‘Maintaining Confidence’ paper is up January 8, 2013 at 6:11 pm

My paper Maintaining Confidence – Understanding and preventing a major financial institution failure mode has been published as an LSE Financial Markets Group special paper, and is available here. From the abstract:

This paper proposes the solvency/liquidity spiral as an failure mode affecting large financial institutions in the recent crisis. The essential features of this mode are that a combination of funding liquidity risk and investor doubts over the solvency of an institution can lead to its failure. We analyse the failures of Lehman Brothers and RBS in detail, and find considerable support for the spiral model of distress.

Our model suggests that a key determinant of the financial stability of many large banks is the confidence of the funding markets. This has consequences for the design of financial regulation, suggesting that capital requirements, liquidity rules, and disclosure should be explicitly constructed so as not just to mitigate solvency risk and liquidity risk, but also to be seen to do so even in stressed conditions.

3 Responses to “‘Maintaining Confidence’ paper is up”

  1. David – an interesting paper. Thanks for posting the link. It prompted a thought and a comment.

    My thought is that one way of characterising the spiral is one in which creditors become more and more interested in marking-to-market the entire balanace sheet of a bank. In good times they don’t care to do so, seeing high asset prices and just assuming all is well. In bad times they do care – increasingly so – and apply broad, aggregate marks which may actually be wrong (or more politely, horribly pro-cyclical). The point is that in attempting to overcome the problems of assessing solvency through accounting disclosure, they use imperfect methods which potentially lead them into the wrong actions (ie pulling funding) which have wider systemic implications. How to overcome this? I’d like to see more prominence for balance sheets shown entirely at market value (think that already happens in US??).

    My comment was on recommendation 4 (institutions should hold sufficient capital above the minimum to absorb losses in a stress without the market losing confidence). Isn’t that what Pillar 2 requirements do and which high-trigger coco instruments can supplement?

  2. Thanks QM.

    I agree with you mostly, but would make the following points.

    1. There is no one correct fair value. Even with perfect information, reasonable people can disagree about where to mark an illiquid asset.

    2. The size of that disagreement can be a material fraction of an institution’s capital. It was with Lehman (as the valuation volume in the Valukas report makes clear).

    3. Without perfect info, looking in, investors apply an even bigger spread. Thus they talk about a firm be insolvent meaning that if it was marked where they would mark it as buyers, it would be insolvent.

    4. Therefore while full FV would help, it is both profoundly procyclical and not a panacea, due to valuation uncertainty.

    5. I agree with you about the function of Pillar 2, but in practice it is wafer thin compared to what is needed to do the job. What a few of us (see Charles Goodhart’s new paper on Reconsidering ratios for a similar take to mine) are coming to is the proposal that pillar 1 needs to be much smaller, and pillar 2 much, much bigger.

  3. […] Deus Ex Macchiato » ‘Maintaining Confidence’ paper is up. […]