IMF Says Steps Needed to Avert Systemic Liquidity Shortages

Wholesale funding raised systemic liquidity risks during global crisis

Financial institutions, regulators failed to account for liquidity risks

Practices in wholesale funding markets must be improved

Financial institutions increasingly relied on short-term wholesale rather than deposit-based funding to finance their activities, which caused systemwide liquidity shortages when wholesale markets dried up, the IMF’s Global Financial Stability Report said. The systemic liquidity shortage—essentially the simultaneous and widespread inability of institutions to find the cash they need to operate—was one of the key factors that threatened the health of the global financial system and triggered massive interventions by authorities to keep banks and other financial institutions afloat.

Financial institutions failed to take into account the sharp declines in collateral valuations that undermined their funding strategy in secured lending markets such as those for repurchase agreements (repos). Nor did they factor in the possibility of a sudden, large-scale disruption to money markets, when investors—uncertain about asset valuations, the ability of counterparties to live up to their obligations, and the availability of liquidity—withdrew and cut back credit lines, the IMF said in the special report released on September 29.

Banks, and nonbanks, raise cash in repo markets by selling securities and promising to buy them back at an agreed price at a future date. If the borrower cannot repay, the securities serve as collateral that the creditor can sell. But during the global crisis the value of much of the collateral was questioned and creditors were reluctant to make loans.

Worldwide dollar shortage

Money market mutual funds, which invest with a goal of keeping their net asset value at $1 a share, essentially ceased buying asset-backed commercial paper that depended on mortgages and certificates of deposit. That also contributed to a worldwide shortage of dollars and affected many internationally active non-U.S. banks that fund their dollar-denominated assets in the U.S. wholesale market. To ease the global shortage, the U.S. Federal Reserve engaged in swaps with other central banks to pump out dollars in the world economy.

The IMF report on systemic liquidity problems is one of two special analyses that accompany the IMF’s Global Financial Stability Report, whose main chapter will be released October 5.

The IMF says that policymakers...