I had a difficult time in the past to explain liquidity risk management and ratios.
Now I know what to do. Problem solved!
I will use a pollution-mitigating technology, like scrubbers to explain liquidity risk.
Mr. Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System explained how:
"Suppose we have a power plant that produces energy and, as a byproduct, some pollution.
Suppose further that regulators want to reduce the pollution and have two tools at their disposal:
They can mandate the use of a pollution-mitigating technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the plant.
In an ideal world, regulation would accomplish two objectives.
First, it would lead to an optimal level of mitigation - that is, it would induce the plant to install scrubbers up to the point where the cost of an additional scrubber is equal to the marginal social benefit, in terms of reduced pollution.
And, second, it would also promote conservation:
Given that the scrubbers don't get rid of pollution entirely, one also wants to reduce overall energy consumption by making it more expensive.
A simple case is one in which the costs of installing scrubbers, as well as the social benefits of reduced pollution, are known in advance by the regulator and the manager of the power plant.
In this case, the regulator can figure out what the right number of scrubbers is and require that the plant install these scrubbers.
The mandate can therefore precisely target the optimal amount of mitigation per unit of energy produced.
And, to the extent that the scrubbers are costly, the mandate will also lead to higher energy prices, which will encourage some conservation, though perhaps not the socially optimal level.
This latter effect is the implicit tax aspect of the mandate.
A more complicated case is when the regulator does not know ahead of time what the costs of building and installing scrubbers will be.
Here, mandating the use of a fixed number of scrubbers is potentially problematic:
If the scrubbers turn out to be very expensive, the regulation will end up being more aggressive than socially desirable, leading to overinvestment in scrubbers and large cost increases for consumers; however, if the scrubbers turn out to be cheaper than expected, the regulation will have been too soft.
In other words, when the cost of the mitigation technology is significantly uncertain, a regulatory approach that fixes the quantity of mitigation is equivalent to one where the implicit tax rate bounces around a lot.
By contrast, a regulatory approach that fixes the price of pollution instead of the quantity - say, by imposing a predetermined proportional tax rate directly on the amount of pollution emitted by the plant - is more forgiving in the face of this kind of uncertainty.
This approach leaves the scrubber-installation decision to the manager of the plant, who can figure out what the scrubbers cost before deciding how to proceed.
For example, if the scrubbers turn out to be unexpectedly expensive, the plant manager can install fewer of them.
This flexibility translates into less variability in the effective regulatory burden and hence less variability in the price of energy to consumers.
Scrubbers and high-quality liquid assets
What does all this imply for the design of the LCR?
Let's work through the analogy in detail.
The analog to the power plant's energy output is the gross amount of liquidity services created by a bank - via its deposits, the credit lines it provides to its customers, the prime brokerage services it offers, and so forth.
The analog to the mitigation technology - the scrubbers - is the stock of HQLA that the bank holds.
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