liquidity ridge summer school montevideo, december 2015 ridge summer school december 20151

RIDGE SUMMER SCHOOL DECEMBER 2015 1

LIQUIDITY

RIDGE SUMMER SCHOOLMontevideo, December 2015


Contents

1. Motivation2. Holmstrom-Tirole approach3. Cash in the Market and Asset Fire Sales4. Interbank Market and Banks’ Liquidity5. Lender of Last Resort


Motivation: the 2007 liquidity crash

• Collapse of market liquidity with the so-called « toxic assets ».

• Freeze of the interbank market.• Increased liquidity hoarding by banks.


Liquidity freeze

5

The Freezing of the interbank market

• No pure liquidity risk: counterparty risk increases too.


Haircuts

RIDGE SUMMER SCHOOL DECEMBER 2015

Holmstrom-Tirole liquidity shocks

• Firms invest at time t=0• Face a cost overrun/liquidity shock at time t=1, if

liquidity is not injected it implies a zero return• Projects mature at time t=2• No aggregate shock: firms invest in cash and at time

t=1 there is a market for the liquid asset.• Aggregate supply shocks implies “cash in the

market”

7


Holmstrom Tirole (II)

• Firms’ managers may choose a project with negative net present value and private benefits if leverage is too high. This implies there is a limit to the firms’ leverage and size.

• The market solution is inefficient because of the lack of commitment of private investors.

8


Holmstrom Tirole (III)

• Case 1: no aggregate liquidity shock– If firms can carry liquidity at no cost the second

best is reached. If this is not the case, the second best cannot be reached by holding securities on other firms.

– Credit lines allow to reach the second best, which justifies the existence of banks.

• Case 2: aggregate liquidity shock– The Treasury is able to provide liquidity because it

can tax future generations


Cash in the Market and Asset Fire Sales

A simplified approach assumes a segmented market with limited resources, M, from investors.

If S is the supply of assets, in equilibrium, p.S=M, for p below some threshold.


Liquidity and cash in the market

• Acharya and Yorulmazer (2008)• n banks• A number k (k<n) of banks fail • These banks sell their assets to the surviving ones• Their cash determines the price of the banks’ assets


Acharya and Yorulmazer results

• Banks’ available liquidity is limited and depends upon the number of banks failing. This will determine the asset price as a function of k.

• If there is not enough cash outsiders may buy the banks’ assets and put the assets to an inefficient use

• Bailouts are justified.


Banks’ optimal selling policy

• Diamond and Rajan(2011) raise the question: why don’t banks prefer to liquidate their assets during the previous period.

• They show that solvent banks prefer to do so; banks in distress are better off by taking the risk of becoming illiquid.


Haircuts

Initial 5% haircutSubsequent 10 % haircut

ASSETS LIABILITIES ASSETS LIABILITIES

ABS 100 REPO 95 ABS 50 REPO 45EQUITY 5 EQUITY 5

100 100 50 50

14


Repo borrowing and price drops

15


Brunnermeier and Pedersen• Cash in the market leads to asset price volatility.• Could be mitigated by funding liquidity.• Speculators (Investment banks) need access to funding to

intervene in the markets. They get these funds through repos• Margins (Haircuts) are set so as to preserve a given value-at-risk

(therefore they depend on volatility that depends upon shocks to fundamentals) they depend upon the volatility of the assets

• Total value of margins on their positions cannot exceed their capital

• Limited access to credit by speculators implies that prices diverge from fundamentals.


Liquidity Spirals

17


Interbank Market and Banks’ Liquidity

1. The basic Diamond-Dybvig-Bhattacharya-Gale model

2. Interest rate formation3. Unsecured interbank market freeze4. Secured interbank market freeze


Bhattacharya and Gale(1987)

• No aggregate risk, but bank idiosyncratic liquidity risk related to the random amount of withdrawals at time t=1.

• If banks operate in isolation, the bank can only offer contracts contingent on its own liquidity shocks

• The creation of an interbank market allows to restore efficiency.

20

Generalizing Bhattacharya and Gale• Freixas, Martin & Skeie (2010)• Consider a probability ρ of idiosyncratic liquidity shocks.• For ρ=0 Diamond Dybvig obtains• For ρ=1 Bhattacharya and Gale obtains• In between a continuum of REE because of the

inelasticity of demand and supply in the interbank market.

• The efficient equilibrium is characterized by a low level of interest rate in the liquidity crisis state.

• Implications for monetary policy in a (2007) liquidity crisis

21

Allen and Gale

• Build upon Bhattacharya and Gale (87)• Case 1: Zero aggregate risk – To prevent unnecessary liquidation banks make cross

deposits or commit to lend– This allow banks to hold less liquid assets

• Case 2: With zero probability there is aggregate risk– The aggregate amount of liquidity is insufficient: systemic

risk• Distinguish different financial architectures

22

Freixas Parigi Rochet (2000)

• Concern on systemic risk• Is a liquid interbank market a sufficient

guarantee against a liquidity crisis affecting one institution? Or should the LOLR step in?

• What are the determinants of contagion through the interbank market?

• Two solutions: the efficient one and the “gridlock solution”

23

EXAMPLES OF « TRAVEL PATTERNS » (MATRIX T)

CREDIT CHAINS

DIVERSIFIED LENDING

MONEY CENTER BANK

1312312 ttt

jitij 2

1

2

11

1213

2131

tt

tt

1

23

1

23

1

23

24

Rochet and Vives (2004)

• The liquidity coordination problem: banks have different opinions about other banks solvency.

• Banks are willing to lend to solvent banks provided they don’t have a strategic risk stemming from other agents withdrawing

• Use the Van Damme Morris-Shin global games approach that allows to solve for coordination within a game.

25

Rochet and Vives results

• In equilibrium there exists a critical value of banks’ assets such that, whenever the value of the bank’s assets falls below this threshold, the banks will not have access to liquidity.

• This threshold is above the solvency threshold.

26

Asymmetric Information and Interbank Market Structure

• Freixas and Holthausen (2004)• Motivation– Understanding Europe Money Markets integration– Understanding external debt crises in emerging

countries (Tequila crisis, East Asian crises)

27

Asymmetric Information

• Countries/Regions Assumption:– better soft information about domestic borrowers

• Questions:– Can an integrated market always emerge?– Compare the combined role of repo and

unsecured markets

28

Country H Country L

(sG,sG)

(sB,sG)

(sG, sB)

(sB, sB)

H-captive

L-captive

No credit

1-

29

Equilibrium (II)• Result:– Segmentation ( = 0) is always an equilibrium– Multiplicity of equilibria possible– For some parameters only the segmented

equilibrium exists

30

Liquidity Dry-ups

• Malherbe (2014)• Banks cover their liquidity needs with T-Bills or

with the interbank market• Adverse selection in the interbank market• Multiplicity of equilibria

Liquidity and information sensitive assets

• Why the toxic assets illiquidity of 2007?• Is transparency required for markets to

function?• Dang Gorton and Holmstrom argue the issue

is adverse selection• Distinguish: information insensitive debt vs.

Information sensitive debt.

31


Dang, Gorton and Holmstrom

• Motivation: complexity of ABS prior to the crisis

• Opacity need not prevent trading• Adverse selection leads to a collapse of the

market because of the Akerlof result (market for lemons)

• Implication: distinguish information insensitive securities from information sensitive securities


Dang Gorton Holmstrom

Asset value

Information sensitive Information insensitiveDensity

DebtHoldersreturn


Lender of Last Resort

RIDGE SUMMER SCHOOL DECEMBER 2015 3535Diagram 1: Central bank total liabilities

Liquidity Injection


Monetary policy rates(USA, UK, EUR, JAP, SWT)

-0,50

0,50

1,50

2,50

3,50

4,50

5,50

6,50

Jun-

07

Jul-0

7

Jul-0

7

Aug-

07

Sep-

07

Oct

-07

Nov

-07

Dec

-07

Jan-

08

Feb-

08

Mar

-08

Apr-

08

May

-08

Jun-

08

Jul-0

8

Aug-

08

Sep-

08

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb-

09

Perc

enta

ge p

oint

s

Switzerland (Lowe Bound) USA UK Japan Euro

Diagram 2

Interest Rates Policy


New Channels for Liquidity Injection

• In the Eurozone– Broadening of the class of assets that can be

used as guarantees in repo operations.– LTRO: ECB buys sovereign bonds.

• In the US: three types of targets1. Banks liquidity provision (TAF, TSLF, PDCF).2. Final user liquidity provision (TALF, CPFF,

MMIFF).3. Long term Debt acquisition.

38

Bagehot’s rules

• Only illiquid solvent institutions should have access to credit

• Loans should be made against good collateral at a penalty rate

• This rules should be made public

39

Are these rules realistic?

• Goodhart(1985, 1987) asserts that the distinction between illiquidity and insolvency is a myth

40

Goodfriend and King

• LOLR only at the aggregate level through open market operations

• Unsecured interbank market will then redistribute liquidity to illiquid solvent banks

• This implies market discipline• Humphrey (1984) argues this would be

Bagehot position today

41

Central banks: Liquidity provider or Crisis manager?

• Bagehot, Allen and Gale: because of the risk of aggregate illiquidity, the Central Bank has a monetary policy role.

• Rochet and Vives(2004), FPR(2004), role as lender of last resort to solve market inefficiency.

Central banks: : Liquidity provider or Crisis manager? (II)

• FPR (2000), because of the risk of gridlock the Central Bank has a coordinating role as crisis manager and liquidity provider

• FPR (2000) because bank closure may lead to contagion, role in the orderly closure of the insolvent bank.

42


Maturity mismatch and the Central Bank put

• Farhi and Tirole (2010) on collective moral hazard.• What are the incentives of Central bank liquidity

injection on banks portfolio (liquidity) decisions? • What are the banks’ decisions?– Banks strategies regarding their holding of a liquid

asset are strategic complements.– Two equilibria emerge: one with banks holding

liquidity and the other with banks expecting to be bailed out by a generous monetary policy.

liquidity ridge summer school montevideo, december 2015 ridge summer school december 20151

Documents