Liquidity risk surcharges as a macroprudential tool

Time: 2012, Thursday March 15, 13.00-14.00 hours
Location: CPB-office, Van Stolkweg 14, The Hague

Presentation: Enrico Perotti (UvA)

Discussant: Andrei Dubovik (CPB)

Language: English

Registration:  Please register by sending an email to polinars@cpb.nl.

Abstract subject: The recent financial crisis was unprecedented in scale and speed of propagation. A well recognized reason is that the original shock (started in US real estate funding structures heavily distorted by regulatory arbitrage) was severely compounded by the extreme funding fragility built up by banks. Bank risk absorbing capacity had been reduced not just by lower capital buffers, but by extremely short term funding. The panic withdrawals of wholesale short term investors propagated and compounded losses as it forced massive distress sales. These in turn caused rapid asset price declines, triggered further margin calls and thus more fire sales across markets. The resulting uncertainty undermined access to new financing, leading to inefficiently rapid deleveraging. After wholesale money markets had been severely dysfunctional for over a year, barely contained by massive liquidity provision, practically all uninsured bank liabilities had to be bailed out after panic broke out in September 2008. The crisis led to a consensus on the need to control propagation risk. We propose  a new macro prudential tool, liquidity risk charges, to discourage liquidity risk creation by banks. The charges target liability risk, so they need to be complemented by other reforms, such as capital requirements, aimed at asset risk. The proposal has been extensively debated, and is currently receiving substantial attention by policymakers engaged in defining macro prudential policy. We refine the proposal, addressing a number of frequently asked questions, and offer more implementation details.

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