Claire Jones Liquidity management: the case for haircuts

External MPC member David Miles said last week he was a lot more concerned about getting capital requirements right than liquidity buffers.

This is odd. Few would deny that banks needed more and better quality capital. But, as Andy Haldane, the Bank of England’s executive director for financial stability, said on Monday, liquidity droughts were perhaps the defining feature of the crisis during 2007 and 2008.

Maybe Mr Miles was reluctant to address what has become one of the most controversial aspects of the Basel III regulatory framework.

But not Mr Haldane. He has suggested haircuts on collateral as a means to avoid systemic liquidity crises.

As shown below, collateral haircuts are procyclical – they’re low in boom times, then soar in busts.

To avoid this, Mr Haldane moots policy options such as minimum limits, and haircuts that lean against credit booms.  These ideas are not new. As he mentions, both the UK Treasury and Tim Geithner have suggested haircuts on derivatives transactions.

However, Mr Haldane adds weight to the idea by building a model, with Bank colleague Sujit Kapadia and academic economist Prasanna Gai, which analyses the impact of haircuts on the financial network.

As with much of Mr Haldane’s work, and indeed that of Mr Kapadia and Mr Gai, the analysis is based on a model characterised by tipping points at which interconnections between firms spread risk instead of dispersing it, threatening stability in the process.

A problem shared is a problem multiplied.  The best of financial friends become the worst of enemies.  In the model, one of the key channels for contagion is the secured financing market as banks hoard rather than lend liquidity when haircuts rise.  The liquidity feast then turns to famine as secured and unsecured financing markets dry up.

So what happens when haircuts are higher in such a model? As the chart below shows, rather a lot. The chances of a crisis diminish from a near certainty to less than 10 per cent.

It would be foolish to read too much into the findings. There will be many ways to circumvent the haircuts. And the model, as the paper notes, is in its infancy; many are far from convinced that the degree of interconnections between firms is as crucial as it suggests.

But it looks a decent start. Plus, though economists did not entirely ignore liquidity droughts during the flood, they scarcely got the attention they deserved. As Mr Miles’s comments show, many still regard them as a second-order problem. For attempting to understand the nature of to liquidity cycles alone, then, the research should be welcomed.