I am gradually coming to a general rule on actually reading the speeches published by the BIS – the less interesting the title is, the more likely it is that the speech is actually worth reading.
This one “Some thoughts on securitization and financial turbulences” by Jean-Pierre Landau, Deputy Governor of the Bank of France, is a good example. Fairly boring title – quite good content. His (or, more likely, his underling’s) analysis is robust, with a good idea of what happened over the last few months. He is also right that the worst is currently behind us as the real problem was always the liquidity freezing up, not the size of the actual losses.
Where I feel he is wrong, though, is in the policy prescription:
Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increases in the demand for liquidity. That’s the job of Central Banks to help in those circumstances. But a strong capital base in the system – and in all its components – is likely to limit future liquidity shocks.
The first two sentences are perfectly correct. Capital is simply not a substitute for liquidity. The next two, though, are wrong – and they do not logically flow from any of the analysis in the rest of his “Thoughts”. Bank regulators commonly get fixated on capital as the be-all and end-all of bank risk management. The attitude commonly seems to be more risk (of any type)? More capital needed. Liquidity, though, is not improved by having more capital; in fact, it may be hurt.
The best capitalised bank in the world will not be able to pay its debts as and when they fall due without liquidity – i.e. it will be bankrupt. Liquidity management is, and always should be, considered separately from capital management.
He is right that a well capitalised bank will find it easier to get liquidity in a liquidity poor market – but Northern Rock was, by the standards of the industry, well capitalised and profitable. Having to go to the Central Bank (the Bank of England) was what destroyed them. Adequate liquidity would have meant that they had no problems and no need for the Bank of England’s help.
The message? Good capital will help – but in a liquidity crisis what you actually need is liquidity. Also, don’t always believe that a Central Banker is right.
3 comments
13 November, 2007 at 01:53
Bruce
I think a slight adjustment of your view, is worth considering:
Liquidity risk mitigation should not be considered purely a capital issue.
Certainly liquidity should be part of a capital assessment (ie ICAAP or similar). In the event of a shift in the money markets, it is reasonable to assume that the cost of funding would increase and capital would be an exceptable method of mitigating this.
However, I do agree that capital cannot fix a liquidity issue where no funds are available at any cost. In the recent environment, those who had a spread of funding sources and had set up emergancy plans such as conduits facilities (paying the ongoing cost as an insurance premium) were in a better position.
Much like any other risk, you don’t go flying a kite next to power lines just because you have good health insurance.
13 November, 2007 at 08:59
Andrew
Bruce,
In the absence of a system-wide event this sort of liquidity issue can be regarded as transient – the trick is to have enough liquidity (and, as you note, from enough sources) to get you through. The Rock failed to diversify its funding sources and paid the price when it was caught between securitisations. It had (and I presume still has) enough capital to comfortably meet the FSA requirements, but this was no help – except that the B of E rode in on their charger, making a lot of noise on the way in.
OTOH, if they had maintained enough liquidity at all times to see them through a drying up of their primary funding source for a month or two there would not have been an issue in the first place. No liquidity problems, no B of E announcement to the LSE, depositors are unaware of any problems (because there aren’t any) business continues.
The extra cost of funding could have been, and should have been, met out of current profits rather than through a call on reserves, with the added margin past on to customers at the next rate reset.
If you look at the Rock incident one way, it was bad luck that the crunch happened just short of their next securitisation (as happened in Oz to a couple of wholesale funded lenders) but really it was bad liquidity management.
15 November, 2007 at 01:28
Bruce
I agree that the recent situation with NR should not have consumed capital as the liquidity strategy should have prepared for a lack of wholesale/ securitised funding and the additional costs should have consumed profit not capital.
However, in terms of normal business practise, the risk management process (ie. pillar 2) would consider an event where a number of significant shocks occur. When a combination of debt losses, operation risks, interest rate shocks and liquidity issues occur in parallel. Therefore all profit will be destroyed and capital is required to prevent bankruptcy. In that sence, capital allocation has to include liquidity risks.
To my mind, a part of the risk with NR and other banks, is the business need to commit to lending prior to funds being needed. With the level of business NR were writing, the constant pipeline of mortgages where they had entered a contract to lend was sizable (£billions). As soon as the wholesale funding dried up, they were really stuck as they had no significant short term alternative in place and combined with no functioning securisitation market, the ‘gravy’ train ran out of track.