Ed Dolan's Econ Blog

What is the Liquidity Coverage Ratio for Banks and why should we Care that it has been Watered Down?

Massive softening of Basel bank rules” read the headline in the print edition of Monday’s Financial Times. “Betrayed by Basel,” wrote Simon Johnson in a blistering post on his New York Times blog. At issue was a rule called the liquidity coverage ratio promulgated by the Basel Committee on Banking Supervision. If you are a banking wonk, the headlines would have been enough, but in case you are among those who are hazy on just what the liquidity coverage ratio is, what the Basel Committee does, and why we should care, read on.

What is the Basel Committee?

Bank regulators of individual countries do not act alone in setting rules for bank capital. If they did, the result would all too likely be a race to the bottom in which each country tried to gain market share for its banks by issuing rules that were as lax as possible. In an attempt to prevent that from happening, the world’s bank regulators get together to coordinate regulations through the Basel Committee on Bank Supervision.

The Committee meets at the Bank for International Settlements, an international organization, founded in 1930,that fosters monetary and financial cooperation and acts as a bank for central banks. The Basel Committee periodically issues “accords” that set out international standards for bank capital, liquidity, and other aspects of bank operations. The first Basel  Accords, now called Basel I, were issued in 1988. They were replaced by a new set of standards, Basel II, in 2004.

Unfortunately, Basel II did not prevent the most recent global financial crisis. Failure or near-failure of banks like Citibank, RBS, and Fortis required rescues and restructurings that ran to billions of dollars, pounds, and euros. It was back to the drawing boards to devise a new set of regulations. The world’s bank regulators agreed on the main outlines of Basel III at the end of 2010, but the technical details and the timing were left to be worked out later.

That is what all the fuss is about now. Global banks have tirelessly lobbied the working groups assigned to fill in the details of the regulations, and their efforts seem to have paid off. The final rules now being issued look much weaker than the strictest rules that would have been allowed under the outline approved in 2010.

What is the Liquidity Coverage Ratio?

Banks need liquidity because they cannot always control the timing of their needs for cash. Unexpected withdrawals by depositors, the favorite example of textbooks, are just one of many reasons that banks need liquidity. Other contingencies include sudden unavailability of interbank loans, a need for cash to meet line-of-credit agreements, and the need to honor off-balance sheet obligations.

Reserves of liquid assets provide a first line of defense, but as those are depleted, a bank may have to sell less liquid assets at “fire sale” prices below book value. Doing so erodes its capital and may lead to insolvency.

During a crisis, a liquidity spiral may develop that spreads problems from weaker to stronger banks. Early in the crisis, a few weak banks are forced to dump assets to cover deposit losses, collateral calls, or other liquidity needs. Falling asset prices weaken the balance sheets of other banks, and force them, too, to sell assets at fire sale prices. Soon even healthy banks are subject to stress. In the fall of 2008, just such a liquidity spiral helped spread the financial crisis throughout the globe from its origins in the U.S. subprime mortgage market.

Regulations can moderate liquidity risk by setting rules for both the asset and liability sides of bank balance sheets. On the asset side, regulations can require minimum cash reserves, including reserve deposits at central banks, and encourage holding of additional liquid assets like short-term government bonds. On the liability side, regulations can limit banks’ reliance on volatile wholesale funding while encouraging use of stable funding like insured retail deposits.

Negotiations leading up to the 2010 Basel III agreements focused on two major kinds of liquidity regulation. One was a proposal for a liquidity coverage ratio sufficient to guarantee that a bank could survive a 30-day stress period, hopefully long enough to permit recapitalization or orderly wind-up. Another proposal called for a net stable funding ratio that would have encouraged banks to hold more liquid assets and rely less on potentially unstable liabilities. (These ratios are described in greater detail in this slideshow.)

Both kinds of liquidity regulation require measuring the liquidity of various kinds of assets and liabilities. Are the long-term bonds of all governments equally liquid? Are AAA corporate bonds 50 percent as liquid as government bonds, or 40 percent as liquid? What is the risk of a run on consumer bank deposits compared to a run on wholesale funding like repurchase agreements? The answers to questions like these determine the weights that are incorporated in the final regulations. One set of weights could put real teeth in the regulations, another could make them toothless.

It now appears that banks’ lobbying efforts have paid off. Early on, they managed to relegate the net stable funding ratio to a committee for years of further study. Now it appears that the final weights for assets and liabilities incorporated in the liquidity coverage ratio will be close to what the banks wanted wanted. That means business as usual, so bank shares are soaring.

Why should we Care?

All this sounds pretty  technical, so why should we care? If banks are happy to operate with less liquidity, aren’t they the best judges? Wouldn’t it be best just to let them take the risks and let their shareholders pick up the pieces if things go wrong?

Unfortunately, things aren’t so simple. When banks fail, the pain quickly spreads beyond their shareholders. One reason is that the rest of the economy suffers when bank failures suddenly dry up essential credit flows. The other is that banks are politically powerful. In past crises, they have succeeded in transferring a large share of their losses to taxpayers. Privatize the profits, socialize the losses.

Of course, banks are not altogether  indifferent to risk. They check your credit score before they make a loan, they hedge their currency risks when they borrow or lend internationally, and so on. Still, there are some kinds of risks that they do not always adequately control.

The most problematic are so-called negatively skewed risks. Those are risks that have a very small chance of actually happening, but that involve very large losses if they do occur. Banks tend to take inadequate precautions against such risks for two reasons. One is the expectation that, although they themselves may bear losses that are merely large, rare but truly catastrophic losses can be shifted to the government. Bonus-based compensation systems also encourage bankers to pursue strategies that provide profits most of the time, even at the risk of occasional catastrophic loss. Top executives almost never go to jail when their strategies suffer spectacular failures. At worst, they lose their jobs, while retaining bonuses they have banked in the past and golden parachutes that were written into their contracts in better times.

Liquidity risks, by their nature, are negatively skewed. In the normal course of business, banks don’t have to worry much about liquidity. If they need more cash, they can depend on selling assets at fair market prices or they can borrow from their financial peers. Systemic liquidity crises, when sound assets can be sold only at fire sale prices and lines of credit dry up, are rare. Regulations like liquidity coverage ratios and net stable funding ratios are supposed to tame the appetite of bankers for negatively skewed liquidity risks, if they are not weakened beyond all effectiveness.

That, then, is what all the fuss is about. It now looks as if Basel III liquidity regulations are going to be weak. There won’t be as much protection against the risk of a new banking crisis as it seemed a couple of years ago, when the outline of Basel III was first issued. To mix a metaphor, it appears that once again, we are going to leave the vampire squid to guard the henhouse.

For more on the liquidity coverage ratio, net stable funding, capital regulations, and Basel III, check out these slideshows on capital regulations and liquidity regulations.

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