Monday, September 13, 2010

More on Financial Reform and Basel III: Regulating Bank Liquidity

As an earlier post explained, the Basel III agreement, now under negotiation, will set international capital adequacy regulations for banks. It will also set regulations for bank liquidity, which are the subject of this post.

Banks need liquidity because they cannot always control the timing of their needs for funds. For example, depositors may make unexpected withdrawals, sources of wholesale funding may not be rolled over in a crisis, line-of-credit agreements may create demands for liquid assets to fund loans, and off-balance sheet obligations provide further liquidity needs.

Bank runs are the classic form of liquidity crisis. Although deposit insurance mitigates runs on retail deposits in most advanced countries, insurance does not extend to large depositors or wholesale funding. As runs deplete a bank's liquid reserves, it can be forced 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 are 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 to moderate liquidity risk can apply to both the asset and liability sides of bank balance sheets. Asset side regulations can require minimum cash reserves, including reserve deposits at central banks, and can also encourage holding of additional liquid assets like short-term government bonds. Liability-side regulations can limit banks' reliance on volatile wholesale funding while encouraging use of stable funding like capital and insured retail deposits.

The Basel III negotiations, now underway, include discussion of two major liquidity regulation initiatives. One is 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 calls for a net stable funding ratio based on a ratio of available stable funding to required stable funding. The former is a weighted average of liabilities, with stable sources of funding like retail deposits and capital having high weights, and the latter is a weighted average of assets, with the most liquid assets having low weights.

The Basel III agreements are supposed to be completed by the end of 2010. They are the object of tough negotiations among national governments and fierce lobbying by banking interests. A preliminary meeting in July already resulted in some watering down of the initial proposals, including an agreement to postpone implementation of the net stable funding ratio during several years of observation. The final form of the Basel III agreements is certain to be a significant factor in shaping the timing and severity of the next banking crisis.

Follow this link to download a free set of classroom-ready slides explaining the need to regulate bank liquidity and discussing the Basel III proposals. These slides are best used together with those attached to my earlier post on Basel III and bank capital, which provides additional information on the Basel agreements in general.

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