Merv King’s spoiler at the Treasury select committee on Tuesday gave us a bit of a heads up: the FSA was due to publish a report on bank and building society liquidity on Wednesday.
Here in full, is the whole voluminous report, just put up on the FSA’s website. The tome lays the blame squarely at Northern Rock’s door for the mortgage bank’s own demise.
And there is a kernel – or principle, if you will – of principle-based regulation: principles are there to be bent. But if you bend the FSA’s principles too far, they break. Don’t break them.
A few principle-based snippets below:
On the temptations of liquidity risk:
Liquidity stresses are low-frequency, but extreme severity, events that are not well-understood. In contrast, holding a high stock of liquid or short term assets imposes an immediate and on-going cost. So there is a temptation, even if irrational from a long-term perspective, for management and shareholders to neglect this risk, especially if they have had no recent experience of liquidity stresses. In the immediate future this is perhaps less likely as recent events have focused the attention of all on liquidity risk.
On assessing banks’ risks:
Even if some banks mitigate their liquidity risk they face a competitive disadvantage if other banks do not and therefore have lower costs. As liquidity stresses are low-frequency, but extreme severity events, this disadvantage may endure for long periods of time. In a perfect market, these other banks would not be able to exploit this cost advantage, as depositors and other counterparties would be reluctant to do business with them because of their failure to mitigate liquidity risk. In practice, it is often difficult even for wholesale depositors or counterparties to assess from the outside the liquidity position of a bank, and almost impossible for a retail depositor or investor to do this.
On moral hazard:
Third, there is a market perception that central banks will intervene to supply liquidity during a market-wide stress and, at least for banks whose failure might have systemic consequences, for a firm-specific stress. This perception reduces the incentives for banks to mitigate their own liquidity risks, and for depositors and other creditors to avoid doing business with banks that fail to do so. This creates a moral hazard. Further, to the extent that this perception wrongly anticipates that there will be action by central banks, depositors and other counterparties may be exposed to the risk of loss. Even where the perception is accurate, risk remain as central bank lending to a specific bank may, if publicised, lead to a loss of confidence in that bank.
On bank failures and government intervention:
Liquidity crises could, in the extreme, lead to the disorderly liquidation of a bank, or a securities firm that holds significant assets and/or derivative positions. The social cost of a large bank failing would be very large. The social cost of a small bank failing would be considerable, though possibly on the same scale as past events our society has tolerated, such as the collapse of some defined-benefit pension schemes. The costs of a government or central bank acting as LOLR to prevent bank failures are not clear, but could include the taxpayer buying banks’ assets whose credit or market risks exceed the government’s normal risk appetite.
Some lessons:
- Not enough information is provided by banks to the FSA
- Better stress testing models are needed
- Liquidity auctions by central banks do not work in times of liquidity crisis
- Banks are too proud. In times of liquidity stress banks are reluctant to draw down on liquidity facilities because it “might be seen as a sign of weakness”.
- Linked to the above:
At least for some liquidity promises, there appeared to be a strong commercial expectation between the bank and the counterparty that the promise would not be called.