We suggest that banks should be encouraged, through adequate regulatory relief, to issue a new class of securities (the Roll-Over Option Facilities or ROOFs), with the following characteristics:
These ROOFs would allow banks to keep liquidity during a crisis, reducing their need to return to panicked markets to get funding or to “fire-sale” assets giving rise to price spirals. Given that the roll-over option would be activated only in the wake of a systemic crisis, in normal times the impact and the distortions in the market for liquidity would be contained
- the securities (any standard, plain vanilla bond will do) have a roll-over option attached to them, i.e. the possibility for banks to keep the underlying funds for a pre-specified new maturity;
- the option is activated if, and only if, at expiration there is “sufficient tension” on liquidity markets according to an easily observable indicator, e.g. the Libor-OIS spread is above a pre-determined trigger level;
- the securities are rolled over with a yield that reflects both the credit-worthiness of the bank and the price of liquidity in the market at the moment of roll-over; for example it could be indexed to sector-rating class specific yield indices that are routinely published.
Tuesday, June 15, 2010
I found a very interesting article by Sergio Nicoletti-Altimari and Carmelo Salleo on how to address the evaporation of liquidity witnessed in the interbank markets during the crisis. Here is their key proposal: