Leading crisis experts are trying to get our attention

When three of the economists most knowledgeable about the financial crisis of 2007-2008 start jumping up and down, waving their arms and shouting “fire!” … maybe we should listen?

That’s happening now.

Three prominent economists are calling for a solution to a danger thus far ignored by post-crisis reforms – a danger caused mainly by repos, asset-backed commercial paper, securities lending and derivatives* – and they’re warning central banks not to stop supporting the financial markets until reforms are in place.

The economists call the danger “liquidity risk,” which is the risk that a financial institution won’t be able to sell assets and raise enough cash or collateral to meet its obligations, and it will be forced into bankruptcy, as Lehman Brothers was.

Until regulators devise a structural solution to this problem, we’re trapped in a cycle of financial risk taking, government bailout, and then more risk taking encouraged by the bailout, the authors say.

So far, regulatory reform has targeted bank leverage and started to focus on too-big-to-fail. Yet there is still little public action on another proven source of systemic risk, namely liquidity risk …

Repos, ABCPaper, securities lending and derivatives carry liquidity risk in part because they’re short term, often just for overnight, and they’re collateralized. That means one party can suddenly demand its cash or securities back, or more collateral, or higher interest. This can quickly become a crisis throughout the financial markets if the other party is a giant institution that can’t meet the demands.

An example was in 2008, when repo lenders like JP Morgan demanded more cash or collateral from investment banks like Bear Stearns and Lehman Brothers, and the investment banks failed, or nearly failed, because they couldn’t sell enough securities – especially mortgage securities, which no one wanted to buy – to raise cash and meet the demands. They weren’t “liquid” enough.

Inadequate liquidity on the repurchase market was the crisis most responsible for the Federal Reserve’s dramatic intervention in the financial markets in 2008, according to Federal Reserve Chairman Ben Bernanke. Some economists have called it a run on the repurchase market.

Liquidity risk also underlies the current panic in Europe, say the three authors.

Experts have proposed solutions, and nations need to get moving on this, the authors write.

From the September 14 paper, “A consensus view on liquidity risk,” by Viral Acharya at New York University, Arvind Krishnamurthy at Northwestern University, and Enrico Perotti at University of Amsterdam:

Liquidity risk – which was at the heart of the September 2008 financial meltdown and explains regulatory concerns about a Greek default today – remains an open issue in financial regulatory reform. This column presents a consensus view of several leading academics on what more needs to be done to close this regulatory gap.

On 15 April 2011 a joint IMF-Financial Stability Board workshop gathered senior policymakers and academics in Washington to review the open issue of systemic liquidity risk. Some participating academics agreed to underwrite this common statement, in the belief that this regulatory gap, though intellectually well-recognised, still requires concrete attention.

There are clear and important lessons to be learned from the crisis of 2007-09. The crisis originated from bad credit, but was intensified by massive runs on financial intermediaries. Fire sales and a jump in perceived counterparty risk propagated losses across markets and economies, causing a systemic crisis.

According to the authors, two proven sources of liquidity risk are “unstable funding,” meaning mainly repos and ABCPaper but also securities lending,  and “contingent obligations such as derivatives.”

These liquidity risks are the same risks that face Europe in the current sovereign debt crisis, the authors write. Just as the Federal Reserve has had to inject trillions of dollars into the U.S. financial markets to keep credit flowing, so now must leaders in Europe.

In other words, central bankers and political leaders, and the taxpayers who stand behind them, are trapped in a cycle of bailouts. As long as the bailouts continue, so will the risk taking.  From the paper:

At this point, governments and central banks have been rendered hostages in any large potential default, inducing bailouts and forbearance. Ex post (after-the-fact) intervention in turn only reinforces the return to using such strategies.

That’s because taking risks with repurchase agreements, ABCPaper, securities lending and derivatives can be highly profitable for financial institutions. The authors note that the popularity of repurchase agreements and derivatives has skyrocked since 2005, when repo and derivative holders were given the special right in the U.S. and Europe to reposses collateral and resell it immediately if a counterparty filed bankruptcy. This exemption from having to share losses with other creditors added an attractive layer of safety to the contracts.

Steps taken thus far to address liquidity risk are not enough, according to the paper.

The Basel III liquidity proposals (such as the 30-day Liquidity Coverage Ratio and Net Stable Funding Ratio), if not weakened by industry pressure, would help, but are insufficient. They suffer from three weaknesses.

First, they focus on individual firm liquidity risk, not on systemic liquidity risk.

Second, they are not countercyclical.

And third, they do not target liquidity risk in the shadow banking system, in particular in repos and derivatives.

In addition to fixing these Basel III weaknesses, further action should include the following, according to the writers:

-Regulators need to measure liquidity risk system-wide, including the shadow banking system, not just at each financial institution.

-Regulators need to set limits or fees that fluctuate to offset liquidity risk  – for example, fees that rise when risk rises and fall when risk falls – to limit the use of “unstable funding” and “contingent obligations such as derivatives” during frothy times.

The authors conclude their paper by warning that central banks must stay available to pump cash into financial markets when needed, until ways are found to reduce liquidity risk:

Our intervention is meant to signal a broad academic agreement on this critical issue, which calls for a structural solution. In particular, the excessive reliance of intermediaries on destabilising funding and hedging strategies needs to be resolved ahead of central banks’ exit from their support operations.

The authors refer readers to the following papers which offer solutions:

Acharya, Viral V (2011), “A Transparency Standard for Contingent Liabilities such as Derivatives”, mimeo (presentation), New York University Stern School of Business.

Brunnermeier, Markus, Gary Gorton, and Arvind Krishnamurthy (2011), “Risk Topography”, NBER Macroannual 2011.

Brunnermeier, Markus, Gary Gorton, and Arvind Krishnamurthy, Liquidity Mismatch.

Perotti, Enrico (2010), “Systemic liquidity risk and bankruptcy exceptions”, VoxEU.org, 13 October.

Perotti, Enrico and Javier Suarez (2011), “The Simple Analytics of Systemic Liquidity Risk Regulation”, VoxEU.org, 16 March.

Perotti, Enrico and Javier Suarez (forthcoming), “A Pigovian Approach to Liquidity Regulation”, International Journal of Central Banking.

Shin, Hyun Song (2010), “Macroprudential Policies Beyond Basel III”, Policy memo.

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*Asset-backed commercial paper (ABCPaper) is a short-term, often overnight, collateralized IOU. Companies that pool loans and sell securities backed by the loans – that is, companies that securitize – often sell ABCPaper to help raise money for their operations.

Securities lending is a smaller cousin to the repo market, where financial institutions lend their stock holdings in return for cash.

The most dangerous derivatives during the crisis were credit default swaps. A financial institution could buy credit default swaps – from American International Group, or AIG, for example – to insure itself against borrowers defaulting on their mortgages, and the company selling the swaps had to post collateral to prove it could pay up if needed. Also, some companies pooled credit default swaps and sold securities backed by the swaps.