Dr. P.V. Viswanath
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The perils of a sudden evaporation of liquidity
Feb 11th 2010 | from the print edition of the Economist
STAMPEDING crowds can generate pressures of up to 4,500 Newtons per square metre, enough to bend steel barriers. Rushes for the exit in financial markets can be just as damaging. Investors crowd into trades to get the highest risk-adjusted return in the same way that everyone wants tickets for the best concert. When someone shouts “fire”, their flight creates an “endogenous” risk of being trampled by falling prices, margin calls and vanishing capital—a “negative externality” that adds to overall risk, says Lasse Heje Pedersen of New York University.
This played out dramatically in 2008. Liquidity instantly drained from securities firms as clients abandoned anything with a whiff of risk. In three days in March Bear Stearns saw its pool of cash and liquid assets shrink by nearly 90%. After the collapse of Lehman Brothers, Morgan Stanley had $43 billion of withdrawals in a single day, mostly from hedge funds.
Bob McDowall of Tower Group, a consultancy, explains that liquidity poses “the most emotional of risks”. Its loss can prove just as fatal as insolvency. Many of those clobbered in the crisis—including Bear Stearns, Northern Rock and AIG—were struck down by a sudden lack of cash or funding sources, not because they ran out of capital.
Yet liquidity risk has been neglected. Over the past decade international regulators have paid more attention to capital. Banks ran liquidity stress tests and drew up contingency funding plans, but often half-heartedly. With markets awash with cash and hedge funds, private-equity firms and sovereign-wealth funds all keen to invest in assets, there seemed little prospect of a liquidity crisis. Academics such as Mr Pedersen, Lubos Pastor at Chicago’s Booth School of Business and others were doing solid work on liquidity shocks, but practitioners barely noticed.
What makes liquidity so important is its binary quality: one moment it is there in abundance, the next it is gone. This time its evaporation was particularly abrupt because markets had become so joined up. The panic to get out of levered mortgage investments spilled quickly into interbank loan markets, commercial paper, prime brokerage, securities lending (lending shares to short-sellers) and so on.
As confidence ebbed, mortgage-backed securities could no longer be used so easily as collateral in repurchase or “repo” agreements, in which financial firms borrow short-term from investors with excess cash, such as money-market funds. This was a big problem because securities firms had become heavily reliant on this market, tripling their repo borrowing in the five years to 2008. Bear Stearns had $98 billion on its books, compared with $72 billion of long-term debt.
Even the most liquid markets were affected. In August 2007 a wave of selling of blue-chip shares, forced by the need to cover losses on debt securities elsewhere, caused sudden drops of up to 30% for some computer-driven strategies popular with hedge funds.
Liquidity comes in two closely connected forms: asset liquidity, or the ability to sell holdings easily at a decent price; and funding liquidity, or the capacity to raise finance and roll over old debts when needed, without facing punitive “haircuts” on collateral posted to back this borrowing.
The years of excess saw a vast increase in the funding of long-term assets with short-term (and thus cheaper) debt. Short-term borrowing has a good side: the threat of lenders refusing to roll over can be a source of discipline. Once they expect losses, though, a run becomes inevitable: they rush for repayment to beat the crowd, setting off a panic that might hurt them even more. “Financial crises are almost always and everywhere about short-term debt,” says Douglas Diamond of the Booth School of Business.
Banks are founded on this “maturity mismatch” of long- and short-term debt, but they have deposit insurance which reduces the likelihood of runs. However, this time much of the mismatched borrowing took place in the uninsured “shadow” banking network of investment banks, structured off-balance-sheet vehicles and the like. It was supported by seemingly ingenious structures. Auction-rate securities, for instance, allowed the funding of stodgy municipal bonds to be rolled over monthly, with the interest rate reset each time.
The past two years are littered with stories of schools and hospitals that came a cropper after dramatically shortening the tenure of their funding, assuming that the savings in interest costs, small as they were, far outweighed the risk of market seizure. Securities firms became equally complacent as they watched asset values rise, boosting the value of their holdings as collateral for repos. Commercial banks increased their reliance on wholesale funding and on fickle “non-core” deposits, such as those bought from brokers.
Regulation did nothing to discourage this, treating banks that funded themselves with deposits and those borrowing overnight in wholesale markets exactly the same. Markets viewed the second category as more efficient. Northern Rock, which funded its mortgages largely in capital markets, had a higher stockmarket rating than HSBC, which relied more on conventional deposits. The prevailing view was that risk was inherent in the asset, not the manner in which it was financed.
At the same time financial firms built up a host of liquidity obligations, not all of which they fully understood. Banks were expected to support off-balance-sheet entities if clients wanted out; Citigroup had to take back $58 billion of short-term securities from structured vehicles it sponsored. AIG did not allow for the risk that the insurer would have to post more collateral against credit-default swaps if these fell in value or its rating was cut.
Now that the horse has bolted, financial firms are rushing to close the door, for instance by adding to liquidity buffers (see chart 4). British banks’ holdings of sterling liquid assets are at their highest for a decade. Capital-markets firms are courting deposits and shunning flighty wholesale funding. Deposits, equity and long-term debt now make up almost two-thirds of Morgan Stanley’s balance-sheet liabilities, compared with around 40% at the end of 2007. Spending on liquidity-management systems is rising sharply, with specialists “almost able to name their price”, says one banker. “Collateral management” has become a buzzword.
Message from Basel
Regulators, too, are trying to make up for lost time. In a first attempt to put numbers on a nebulous concept, in December the Basel Committee of central banks and supervisors from 27 countries proposed a global liquidity standard for internationally active banks. Tougher requirements would reverse a decades-long decline in banks’ liquidity cushions.
The new regime, which could be adopted as early as 2012, has two components: a “coverage” ratio, designed to ensure that banks have a big enough pool of high-quality, liquid assets to weather an “acute stress scenario” lasting for one month (including such inconveniences as a sharp ratings downgrade and a wave of collateral calls); and a “net stable funding” ratio, aimed at promoting longer-term financing of assets and thus limiting maturity mismatches. This will require a certain level of funding to be for a year or more.
It remains to be seen how closely national authorities follow the script. Some seem intent on going even further. In Switzerland, UBS and Credit Suisse face a tripling of the amount of cash and equivalents they need to hold, to 45% of deposits. Britain will require all domestic entities to have enough liquidity to stand alone, unsupported by their parent or other parts of the group. Also controversial is the composition of the proposed liquidity cushions. Some countries want to restrict these to government debt, deposits with central banks and the like. The Basel proposals allow high-grade corporate bonds too.
Banks have counter-attacked, arguing that “trapping” liquidity in subsidiaries would reduce their room for manoeuvre in a crisis and that the buffer rules are too restrictive; some, unsurprisingly, have called for bank debt to be eligible. Under the British rules, up to 8% of banks’ assets could be tied up in cash and gilts (British government bonds) that they are forced to hold, reckons Simon Hills of the British Bankers Association, which could have “a huge impact on business models”. That, some argue, is precisely the point of reform.
Much can be done to reduce market stresses without waiting for these reforms. In repo lending—a decades-old practice critical to the smooth functioning of markets—the Federal Reserve may soon toughen collateral requirements and force borrowers to draw up contingency plans in case of a sudden freeze. Banks that clear repos will be expected to monitor the size and quality of big borrowers’ positions more closely. The banks could live with that, but they worry about proposals to force secured short-term creditors to take an automatic loss if a bank fails.
Another concern is prime brokerage, banks’ financing of trading by hedge funds. When the market unravelled, hedge funds were unable to retrieve collateral that their brokers had “rehypothecated”, or used to fund transactions of their own; billions of such unsegregated money is still trapped in Lehman’s estate, reducing dozens of its former clients to the status of unsecured general creditors. Brokers suffered in turn as clients pulled whatever funds they could from those they viewed as vulnerable. Temporary bans on short-selling made things even worse, playing havoc with some hedge funds’ strategies and leaving them scrambling for cash. Regulators are moving towards imposing limits on rehypothecation.
Early reform could also come to the securities-lending market, in which institutional investors lend shares from their portfolios to short-sellers for a fee. Some lenders—including, notoriously, AIG—found they were unable to repay cash collateral posted by borrowers because they had invested it in instruments that had turned illiquid, such as asset-backed commercial paper. Some have doubled the share of their portfolios that they know they can sell overnight, to as much as 50%.
Regulators might consider asking them to go further. Bond markets, unlike stockmarkets, revolve around quotes from dealers. This creates a structural impediment to the free flow of liquidity in strained times, argues Ken Froot of Harvard Business School, because when dealers pull in their horns they are unable to function properly as market-makers. He suggests opening up access to trade data and competition to quote prices. Some senior figures at the Fed like the idea, as do money managers, though predictably dealers are resisting.
The other brutal lesson of the crisis concerns the way liquidity can affect solvency. In a world of mark-to-market accounting, a small price movement on a large, illiquid portfolio can quickly turn into crippling paper losses that eat into capital. Highly rated but hard-to-shift debt instruments can finish you off before losses on the underlying loans have even begun to hurt your cash flows. If markets expect fire sales, potential buyers will hold off for a better price, exacerbating fair-value losses.
In future banks will be more alert to these dangers. “We were looking at the bonds we held, focusing on the credit fundamentals. We lost sight of the capital hit from illiquidity and marking to market that can seriously hurt you in the meantime,” says Koos Timmermans, chief risk officer at ING, a large Dutch banking and insurance group. “We now know that you have to treat the accounting reality as economic reality.”
Another lesson is the “opportunity value” of staying liquid in good times, says Aaron Brown, a risk manager with AQR, a hedge fund. In an efficient market dollar bills are not left lying around. But in the dislocated markets of late 2008 there were lots of bargains to be had for the small minority of investors with dry powder.
For some, though, bigger liquidity problems may yet lie ahead. Some $5.1 trillion of bank debt rated by Moody’s is due to mature by 2012. This will have to be refinanced at higher rates. The rates could also be pushed up by an erosion of sovereign credit quality, given implicit state guarantees of bank liabilities. And, at some point, banks face a reduction of cut-price liquidity support from central banks—offered in return for often dodgy collateral—which has buoyed their profit margins. Mortgage borrowers on teaser rates are vulnerable to payment shock. So too are their lenders.