Contingent Liquidity

26 Pages Posted: 8 Dec 2010

Date Written: September 7, 2010

Abstract

After the crisis, bank regulators are considering mitigating liquidity risk by introducing quantity limits on liquidity and maturity mismatch. We argue that aggregate liquidity risk can be reduced with little deadweight loss by encouraging banks, through adequate regulatory relief, to satisfy part of their financing needs with a new class of securities. These would include a Roll-Over Option Facility (ROOF) that allows the issuer, for a price, to keep the funds if at maturity a readily observable variable correlated with systemic liquidity risk (e.g. the LIBOR-OIS spread) is above a trigger threshold. At roll-over the yield would reflect the current price of liquidity and credit risk, making ROOFs attractive to investors. The instrument could attenuate a liquidity crisis by reducing banks’ need to roll debt over or sell off assets, and diminish the probability of runs, if markets are convinced that banks can secure sufficient liquidity when needed thanks to the widespread use of this contingent claim.

Keywords: funding, liquidity, contingent claim, financial crisis

JEL Classification: G18, G21, G28

Suggested Citation

Nicoletti-Altimari, Sergio and Salleo, Carmelo, Contingent Liquidity (September 7, 2010). Bank of Italy Occasional Paper No. 70. Available at SSRN: https://ssrn.com/abstract=1721431 or http://dx.doi.org/10.2139/ssrn.1721431

Sergio Nicoletti-Altimari (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Carmelo Salleo

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

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