolvency was remote.
We can contrast this conceptual situation with the recent sustained period of stress that finance companies experienced, where liquidity management for the most part proved adequate except for vulnerabilities in relation to property financing companies. The main difference here is that, in the recent period, the stress developed over time allowing deposit takers the time to respond and manage stresses as they developed. Another crucial difference is that the stress mainly affected the finance company sector where the long term nature of funding prevented large scale withdrawals of call funding. This argument would suggest that there is potential for NBDTs’ appetite for liquidity risk to be higher than socially optimal in normal times (unlike the current period), but it is not immediately obvious that it has been, or if it was, significantly so.
- During the recent period of stress, most finance companies appear to have had adequate liquidity positions.
- During the recent period of stress, the stress developed slowly, allowing more opportunity for management responses.
- During the recent period of stress, mainly finance companies suffered.
- Finance companies had mostly long term funding.
- Therefore: there is potential for NBDTs’ appetite for liquidity risk to be higher than socially optimal in benign times (unlike the recent period of stress)
- There is no theoretical or analytical reason to suspect that there could be a problem,
- There is no evidence that there has been a problem recently, and
- There is no evidence that any future potential problem is likely to be realised.
'Prescribed liquidity requirements can also be justified from the purpose of NBDT prudential regulation more generally, that is, to avoid significant damage to the financial system that could result from the failure of a deposit taker. While NBDTs are not systemic to the financial system, they are systemic to a local group of similar entities. Since similar entities have similar business models (particularly in terms of lending) the failure of an entity would have an impact on the availability of funding to particular segments of the economy.'
- Quantitative liquidity requirements are prudential regulations
- Prudential regulations have the purpose of avoiding significant damage to the financial system resulting from financial institution failures
- NBDTs are not systemic to the financial system
- NBDTs may be systemic to a group of similar entities
- Similar NBDT entities have serve similar borrowing customers, who serve particular segments of the economy, could suffer liquidity problems at the same time, causing reduced access to funding for that segment.
- Therefore, quantitative liquidity requirements on NBDTs are justified.
- Most credit institution failures are caused by credit risk (i.e. too many bad loans)
- Credit institutions with the highest credit losses suffer them primarily as a result of lower efficiency (e.g. less effective credit control processes and systems) and worse management (e.g. poor credit judgement)
- Information about lower efficiency, poor management and higher past and prospective credit losses causes depositors and other funding providers to withdraw or not roll over funding, causing liquidity problems for the institution.
- Higher required liquidity positions give the institution and its management more time to manage the institution, before they are replaced.
- Therefore, higher required liquidity positions has the effect of putting resources in less efficient institutions and under poor management for longer, worsening the social costs of such inefficiency and poor management.
To manage that risk, banks can accumulate liquid assets, or enhance transparency to facilitate refinancing. A liquidity buffer provides complete insurance against small liquidity needs, while transparency offers partial insurance against large ones as well. ...Liquidity requirements can compromise banks endogenous transparency choices, leaving them exposed to large shocks. Liquidity risks can increase in response to seemingly more stringent regulation.
Dr. Ratnovski's conclusion holds because the expected benefits from transparency are reduced by higher liquidity ratios. Mandating higher liquidity ratios should therefore be expected to cause better capacity to handle small liquidity shocks, and reduced capacity to handle large liquidity shocks. Wouldn't it be better to address the cause of the risk, i.e. increase the incentive of the institution to invest in improving their capacity to credibly signal their solvency? Institutions could do this by, for example, having more transparent assets, more frequent release of financial accounts, having a more credible trustee and auditor, having a higher capital ratio or having lower risk assets -- the point is that there are complex trade offs between these different approaches, and regulators have no way to judge the merits of the different approaches, which require trial and error, market selection and evolution instead.
However, as stated above, the economic argument for precise quantitative liquidity requirements is not as strong as the case for capital or related party requirements, and issuing further non-binding guidelines could potentially address some of the current liquidity issues. In this case there are still arguments for prescriptive requirements to be set to achieve consistency across the sector and to prevent liquidity management presenting relative competitive advantages or disadvantages across the sector. Short of prescribing quantitative liquidity requirements, prescribing measurement frameworks could also achieve some amount of consistency across the sector and could fill gaps identified in the current framework.
Do you agree that consistency of measurement frameworks for key liquidity constructs across the NBDT sector is advantageous?
Are there any other matters the Reserve Bank should take into consideration when considering prescribing a liquidity risk measurement or management framework?
- the inherent complexity of managing liquidity risk
- the subjectivity inherent in measuring future potential cash flows
- the difficulty of determining the relevant future scenarios to plan for
- the inherent limitation of any liquidity indicator or indicators, and
- the futility of good liquidity management in addressing institutional insolvency.
To support my 5 points above consider what liquidity risk is and how it can be measured. Liquidity risk is the risk that the institution will run out of cash in the future. What happens in the future depends on future conditions, future perceptions, and future actions taken by the institution's counterparties. The future is unknown, so the best we can do is make a load of assumptions that institutions, managers, supervisors and others can debate and discuss or perhaps come to some kind of compromise that will inevitably turn out to be flawed. This makes regulation of liquidity risk by way of cash flow modeling very troublesome. Regulators can therefore be tempted to avoid the use of cash flow modeling and use liquidity indicators instead. Liquidity indicators are basically accounting ratios that can be more easily measured, because they are measuring the present rather than the future, but provide a limited and flawed measure of liquidity because they ignore the future cash flows that determine whether or not the institution actually runs out of cash. The most important limitation of liquidity ratios is that they are totally ineffective at curing the majority cause of institutional failure: insolvency.
As a result of considering these factors the RBNZ should appreciate that imposing a measurement framework or suite of indicators is will:
- Not be an effective method of promoting the purposes of the Reserve Bank Act (i.e. an efficient financial system and avoiding significant damage to the financial system)
- Be a risky, costly policy that will have very limited benefits. The benefits are likely to be small in relation to the costs.
'37 Our preliminary analysis suggests that many of the larger NBDTs would easily exceed the ratio requirements calibrated for locally incorporated banks. This result is unsurprising given NBDTs’ reliance on retail funding compared with banks. Other obvious differences between NBDTs and banks which would require different calibrations in the policy are the assumptions around reinvestment rates of retail term funding and the accessibility of committed lines.
- If imposed on the same basis as on registered banks, they would be non-binding and therefore achieve no liquidity increase effect, and therefore be bad public policy.
- If imposed at a higher level, as might be appropriate for many but not all NBDTs, it would be competitively non-neutral, and therefore bad public policy. It would also give a false comfort to investors, institutions and trustees, and make them less likely to independently assess their policies, and this also makes it bad public policy.
- If imposed at different levels within the different business models in the NBDT sector, it becomes very complex, and even more competitively non-neutral, and therefore bad public policy.
The calibration of quantitative liquidity requirements, should the RBNZ be determined to impose them on the NBDT sector, should take into account:
- The possibility that a long term liability may become due early due to credit rating downgrade or breach of financial covenants such as interest coverage. For example, South Canterbury Finance US Private Placement Notes became repayable on demand when the company's credit rating was downgraded, which resulted in it running out of cash. I suggest that any long term funding measure be not subject to early repayment other than in the case of receivership or liquidation of the institution.
- The security ranking of funding. To qualify as long term funding, the funding should be unsecured or should rank equally with the principal class of debenture stock.
- Availability of unused allowances for prior charges. These can be utilised in times of stress, and many stressed and failed NBDTs have used such allowances to delay running out of cash despite failing due to insolvency.
- The liquidity that can be provided from supposedly illiquid assets such as loans and advances. These can provide liquidity by way contractual repayments, securitisation or use as security for borrowings, or by way of sale of senior tranches. I suggest that impaired and past due assets be excluded from any such measure.