In commentary on other papers, Shleifer himself has argued against one of the fundamental drivers of the crisis being the liquidity exposures stemming from ABS and other securities being financed by short-term repos; what Gary Gorton and others have called the run on repo.8 But the spirit – if not the analytics – of his paper could extend to myopia about liquidity risk; it was neglected because agents forgot about it. Only recently the leader of a financial institution that emerged relatively unscathed from the crisis told me that they had been blind to the possibility of a really severe liquidity crunch; and that they had reacted by massively cutting their short-term funding in the worst days of the crisis. As a policymaker, for whom explanations can be complementary rather than seminar papers in competition, the myopia and run-on-repo se stories seem to me to join up rather well. What to do? As the Basel Supervisors Committee proceeds with the FRTB, I can imagine reluctance to opine on the liquidity of markets, but it was not beyond the wit of the official sector to observe that crucial parts of the ABS market were utterly dependent on levered money and so very unlikely to be liquid when the music stopped. This partly makes the case for reconnecting supervisors and markets specialists in central banks. This is all part of getting the level of capital in the banking industry closer to what is warranted. Adair has said a great deal about that this evening.
Thankfully, all this is now also being worked on internationally in the Financial Stability Board. A second and obvious policy inference that one could draw from Shleifer’s paper, and one I want to spend a little more time on this evening, is that it is absolutely vital that (regulatory) capital requirements for banks more or less truly capture their risks. Two thoughts on that, of rather different kinds. First, it was very obviously a false step when, in Basel 2, the international-standard setters tried to follow the techniques and calibrations of private sector risk managers rather than engaging with the externalities that warrant State intervention in this area in the first place. Second, more particularly and more concretely, this underlines the vital importance of the current Basel work to review fundamentally the capital requirements for banks’ trading books. In short, Basel has recognised that the amount of capital a bank should hold against a liquid trading position often has good reason to be smaller than needed for a hold-to-maturity portfolio, ie where the bank can shed its exposure. But it failed utterly to recognise that since such books are marked-to-market (or model) and since the boundary conditions for solvency derive partly from accounting measures of asset values, it is vital that banks hold capital against the risk of violent swings in liquidity premia. Yet that is exactly what torpedoed a fair fraction of the largest banks and dealers in the world through their (levered) holdings of leveraged loans and super senior tranches of CDOs.