LOLR

[Kavita.bhangdia]

HI David,

reading on this topic says"

1. "The classical view is that firm should provide funds freely to solvent but illiquid firm. However, in the short run it can be difficult to discern the difference between illiquid troubled institutions and illiquid sound institutions."

What is the difference between illiquid troubled institutions and illiquid sound institutions ?

2. The second challenge is related to collateral. If the Fed takes too much collateral can cause a run on a financial institution in times of stress. Had the Fed taken enough collateral during crisis, it would have likely done more damage overall as it would have increased risk to remaining investors and shareholders.

How?

Thanks
Kavita

 

[David Harper CFA FRM]

Great questions (I am going to admit that macro is not my expertise such that some of our customers surely know more about your second question than myself)

1. There is a classic distinction between solvency, which is a balance sheet perspective, versus liquidity, which is a cash flow perspective. The basic definition of insolvency is when the equity is negative; for example, if a bank carries $100 in assets, it is solvent if debts are $90 but insolvent if debts are $110. About liquidity, my favorite definition is illiquidity is "we're good, we just need more time!" An illiquid bank has a short-term cash flow problem; the classic crisis-related example is a bank can't rollover short-term funds (eg, repo loans). A solvent bank can be illiquid: $80 debt might fund $100 in assets but the assets are risky and can't be converted into cash. This would be their "solvent but illiquid firm;" i.e., assets > (debt + liabilities) but on the asset side, the bank cannot convert to cash anytime soon (without a fire sale) and/or on the debt side, the bank cannot refinance or rollover short-term obligations. So the classic view, in this context, hopefully makes sense: if you were going to loan me money, you'd rather loan me money if my issue is liquidity rather than solvency. If I am solvent but illiquid, I should be able to repay you in a matter of time. But here is a problem with banks especially: it's hard to determine solvency, it's a tougher measurement problem than liquidity. FYI, this classic principle is sometimes called Bagehot's Rule; eg, http://newramblerreview.com/book-re...mbard-street-really-means-for-central-banking
2. During the crisis the Fed extended many loans under at least a dozen or so programs. To my knowledge, the Fed required collateral in most (all?) of these programs. Collateral scarcity played a major role during the crisis. Gary Gorton blamed the increase in collateral haircuts as the essential triggers that caused a run on the shadow banking system; according to his view, the crisis itself can be seen as an issue of collateral scarcity. Imagine a bank needs to borrow $100 to fund an obligation due. If it has cash for collateral, the haircut is presumably zero. Maybe it has high-quality almost-cash (asset) collateral to post, so maybe the haircut is only 10%; in this case, the bank posts high-quality collateral with a value of $110 in order to borrow $100. But lower quality collateral, such as mortgage backed securities, require higher haircuts. Maybe the haircut of lower-quality collateral is 30%, so now $130 in collateral is posted to borrow $100. The crisis saw an escalation of haircuts across the board. This pulls liquidity from the system. For any given asset profile, a bank can borrow (much) less. Meanwhile, the Fed as LOLR is lending and must decide what type of collateral it will accept and, importantly, what haircuts to charge on the collateral. When the authors say "If the Fed takes too much collateral," I assume that refers to both (i) higher haircuts and/or (ii) tighter requirements on the type of collateral. Consider the extremely "tight" scenario, where the Fed might only accept very high-credit-quality collateral, and with higher haircuts. The problem here is that each bank has scare collateral to post, and if posted to the Fed, can't post the collateral to other banks, which it also needs to do, in order to rollover short term obligations (eg., repo). Further, if the Fed requires the best collateral (again, which are the borrowing bank's assets) at the highest prices (again, at higher haircuts), then the bank's sharesholders and lenders can't (generally) use those assets. For example, they can't sell the assets to raise cash. I hope that's helpful!

 

[Kavita.bhangdia]

Wow.. That was pretty detailed ..
Liked illiquidity as lack of time.. Won't forget that,....
I am feeling pretty illiquid right now....

Thanks
Kavita