A Simple Macroprudential Liquidity Buffer

Daniel C Hardy and Philipp Hochreiter

A banking crisis and, in particular, a systemic crisis, often involves, and is aggravated by, strains in funding markets. Even a bank that is not initially short of capital can make large losses and thus become undercapitalised if it has to sell assets in a “fire sale” to meet short-term obligations or pay very high rates for funding or suffers quantitative rationing. Some banking crises may consist almost entirely of an intensification of credit risk in the loan book of individual banks, but such crises may be characterised by the relative weakness of systemic feedback loops, at least among financial institutions. Liquidity strains, in contrast, are inherently systemic: one agent’s liquid asset is another agent’s liquid liability, and what is liquid is defined in terms of what can be disposed of in the market rapidly and without major price changes, that is, in terms of its properties within the financial system. Hence, as part of efforts to strengthen macroprudential oversight, it is worth considering what instruments might be used to sustain system-wide liquidity in case of strain, and to reduce the likelihood of such strain occurring. In this chapter we present one such