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Liquidity and Transparency in Bank Risk Management. Lev Ratnovski Bank of England & University of Amsterdam. Liquidity Risk. A solvent bank cannot refinance Stylized facts (recent events) Solvency concerns 1991, Citibank and Standard Chartered (HK) 1998, Lehman Brothers

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liquidity and transparency in bank risk management

Liquidity and Transparencyin Bank Risk Management

Lev Ratnovski

Bank of England & University of Amsterdam

liquidity risk
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

Ratnovski: Liquidity and Transparency

liquidity and transparency
Liquidity and Transparency
  • Two ways to manage liquidity risk:
    • Liquidity

buffer of short-term assets

    • Transparency

mechanisms that facilitates communicationof solvency info  enable refinancing

  • Both - strategic ex-ante decisions
  • Optimal choices, interaction, policy implications

Ratnovski: Liquidity and Transparency

strategic 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

Ratnovski: Liquidity and Transparency

main results
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

Ratnovski: Liquidity and Transparency

policy
Policy
  • Solvency is not enough
    • Asymmetric info  Liquidity risk
  • Liquidity regulation
    • If incorrect, can compromise transparency
    • Extra emphasis on transparency beneficial

Ratnovski: Liquidity and Transparency

set up
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

Ratnovski: Liquidity and Transparency

economy
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

Ratnovski: Liquidity and Transparency

intermediate refinancing date 1
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
    • Probability 1–s–q: correct signal “solvent”

Outsiders willing to refinance

    • Probability s+q: “possibly insolvent”

High posterior insolvency s /(s+q) > s

Outsiders unwilling to refinance, inclqsolvent banks

Ratnovski: Liquidity and Transparency

slide10

Solvent1–s

Insolvent

s

Negative signal,pooled together

Positive signal, known solvent

1–s–q

q

s

Solvent,but unableto refinance

Ratnovski: Liquidity and Transparency

hedging
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

Ratnovski: Liquidity and Transparency

optimal choices
Optimal choices
  • Liquidity and transparency are costly hedges
  • When costs are sufficiently low…
  • Banks can optimally combineliquidity and transparency in risk management
    • Liquidity – small shocks, complete
    • Transparency – large shocks, partial

Ratnovski: Liquidity and Transparency

distortion
Distortion
  • Banks are leveraged 
  • Can under-invest in bothliquidity and transparency
  • Alternative set-ups possible(LOLR rents or systemic externalities)

Ratnovski: Liquidity and Transparency

regulation
Regulation
  • Liquidity is verifiable  impose ratios
  • Transparency ?
  • Multi-tasking
  • Liquidity requirements can compromisetransparency choices
    • Impose “too much” liquidity on transparent banks,get liquidity only & exposure to larger shocks

Ratnovski: Liquidity and Transparency

contribution
Contribution
  • Novel model of liquidity risk
  • Closest: Chari and Jagannathan, 1988
    • Consumer runs under asymmetric information
    • Uninformed observe a withdrawalMay be not information-basedAmplification 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

Ratnovski: Liquidity and Transparency

main results1
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

Ratnovski: Liquidity and Transparency