This can lead to haircut spirals in which higher haircuts lead to forced asset sales, increased volatility and still higher haircuts. These sources of instability create the risk of a cascade – of firms moving rapidly from the situation represented in Figure 1 to that shown in Figure 2. Once the firm’s viability is in question and it is does not have access to an insured deposit funding base, the next stop is often a full-scale liquidity crisis that often cannot be stopped without massive government intervention. Fortunately, there are ways to mitigate the risk of a cascade. First, we can require that financial intermediaries hold more capital. This would push the probability distribution to the right in Figure 2. With sufficient additional capital, the probability of insolvency could be reduced to a low enough level that liquidity providers would not run. Higher capital requirements work to reduce the risk of liquidity runs, but potentially at the cost of making the process of financial intermediation much more expensive. In particular, a requirement that firms must hold more capital increases intermediation costs. Moreover, banks may respond to higher capital requirements by taking on greater risk. If an increase in risk-taking were to occur, the movement of the probability distribution to the right in Figure 2 might be offset by an increase in the degree of dispersion. Thus, higher capital requirements might not necessarily be sufficient to push all of the probability distribution above zero. Second, regulators could require greater liquidity buffers.

For example, we could improve the resolution process so that less of a firm’s value is destroyed by the liquidation process. If we could reduce the difference in value between a firm as a going concern versus the same firm in liquidation we could reduce the severity of the cascade effect when financial conditions deteriorate. Sixth, we could make structural changes to the financial system to make it more stable in terms of liquidity provision. For example, consider the three structural issues outlined earlier that amplified the crisis – tri-party repo, collateral requirements tied to credit ratings, and haircut spirals. In the case of tri-party repo, the amplifying dynamics could be reduced by enforcing standards that limited the scope of eligible collateral or required more conservative haircuts. Formal loss-sharing arrangements among tri-party repo borrowers, investors, and clearing banks might reduce or eliminate any advantage that might stem from running early. Eliminating the market’s reliance on intraday credit provided by clearing banks could eliminate the tension between the interests of clearing banks and investors when a dealer becomes troubled. In the case of collateral requirements, collateral haircuts could be required to be independent of ratings. Many of these suggestions are already in the process of being implemented. For example, the Basel Committee is in the process of strengthening bank capital in four ways: 1) higher capital requirements; 2) higher quality capital; 3) more complete risk capture; and 4) capital conservation measures, including the use of contingent capital instruments.