Liquidity Requirements, Liquidity Choice and

Financial Stability
Douglas W. Diamond and Anil K Kashyap
Asian Development Bank Institute: July 27, 2015

The views expressed in this presentation are the views of the author and do not necessarily reflect the views or
policies of the Asian Development Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or
the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and
accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with
ADB official terms.
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The Net Stable Funding Ratio

Notice that it:

a) Broadly ties the liability structure to the characteristics of assets

b) Various subtle and possibly conflicting objectives in the definition
(next page)

The Net Stable Funding Ratio, continued

The Liquidity Coverage Ratio

a) Must identify unencumbered HQLA in times of stress

b) Must forecast net inflows and outflows in times of stress

Motivating Questions
Why wont banks self-interest lead the banks to hold the
socially optimal amount of liquidity? (i.e. why is any
regulation needed?)

Do we need rules regarding both sides of the balance

sheet? (i.e. cant we just start by netting cash against
debt?)
Is it possible to derive the NSFR and LCR as nearly
optimal regulations?
How do we forecast outflows, identify liquid assets, anticipate bank
behavior, anticipate counter-party behavior?
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Main Takeaways
1. Most analysis of liquidity requirements asks: how much
liquidity is needed to meet extreme withdrawals (as in a
crisis)?
2. Rather, a key goal should be to provide incentives for
banks to chose to hold the proper amount of liquidity, in
excess of the required amount.
3. This extra liquidity is to deter runs.
4. Unregulated banks may not hold enough liquidity.
5. Regulation that forces banks to hold more liquidity than
they prefer can potentially improve outcomes.
6. LCR and NSFR are not optimal regulations and each
differentially affect incentives to deter runs.
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Our Variant of Diamond-Dybvig

t=0
Riskless loan and
safe assets are
funded by deposits

t=1
Idiosyncratic
preference shocks

t=2
Loans repaid

Fraction ts fundamentally must withdraw

of patient people see a sunspot
Investment
payoff
Bank run
possible

$1 invested at date 0 in:

Riskless assets
Deposit
Loan

at date 1 pays
R1
r1
R2

Liquidated loans repay R2

at date 2 pays
R1 * R1
r2
R2
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Assets and Deposits

$1 invested at date 0 in:
at date 1 pays
Liquid asset
Deposit
Loan

R1
r1
R2 <r1

at date 2 pays

or

R1 * R1
r2 r1
R2 >r2

Details on deposits withdrawals

A fraction ts of depositors will need to withdraw,
ts varies and is known only by the bank.
In addition, a fraction <1 of depositors see a
report that can make them expect others to run
(see a sunspot or some news). This may or
may not make them run in response.
measures how hot is the money deposited.
Core deposits: =0 vs. Wholesale deposits: >0.
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Depositors want safe deposits. How

much illiquid lending is still possible?
If banks hold sufficient liquidity, they will be
stable.

This requires that when the hot money

(fraction of deposits) expect others to run,
none of them actually run.
How does one implement run free banking?

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Privately optimal choices for the bank

Fraction of liquid assets () is chosen to equate available
funds (R1) to deposit outflows (r1 each to the fraction f1
that withdraw: (total outflow of r1f1).
This profit maximizing amount is Automatically
Incentive Compatible.

(AIC)

Because the bank never plans to make illiquid loans only

to liquidate them at a loss.

Withdrawals differ: without a run, f1=ts,

or in a run, f1= ts+

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Automatically Incentive Compatible

Liquidity, for given f1 withdrawals.
= Fraction
in liquid
asset

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Automatically Incentive Compatible

Liquidity, for given f1 withdrawals.
= Fraction
in liquid
asset

tlow
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Automatically Incentive Compatible

Liquidity, for given f1 withdrawals.
= Fraction
in liquid
asset

thigh
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Withdrawals differ without a run, f1=ts,

and in a run, f1= ts+
=
Fraction
in liquid
asset

ts

ts+

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Will bank choices deter runs?

If the bank can cover withdrawals of f1 in all cases
without failing, the hot money never runs.

Will bank choose enough liquidity for

normal withdrawals f1=ts, or to stay
solvent even during a run, f1= ts+?
These could be the same (if fire sale
losses are less than net worth without a
run), or they could differ.
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Definitely deterring runs can require

more liquidity than self interest assures
= Fraction
in liquid
asset

(With Full Information about ts)

ts

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Stability Requires Some Unused Liquidity

= Fraction
in liquid
asset

(With Full Information about ts)

ts

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Does simply requiring excess liquidity

overcome private information about t s ?
Not generally:
When there is full information, all
liquidity is released in any run ( f1 ts)
If a regulator does not know t s ,
releasing this liquidity only in a run may
not be feasible.

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Liquidity Should be Released in a

f1 ts )
= Fraction
Known
Run
(
in liquid
asset

ts
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Not all liquidity (taxicabs) can be

released in all runs (if t s is not known)
= Fraction
in liquid
asset

ts

ts ts
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Evaluation of Basel III regulations

The Basel regulations are NOT optimal
regulations constrained by requiring honest
reporting of the banks private information.
They require more liquidity and less lending
than the optimal mechanism.
We can still compare them using our
framework.

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Run-Proof NSFR Must Cover the Worst Case

= Fraction in
liquid asset

ts

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LCR [of (1-f1)] can allow more

= Fraction
lending
that
a
NSFR
()
in liquid
asset

ts

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There must be excess liquidity

To enforce the LCR regulation, the regulator
need only measure how much liquidity per
deposit remains after withdrawals occur.
There must be a positive fraction of liquidity
left unused after fraction ts withdraw. Last
taxicab at the train station must not leave.
Regulator cant tell if withdrawals are normal
or run, but if the extra liquidity is held, only
normal withdrawals will occur.
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Measurement and Calibration Issues

We should not calibrate liquidity requirements
just to cover predicted withdrawals, but in
instead take account of the incentive effects of
requiring unused liquidity (LCR).
Behavior in the near future will be very
different with requirements to hold liquid
assets with higher interest paid on reserves by
central banks (set to induce holdings of
reserves).
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Implementing the optimal regulation

Can implement the full information allocation:
Bank reports t s , give the full information
payoff to the bank if f1 ts, and zero if f1 ts .
This can also be implemented by lender of last
resort policy tied to the full information
unused liquidity requirement U ( f1 ) .
If violated, lend against the liquidity, but drive
compensation to zero.
As in the original Federal Reserve Act.
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Summary
1. Unregulated banks with unobservable liquidity needs
are unlikely to be run proof.
2. Simply disclosing liquidity at one date is not enough.
3. Liquidity regulation can correct this.
4. Basel style regulations are not the optimal
mechanisms. They will typically result in excess
liquidity being held.
5. Mandating surplus liquidity is necessary, so the last
taxicab cant be released.
6. Lender of last resort policies and liquidity regulation
ought to be integrated.
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