Fixing the Funding Machine

In a new hard-hitting paper, Macer Gifford, Visiting Fellow at the Globalization and Finance Project, argues that half of the regulatory response to the global financial crisis is misconceived.

Much of the regulatory response to the global financial crisis has been aimed at curtailing the liquidity risk taken by banks. The objective has been to avoid the GDP hit of a repeat occurrence, whilst also minimising the risk to the public purse. But in getting stuck straight in to a solution, the mainstream debate has largely bypassed the question of just why the system built up to a cash flow crunch in the first place.

This paper gives practitioner’s insight into why and how the banks stretched their balance sheets in the run-up to the crisis, delving into the murky area of system-wide “funding liquidity”. With this framing, it is possible to conclude that the new regulations could be having the opposite of the desired effect - prolonging the GDP pain. Key to this line of reasoning is the existence of a Term Liquidity Premium, providing an incentive for banks to manufacture long term liquidity. The paper argues that the manufacturing process lowers the cost of term lending and stimulates GDP growth. Restricting it has the opposite effect, holding liquidity premiums at near-crisis levels in an unnecessary “phony war”, which increasingly necessitates central bank lending of first resort.