In the aftermath of the outbreak of the economic and financial crisis in August 2007, the world’s most important regulators and supervisors quickly arrived at the conclusion that international liquidity regulation must not only be harmonised, but also improved substantially. In December 2010 the Basel Committee of Banking Supervision published Basel III: International framework for liquidity risk measurement, standards and monitoring. Two ratios constitute the core of the international policy response to the liquidity crisis – the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).
The two liquidity standards …
The former aims at reducing banks reliance on short-term, fragile funding sources (e.g. unsecured interbank deposits with tenors below one month). The LCR is defined as the ratio of High Quality Liquid Assets (HQLA) over net cash outflows over the next 30 days. Banks must maintain their LCR at or above 100 per cent; i.e. the standards do not forbid banks to take liquidity risk, but if they do so, they should hold sufficient liquidity risk bearing capacity to weather short-term liquidity shocks. HQLA are assets that are of (extremely) high credit quality and (extremely) high market liquidity. Eligible asset classes include central bank money, government bonds, covered bonds, and non-financial corporate bonds. Within these asset classes only those assets are eligible that fulfil the additional criteria (e.g. trading volume). The LCR is to be introduced by 2015 after a long monitoring and transition period that effectively spans almost 5 years between the publication of the respective consultative document and the final implementation.
The NSFR aims at “… promot[ing] more medium and long-term funding of the assets and activities of banking organisations.” (BCBS 2010, 26) Depending on the liquidity characteristics of the bank’s assets with a remaining maturity beyond one year, the bank must attract a minimum of stable funding to refinance these assets. The NSFR is to be introduced in 2018 after a monitoring and transition period that effectively spans 8 years. The two liquidity standards are part of the implementation of Basel III in the EU via the Capital Requirements Directive IV and the Capital Requirements Regulation (CRD IV/CRR).
… constitute enormous progress in international banking regulation
The two liquidity standards constitute enormous progress in international banking regulation: (i.) It is the first time in history that liquidity standards are internationally harmonised. For internationally active banks this yields multi-billion USD cost savings: regulatory standards and reporting requirements are fragmented across countries and sometime even within countries (e.g. different ratios for different banking sectors); this requires individual IT solutions, reporting frameworks etc. (ii.) Currently, most liquidity standards have substantial short-comings: they are backward looking, do not cover all sources of material liquidity risk, and are barely risk-sensitive (ECB 2007). The new functional approach (Schmitz, Ittner 2007) is forward looking, takes into account all sources of liquidity risk (e.g. off balance-sheet exposure), and is highly risk-sensitive. (iii.) Liquidity regulation in most countries concentrates on short-term shocks and pays much less attention to stability risk associated with a lack of stable medium- and long-term funding. The new NSFR addresses this risk. A series of economic impact studies concluded that the ratios would reduce the probability and costs of financial crisis. Thus, they would contribute to sustainable economic growth, jobs, and public welfare (Macroeconomic Assessment Group 2011; BCBS 2010).
The international consensus on improving liquidity regulation is dissolving from within
Over the last few months the tone of core players in the regulatory and supervisory arena has changed dramatically casting doubt on the future of the LCR.
On June 14, 2012, Bank of England Governor Mervin King (2012) argued that: “In current exceptional conditions, where central banks stand ready to provide extraordinary amounts of liquidity, against a wide range of collateral, the need for banks to hold large liquid asset buffers is much diminished, and I hope regulators around the world will take note.”
On June 22, 2012, the UK interim Financial Policy Committee recommended that the FSA would consider loosening micro-prudential liquidity standards to facilitate lending to the economy. Some members even pressed for suspending micro-prudential liquidity regulation. In the same meeting, however, the FPC reported that the ESRB Recommendations on USD Funding were implemented in the UK and “… stressed the importance of USD funding risk …”.
In a speech on June 16, 2012, at a Morgan Stanley event ECB Board Member Benoît Cœuré (2012) highlighted that the revival of money markets was essential for the euro area. The LCR is mentioned only once throughout the speech: “It is important that the [LCR] does not hamper the functioning of funding markets. This applies in particular to the calibration of the run-off rates for interbank funding and to the asymmetrical treatment of liquidity facilities extended to financial firms.” Cœuré denounces the very objective of the LCR – incentivising more stable funding instruments and longer funding tenors – as its major drawback.
This view is reiterated by Banque de France Governor Christian Noyer (2012, 3) on June 26: “This is why we are accompanying the prudential reform with more general and macroeconomic reflections on the financing of the economy, (…). The new liquidity ratios therefore cannot be applied as they stand as they do not take into account all their consequences and interactions beyond the prudential objectives themselves, which include in particular the functioning of the interbank market, the level of intermediation or the conditions of monetary policy implementation.”
The reasoning of these key players in the EU regulatory debate rests on the following arguments against the LCR:
(i.) EU banks are under funding stress. The liquidity buffers are designed to help banks absorb short-term liquidity shocks; thus, banks should be able to make use of their liquidity buffers and decrease their liquidity risk bearing capacity to spur lending to the economy.
(ii.) Unsecured money markets are important for the implementation and transmission of monetary policy. The LCR might impede the return of the unsecured Euro money market to pre-crisis activity levels.
(iii.) Unsecured money markets serve as efficient price-discovery mechanisms (e.g. LIBOR rates) and contribute significantly to safe and sound banking via effective market discipline.
Also the IMF in its recent Global Financial Stability Report (IMF 2012) calls for a broader definition of HQLAs. Extrapolating QIS data, the IMF estimates the global additional demand for safe assets “… to be in the range of USD 2 trillion to USD 4 trillion, equivalent to 15 per cent to 30 per cent of banks’ total current sovereign debt holdings.” (IMF 2012, 100) But the IMF clarifies that banks can adapt their funding structure which would reduce these estimates. Nevertheless, it suggests that a broader definition with higher haircuts could reduce the demand for safe assets.
(iv.) The IMF’s stance is motivated by concerns about a shortage of safe assets. The LCR would increase the demand for safe assets further and thus increase pressure on that market.
To sum up, the heads of the ECB, the Bank of England and the Banque de France, have turned critical on one of the core components of regulatory reform – the improvement in liquidity regulation by the LCR. Also the IMF has taken a more critical stance recently.In the following I will go through the arguments put forth against the LCR:
Does the current funding stress of EU banks provide a reason to postpone or even rethink the LCR?
No. The LCR is designed to increase banks’ liquidity risk bearing capacity under short-term liquidity shocks. The current funding stress for European banks is neither short-term nor temporary. The funding conditions for banks have structurally changed (Deutsche Bank 2012): The implicit government guarantee on bank liabilities is not credible anymore, since many sovereigns are unable to honour such a guarantee. Moreover, the future EU framework for bank recovery and resolution aims at reducing tax payers’ costs of banking crisis. Therefore, the current draft proposes that supervisors should have the right to bail-in bank creditors (e.g. via the write-off of bank liabilities or their conversion into equity), if they believe the bank is likely to fail or actually failing. The crisis itself taught investors a lesson on unsecured bank bonds; they were not as safe, as investors had initially thought. The large stocks of unsecured bank bonds on their balance-sheets lead to a strongly enhanced impact on flows (i.e. very low demand on the primary market). The LCR is not an effective lever to prevent or even reverse the structural shift in bank funding, as it does not address its drivers.
Does a general softening of the LCR calibration improve the funding conditions for EU banks?
No. On the contrary, it worsens the funding conditions for EU banks further. Investors discovered that unsecured bank bonds are less attractive in terms of risk-return characteristics than they had initially thought before the crisis. The attractiveness of unsecured bank bonds is further reduced by increasing asset encumbrance (i.e. EU banks aim at increasing collateralised funding – repo, covered bonds, central bank funding – at the expense of unsecured funding). This effectively sub-ordinates unsecured bond holders. Furthermore, claims by the deposit insurance corporation often rank above unsecured bond holders, too. That sub-ordination is reinforced by short-term borrowing; short-term creditors can reduce their exposure quickly by refusing to roll-over short-term funding, if they perceive insolvency risk to increase (e.g. Copeland et al. 2012, Krishnamurty et al. 2012).
A credible commitment of EU banks to lengthen average funding tenors and to maintain a low share of short-term funding in the future is a necessary (though by no means sufficient) condition for unsecured bank bond markets to re-open. Effective liquidity regulation provides exactly that kind of credible commitment to investors.
Are the costs of introducing the LCR substantial enough to impact the costs of lending to the real economy significantly?
The QIS 2011 revealed that the liquidity gap to comply with the LCR amounts to EUR 1,150 billion for the European banks in the sample. That amounts to about 4-5 per cent of their balance sheets. But the QIS also reveals that the main driver of outflows for European banks is unsecured funding from financial institutions which contributes about a quarter of total cash outflows within 30 days. A reduction of EU banks’ short-term funding from financial institutions by about a half would already go a long way to achieve compliance. In addition, the reduction of Euro system minimum reserve requirements in December 2011 reduced the liquidity gap by another EUR 100 billion.
Overall, lending to the real economy does not have to be affected; it accounts for only 45 per cent of total assets of Euro area monetary financial institutions (MFIs), so there is room for manoeuvre to adapt to the LCR without reducing lending to the real economy (Puhr et al. 2012). In that VoxEU/EconoMonitor piece the authors also argue that “… [b]anks’ competitive advantage lies in credit and liquidity risk assessment and management rather than in speculative trading; in order to preserve their franchise values, banks do not resort to a decrease of their market shares in credit markets, unless absolutely unavoidable (e.g. restructuring due to EU state aid conditions). Banks also have relatively more pricing power in loan/deposit markets than in financial markets (i.e. shares, bonds, interbank markets) where they are usually price-takers.”
Furthermore, one would have to look at risk-weighted rather than the absolute costs of increasing liquidity buffers to meet the LCR requirement; HQLA are of higher credit quality (and, thus, have lower capital adequacy risk weights) than the assets they replace. So banks’ cost increases due to increasing HQLA buffers are partly off-set by lower required levels of capital to support a given balance-sheet size.
Finally, banks can also term out funding to meet the LCR. Since term premia are positive, this increases direct funding costs. But that does not necessarily increase credit spreads, since qualitative liquidity regulation already prevents banks from pricing long-term loans based on short-term funding costs. Inter alia, the liquidity fund transfer price has to take into account the direct and indirect costs of funding (CEBS 2010). Finally, without the LCR the respective costs do not go away; they emerge as implicit (not immediately P&L effective) costs in the form of higher liquidity risk and potentially negative external effects on society. The LCR only makes these costs explicit and internalises them.
For all these reasons the impact of the introduction of the LCR on the economy needs to be studied rigorously based on comprehensive bank level data. Art. 481(1) CRR mandates the EBA to do just this; it shall report annually to the EU Commission on whether the LCR is likely to have a material detrimental impact on the macro-economy, SME lending and trade finance. The EBA Subgroup on Liquidity is mandated to draft this report for the EBA. It has put forth a comprehensive approach to fulfil its mandate rigorously.
Does the unsecured money market effectively enforce market discipline?
No. The high leverage and the large share of short-term unsecured funding renders market discipline ineffective for EU banks. The proponents of market discipline assume that it is exerted smoothly without external costs to society. However, the text-book version of the process of market discipline conflicts with empirical evidence of the developments on the unsecured money market since August 9, 2007. The evidence shows that once market discipline actually bites, banks cannot deal with it. This is a consequence of banks’ substantial liquidity risk at the very short tenors and their very high leverage: once counterparties refuse to roll-over short-term funding, banks can neither meet their payment obligations by relying just on cash-inflows nor are their liquidity buffers sufficient to generate liquidity at acceptable costs. They have to resort to asset fire sales which sharply increase insolvency risk and further exacerbate their funding strain (Brunnermeier, Pedersen 2009). Banks have to deleverage quickly and substantially. The resulting adverse economic impact immediately motivates public bail-outs, i.e. by the provision of central bank funding and/or government guarantees (moral hazard) (Posch et al. 2009). Once the LCR is implemented, banks will be able to deal with sharp reductions in short-term unsecured interbank funding without the associated negative impact on the real economy, because they would rely less on short-term unsecured funding and hold higher liquidity buffers. So, the implementation of the LCR is a necessary (though not sufficient) pre-condition for market discipline to work effectively in banking rather than an obstacle to it.
Does the shortage of safe assets warrant a broadening of HQLA?
No. The objective of the HQLAs is increasing banks’ liquidity risk bearing capacity. To reach that objective the eligible assets must be of exceptionally high credit quality and market liquidity. If this collides with a shortage of such assets, banks have to reduce their short-term net cash outflows. As discussed above, it is unlikely that the subordination of unsecured bank bond holders due to the shortening of average maturities of bank liabilities, contributes to bank liabilities regaining their statues as safe and liquid assets. If policy makers want to address the shortage of safe assets (which they should), other instruments are preferable; i.e. increasing the soundness of banks and non-bank bond issuers by increasing their own capital cushion is a more effective strategy.
The dissolving international consensus on the need to harmonise and improve liquidity regulation endangers the future stability of the EU banking system. Furthermore, decreasing banks’ liquidity risk bearing capacity does not contribute to improving banks’ funding conditions, nor does it elevate the pressure on safe assets markets. At the same time, any potential detrimental unintended consequences of the LCR on SME lending, trade finance, and sustainable economic growth will be studied rigorously in the report pursuant to Art. 481(1) CRR.
For all these reasons the high uncertainty that contributes to the caution of potential investors in unsecured bank bonds should not be worsened by conflicting signals on the commitment to the reform of liquidity regulation. This further discourages their investment in unsecured bank bonds and aggravates the funding crisis of EU banks.
Disclaimer: The views expressed in this blog are those of the author and do not necessarily reflect those of the OeNB.
BCBS (2010) An assessment of the long-term economic impact of stronger capital and liquidity requirements, http://www.bis.org/publ/bcbs173.pdf.
Brunnermeier, M., L. Pedersen (2009), Market and Funding Liquidity, Review of Financial Studies 22/6, 2201–2238.
CEBS (2010), Guidelines on Liquidity Cost Benefit Allocation, http://www.eba.europa.eu/cebs/media/Publications/Standards%20and%20Guidelines/2010/Liquidity%20cost%20benefit%20allocation/Guidelines.pdf.
Copeland, A., A. Martin, M. Walker (2012), Repo Runs: Evidence from the Tri-Party Repo Market, Fed Ney York Staff Report No. 506
Coeure, B. (2012) The importance of money markets, speech at the Morgan Stanley 16th Annual Global Investment seminar, Tourrettes, Provence, 16 June 2012 http://www.ecb.int/press/key/date/2012/html/sp120616.en.html.
Deutsche Bank (2012), Corporate lending: structurally unprofitable, consequences for banks, 20 June.
EBA (2012) Results of the Basel III monitoring exercise as of 30 June 2011, http://www.eba.europa.eu/cebs/media/Publications/Other%20Publications/QIS/EBA-BS-2012-037-FINAL–Results-Basel-III-Monitoring-.pdf
ECB (2007) Liquidity risk management of cross-border banking groups in the EU, in: ECB, EU Banking Structures, p. 19-38.
Financial Stability Board – FSB (2008), Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, http://www.financialstabilityboard.org/publications/r_0804.pdf.
IMF (2012), Global Financial Stability Report, http://www.imf.org/external/pubs/ft/gfsr/2012/01/pdf/text.pdf
King, M. (2012) Speech at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House 14 June 2012 http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech587.pdf.
Krishnamurty, A., S. Nagel, D. Orlov (2012), Sizing up repo, NBER Working Paper 17768.
Macroeconomic Assessment Group (2011), Assessment of the macroeconomic impact of higher loss absorbency for global systemically important banks, http://www.bis.org/publ/bcbs202.pdf. BCBS (2010),
Noyer, C. (2012) Basel III – CRD4: Impact and stakes, speech at the ACP conference June 27, 2012, http://www.banque-france.fr/uploads/tx_bdfgrandesdates/Conference-ACP-27-june-2012.pdf
Posch, M., S. W. Schmitz, B. Weber (2009) EU Bank Packages: Objectives and Potential Conflicts of Objectives, OeNB Financial Stability Report 17, 63-84.
Puhr, C, S. W. Schmitz, R. Spitzer, H. Hesse (2012) Room for manoeuvre: The deleveraging story of Eurozone banks since 2008, 14 Jun 2012, http://www.voxeu.org/article/room-manoeuvre-among-eurozone-banks http://www.economonitor.com/blog/2012/06/room-for-manoeuvre-the-deleveraging-story-of-eurozone-banks-since-2008/
RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD of 22 December 2011 on US dollar denominated funding of credit institutions (ESRB/2011/2), http://www.esrb.europa.eu/pub/pdf/recommendations/2011/ESRB_2011_2.en.pdf?92ab1cac1a6e4a81802ab68ca8123610
Schmitz, S. W. (2011), The Impact of the Basel III Liquidity Standards on the Implementation of Monetary Policy, (May 6, 2011). Available at SSRN: http://ssrn.com/abstract=1869810.
Schmitz, S. W., A. Ittner (2007) Why central banks should look at liquidity risk”, Central Banking Vol. XVII No. 4, 32-40.
 “The turmoil demonstrated the central importance that effective liquidity risk management practices and high liquidity buffers play in maintaining institutional and systemic resilience in the face of shocks.” (FSB 2008, 16)
 RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD of 22 December 2011 on US dollar denominated funding of credit institutions (ESRB/2011/2), http://www.esrb.europa.eu/pub/pdf/recommendations/2011/ESRB_2011_2.en.pdf?92ab1cac1a6e4a81802ab68ca8123610
 I will not discuss the argument here, that the LCR should be adapted to address challenges for monetary policy implementation in the Euro area; I discuss that in depth in Schmitz (2011).
 In cases of insolvency collateralised creditors are entitled to their collateral. The latter often constitutes the bank’s assets for which transparency is higher (e.g. cover pool disclosure; tradable securities) and more stable (e.g. mortgages rather than, say, own trading assets; liquid securities with respective haircuts and daily margin calls) relative to those asset classes the unsecured bond holders would be entitled to in bankruptcy proceedings. The continuous monitoring of the cover pool, the potential dynamic enhancements, and the usual over-collateralisation increase the likelihood that covered bond are repaid in full. The cover pool is bankruptcy-remote, i.e. covered bond holders have a priority claim on the assets in the cover pool.
 Total out cash-outflows under the LCR of larger G1 banks in the sample amount to 38.6 per cent of total assets and for smaller G2 banks to 18.7 per cent (EBA 2012).
 ECB Press Release – 8 December 2011 – ECB announces measures to support bank lending and money market activity, http://www.ecb.int/press/pr/date/2011/html/pr111208_1.en.html
 It will reduce “pre-liquidity risk” profits, but not necessarily profits adjusted for liquidity risk cost.
 On August 9, 2007, the spread between 3M Euribor and the Overnight Index Swap (OIS) jumped from a stable level of around 5 basis points by more than 10 times on August 9, 2007 (Cœuré 2012) while market volume effectively dried-up for many banks.
 The ECB bailed-out banks that lost market access on the very same day: “Following the communication given earlier this morning on the ECB page “Announcements on operational aspects”, this liquidity-providing fine-tuning operation aims to assure orderly conditions in the euro money market. The ECB intends to allot 100% of the bids it receives.” http://www.ecb.int/mopo/implement/omo/html/index.en.html