RIDGE SUMMER SCHOOL Montevideo December 2015 RIDGE SUMMER SCHOOL DECEMBER 2015 1 Contents Motivation Holmstrom Tirole approach Cash in the Market and Asset Fire Sales ID: 488641
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LIQUIDITY
RIDGE SUMMER SCHOOLMontevideo, December 2015
RIDGE SUMMER SCHOOL DECEMBER 2015
1Slide2
Contents
MotivationHolmstrom-Tirole
approach
Cash in the
Market
and Asset Fire SalesInterbank Market and Banks’ LiquidityLender of Last Resort
2
RIDGE SUMMER SCHOOL DECEMBER 2015Slide3
Motivation: the 2007
liquidity crashCollapse of market liquidity
with the so
-
called
« toxic assets ».Freeze of the interbank market.Increased liquidity hoarding by banks.
3
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Liquidity freeze
4
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5
The
Freezing of the
interbank
marketNo pure liquidity risk: counterparty risk increases too
. Slide6
Haircuts
6
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Holmstrom-Tirole
liquidity shocksFirms invest at time t=0Face a cost overrun/liquidity shock at time t=1, if liquidity is not injected it implies a zero return
Projects mature at time t=2No 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”7RIDGE SUMMER SCHOOL DECEMBER 2015Slide8
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
RIDGE SUMMER SCHOOL DECEMBER 2015Slide9
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 shockThe Treasury is able to provide liquidity because it can tax future generationsRIDGE SUMMER SCHOOL DECEMBER 2015
9Slide10
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
.
10
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11
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 onesTheir cash determines the price of the banks’ assetsRIDGE SUMMER SCHOOL DECEMBER 2015Slide12
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 useBailouts are justified.RIDGE SUMMER SCHOOL DECEMBER 201512Slide13
B
anks’ optimal selling policyDiamond 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
.
RIDGE SUMMER SCHOOL DECEMBER 2015
13Slide14
Haircuts
Initial 5% haircut
Subsequent 10 % haircut
ASSETS
LIABILITIES
ASSETS
LIABILITIES
ABS 100
REPO 95
ABS 50
REPO 45
EQUITY 5
EQUITY 5
100
100
50
50
14
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Repo borrowing
and price drops15
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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 reposMargins (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.
16RIDGE SUMMER SCHOOL DECEMBER 2015Slide17
Liquidity Spirals
17
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Interbank
Market and Banks’
Liquidity
The basic
Diamond
-Dybvig-Bhattacharya-Gale modelInterest rate formationUnsecured interbank market
freeze
Secured
interbank
market
freeze
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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
.
RIDGE SUMMER SCHOOL DECEMBER 2015
19Slide20
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
crisisSlide21
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 assetsCase 2: With zero probability there is aggregate riskThe aggregate amount of liquidity is insufficient: systemic riskDistinguish different financial architecturesSlide22
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”Slide23
23
EXAMPLES OF « TRAVEL PATTERNS » (MATRIX T)
CREDIT CHAINS
DIVERSIFIED LENDING
MONEY CENTER BANK
1
2
3
1
2
3
1
2
3Slide24
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.Slide25
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.Slide26
26
Asymmetric Information and Interbank Market Structure
Freixas
and
Holthausen
(2004)Motivation Understanding Europe Money Markets integrationUnderstanding external debt crises in emerging countries (Tequila crisis, East Asian crises)Slide27
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 marketsSlide28
28
Country H
Country L
(s
G
,sG)
(sB,sG
)
(s
G
, s
B
)
(s
B
, s
B
)
H-captive
L-captive
No credit
1-Slide29
29
Equilibrium (II)
Result:
Segmentation (
= 0
) is always an equilibriumMultiplicity of equilibria possibleFor some parameters only the segmented equilibrium existsSlide30
30
Liquidity Dry-ups
Malherbe (2014)Banks cover their liquidity needs with T-Bills or with the
interbank
market
Adverse selection in the interbank marketMultiplicity of equilibriaSlide31
Liquidity
and information sensitive assetsWhy the toxic
assets illiquidity of 2007?
Is
transparency
required for markets to function?Dang Gorton and Holmstrom argue the issue is adverse selectionDistinguish: information insensitive debt vs. Information sensitive
debt.
31Slide32
Dang, Gorton
and HolmstromMotivation: complexity of ABS
prior to the crisisOpacity
need
not prevent tradingAdverse 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
32
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Dang Gorton Holmstrom
Asset value
Information sensitive
Information insensitive
Density
Debt
Holders
return
33
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Lender
of Last
Resort
34
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35
35
Diagram 1: Central bank total liabilities
Liquidity
Injection
RIDGE SUMMER SCHOOL DECEMBER 2015Slide36
36
36
Diagram 2
Interest
Rates Policy
RIDGE SUMMER SCHOOL DECEMBER 2015Slide37
37
New Channels
for Liquidity
Injection
In the EurozoneBroadening 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 targets
Banks
liquidity
provision
(TAF, TSLF, PDCF).
Final
user
liquidity
provision
(TALF, CPFF, MMIFF).
Long
term
Debt
acquisition
.
RIDGE SUMMER SCHOOL DECEMBER 2015Slide38
38
Bagehot’s rules
Only illiquid solvent institutions should have access to creditLoans should be made against good collateral at a penalty rate
This rules should be made publicSlide39
39
Are these rules
realistic?
Goodhart
(1985, 1987) asserts that the distinction between illiquidity and insolvency is a mythSlide40
40
Goodfriend and King
LOLR only at the aggregate level through open market operations
Unsecured
interbank
market will then redistribute liquidity to illiquid solvent banksThis implies market disciplineHumphrey (1984) argues this would be Bagehot position todaySlide41
41
Central banks: Liquidity provider or Crisis manager?
Bagehot
, Allen and Gale: b
ecause
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.Slide42
Central
banks: : Liquidity provider or Crisis manager? (II)
FPR (2000),
b
ecause of the risk of gridlock the Central Bank has a coordinating role as crisis manager and liquidity providerFPR (2000) because bank closure may lead to contagion, role in the orderly closure of the insolvent bank.
42Slide43
43
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.RIDGE SUMMER SCHOOL DECEMBER 2015