Edited by Thorsten Beck - Vox

Systemic liquidity risk: A European
approach
Enrico Perotti
University of Amsterdam and CEPR
How should financial regulators address problems stemming from liquidity risk? This
chapter argues that the liquidity coverage and net funding ratios proposed for Basel III
are economically and politically impractical. It recommends using those ratios as longterm
targets while imposing ‘prudential risk surcharges’ on deviations from the targets.
The repeated bursts of financial distress in Europe in 2010-11 reflect vulnerabilities
built up in the previous decade and are germane to the roots of the credit crisis.
Abundant global liquidity relaxed funding constraints for banks and their borrowers,
whether governments, firms, or consumers. Private and public debt grew faster than
domestic savings as they were funded externally, by wholesale funding. Such funding
is cheap because it is short-term, uninsured, and uninformed, and therefore prone to
runs. This classic problem of ‘hot money’ for developing countries has now reached
developed economies, since they have become large net borrowers.
Credit grew fastest in the Eurozone’s periphery, where the stability induced by the euro
eased historical concerns about private productivity or fiscal laxness. Banks abandoned
organic growth on local business credit, and escalated lending to unsustainable real
estate booms and excess public consumption. As this balance-sheet expansion was built
on a very unstable funding structure, Eurozone banks are now visibly over-reliant on
jittery wholesale credit flows.
A radical new architecture is needed to restore proper credit incentives and strengthen
resilience, moving banks away from a failed business model. Central to this
transformation is to steer a desirable structure of bank funding. A banking system based
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