This year’s 2012 Atlanta Federal Reserve Financial Markets Conference was aptly titled, “Financial Reform: The Devil’s In the Details” in light of the flurry of activity going on these days at regulatory agencies charged with implementing various aspects of Dodd-Frank.
Among the topics covered were issues related to mortgage finance, shadow banking and the role of maturity transformation in promoting the crisis and how liquidity regulation may impact this natural role of financial institutions. At the session on maturity transformation, I took a somewhat contrarian position that maturity transformation is easy to disparage at first glance, but going with the theme of the conference, the devil is in the details on this issue. AtlantaFedMatTransCVRApril2012 The simple answer is that excessive risk-taking and the associated growth of risky mortgage products and securities adversely impacted the maturity transformation process that has worked effectively over time. But it seems that the financial crisis has brought about a natural inclination to find fault with many of the most basic financial processes and with it a tendency to seize on some form of corrective action. It certainly makes us all feel better when we are able to show that we have fixed a process. In many instances, however, we are treating the symptom and not the disease.
For context, in a 2009 speech by New York Fed President William Dudley, he acknowledged that maturity transformation, i.e., the tendency for banks to transform relatively shorter-term funding sources into longer-term assets is a natural and expected part of what commercial banks do. http://www.newyorkfed.org/newsevents/speeches/2009/dud091113.html
Under normal market conditions, banks tend to use insured deposits augmented where needed with other funding sources for their asset generation activities. But two issues arose in the years before the crisis that ultimately led to greater risks to the maturity transformation process. First, the form and substance of funding alternatives morphed a bit over time such that it contributed to the liquidity crunch that ensued in 2007. An increase in the use of residential mortgages and related securities with longer durations as collateral over shorter-term forms of collateral amplified the maturity transformation process. Examples of this include asset-backed commercial paper (ABCP) and its attendant uses for funding longer-term assets, getting away from more traditional funding of customer trade receivables with shorter durations, for example. In addition, the tri-party repo market made greater use of whole loans and non-investment grade asset-backed securities that ran into liquidity issues later on. And of course the money market mutual funds (MMMFs) experienced greater volatility under stress from exposures to various investments such as Lehman commercial paper. To be sure, commercial banks bear responsibility in financing so-called shadow banking activities by allowing these entities (e.g., special purpose vehicles, ABCP conduits, MMMFs, etc. not to be confused with the financing of shadow bank entities) to leverage the embedded put option of deposit insurance as well as bank access to Fed liquidity sources.
But along the way, the residential mortgage asset bubble accentuated the traditional maturity transformation process by embedding in it significant credit risk due to product morphing via tremendous asset risk layering. As residential mortgages and associated securities gained in popularity among banks and nonbanks, it further widened the duration gap (absent interest rate risk hedging activities) and thus set the stage for problems in maturity transformation ultimately leading to a liquidity crisis. Mortgage product morphing and the advent of various nontraditional mortgages such as negatively amortizing option ARMs and piggyback second lien products along with aggressive production targets added pressure on the maturity transformation process by requiring banks to augment insured deposits with non-deposit funding sources. These shifts in the traditional maturity transformation process facilitated problems later on as markets became unhinged and funding sources evaporated literally overnight. Banks were relatively unaware of the implications of these activities at a system-level and were effectively caught off-guard on how they would manage this risk.
Unfortunately one lesson learned the hard way in the crisis is that the banking sector vastly underestimated the significance of liquidity risk exposure. We all went through the process of measuring and managing liquidity risk, not realizing fully the broader systemic implications that were brewing. Some of this could be attributed to changes in funding composition as mentioned earlier. But another lesson was that the perception of liquidity that exists during normal periods is ephemeral – gone in a New York minute at the whiff of problems. In the aftermath of the crisis then it is tempting for regulators to want to impose new standards for liquidity as we now see coming in the next incarnation of Basel. But liquidity tends to be procyclical. A number of studies point to this such as Berger and Bouwman (2011) suggesting that liquidity builds up to abnormally high levels preceding a crisis in part as it did before 2008 in the form of relaxed underwriting standards and then crashes after the bubble pops. Moreover, there appears to be some empirical evidence (Allen and Carletti, 2011) of liquidity hoarding by banks during a crisis that suggests the direction of causation between liquidity and financial fragility might be reversed. (See Longbrake and Rossi Procyclicality Study, 2011 referenced in an earlier posting for the citations for these two studies).
So what are the implications of these results? First, liquidity appears to amplify lending activity preceding a crisis, not as a precautionary move, but rather may be symptomatic of underlying drivers of systemic risk generally. Thus imposing a set of required liquidity ratios may help reduce crisis-induced hoarding of liquidity under stress periods, but it has yet to be proven whether the benefit of ensuring a minimum level of liquidity is maintained across the economic cycle offsets potential economic drag such a requirement may impose generally.
So where does this leave us? Increasingly, institutions need to do a much better job at assessing and integrating views of various risks in their firms generally. Had the industry imposed a high enough penalty function for illiquidity and credit risk, for that matter there is a greater likelihood that we would have seen far better results on this dimension than what ultimately were realized. I am reminded by a story at a very large depository, where in response to a serious regulatory problem years before the crisis, overhauled its liquidity risk management process significantly, making it one of the strongest such programs in the industry – the proof of this effort was that the firm weathered the liquidity crisis very well. Stronger oversight of liquidity risk management practices by regulators provides a more flexible yet effective mechanism for ensuring firms have robust liquidity risk management protocols. Finally, firms need to augment existing firm-specific risk management capabilities with activities focused on how systemic risk events could impact their operations. Certainly stress tests provide some measure of this, however they are not sufficiently comprehensive across risk types to get a full appreciation for how systemic risk events could impact their business.