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 bank 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%. HQLA are assets that are of (extremely) high credit quality and (extremely) high market liquidity. The LCR is to be introduced by 2015.
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. 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:
1. It is the first time in history that liquidity and reporting standards are internationally harmonised. For internationally active banks this yields multi-billion USD cost savings.
2. Currently, most liquidity standards have substantial shortcomings: 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 and Ittner 2007) is forward looking, takes into account all sources of liquidity risk (e.g. off balance-sheet exposure), and is highly risk-sensitive.
3. 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 (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 14 June 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 22 June, the UK interim Financial Policy Committee recommended that the FSA would consider loosening micro-prudential liquidity standards to facilitate lending to the economy.
In a speech on 16 June 2012 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 26 June: “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:
1. EU banks are under funding stress. Thus, they should be allowed to make use of their liquidity buffers and decrease their liquidity risk bearing capacity to spur lending to the economy.
2. 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
3. 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 (with higher haircuts), because the demand for safe assets would further increase by $2 trillion to $4 trillion (IMF 2012, 100).
4. 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, some of the key players in international regulatory reform have turned critical on the LCR. 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?
So, 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. Moreover, the future EU framework for bank recovery and resolution aims at reducing tax payers’ costs of banking crisis and proposes that supervisors should be able to bail-in unsecured bank bond holders. The crisis itself taught investors a lesson on unsecured bank bonds; they were not as safe, as investors had initially thought. Given their large holdings of banks bonds, their demand on the primary market is very low. 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 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). This effectively sub-ordinates unsecured bondholders. Furthermore, claims by the deposit insurance corporation often rank above unsecured bondholders, too. That subordination 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 €1,150 billion for the European banks in the sample (roughly 4%-5% 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’ net short-term funding from financial institutions by about a half would already go a long way to achieve compliance.
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 Vox piece the authors also argue that banks’ competitive advantage lies in credit and liquidity risk assessment and management and that they have relatively more pricing power in loan/deposit markets than in financial markets. In order to preserve their franchise value, they'd avoid cutting loans supply.
Furthermore, one would have to look at risk-weighted rather than the absolute costs of increasing liquidity buffers to meet the LCR requirement; HQLAs consume less capital than the assets they replace. This (partly) off-sets lower yields on HQLAs.
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 (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. The EBA Subgroup on Liquidity has put forth a comprehensive approach to fulfil this mandate rigorously.
Does the unsecured money market effectively enforce market discipline?
Does the unsecured money market effectively enforce market discipline? The answer again is 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 textbook version of the process of market discipline conflicts with empirical evidence of the developments on the unsecured money market since 9 August 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 and Pedersen 2009). Banks have to deleverage quickly and substantially. The resulting adverse economic impact immediately motivates public bailouts, 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?
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 (extremely) 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 bondholders due to the shortening of average maturities of bank liabilities, contributes to bank liabilities regaining their statues as safe and liquid assets. If policymakers 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.
The views expressed in this column 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”, BIS.
Brunnermeier, M and L Pedersen (2009), “Market and Funding Liquidity”, Review of Financial Studies, 22(6):2201-2238.
CEBS (2010), “Guidelines on Liquidity Cost Benefit Allocation”.
Copeland, A, A Martin, and M Walker (2012), “Repo Runs: Evidence from the Tri-Party Repo Market”, Fed Ney York Staff Report No. 506.
Cœuré, B (2012), “The importance of money markets”, speech at the Morgan Stanley 16th Annual Global Investment seminar, Tourrettes, Provence, 16 June.
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”.
ECB (2007), “Liquidity risk management of cross-border banking groups in the EU”, in ECB, EU Banking Structures, 19-38.
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IMF (2012), Global Financial Stability Report.
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.
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”.
Noyer, C (2012), “Basel III – CRD4: Impact and stakes”, speech at the ACP conference, 27 June.
Posch, M, SW Schmitz, B Weber (2009), “EU Bank Packages: Objectives and Potential Conflicts of Objectives”, OeNB Financial Stability Report ,17:63-84.
Puhr, C, SW Schmitz, R Spitzer, H Hesse (2012), “Room for manoeuvre: The deleveraging story of Eurozone banks since 2008”, 14 June.
Recommendation of the European Systemic Risk Board of 22 December 2011 on US dollar-denominated funding of credit institutions (ESRB/2011/2).
Schmitz, SW (2011), “The Impact of the Basel III Liquidity Standards on the Implementation of Monetary Policy”, 6 May.
Schmitz, SW and A Ittner (2007), “Why central banks should look at liquidity risk", Central Banking Vol. XVII No. 4, 32-40.