While much attention seems to be focused on setting higher equity requirements for financial institutions, in hopes they can better survive a financial crash, little attention is being paid to the two rules that would deal directly with the financial panic of 2007-2008 and the run on the repurchase market.
One person who is watching is the New York finance lawyer who blogs at Economics of Contempt. He has recently published three items about the two requirements, which are:
- A “liquidity coverage ratio” to improve the panic-resistant quality of bank assets, so some assets will hold their value during a panic, and
-A “net stable funding ratio” to better match the maturities of deposits, loans and repos, so fewer long-term securities will be financed with short-term loans that lenders can suddenly refuse to renew.
Officials at the Bank for International Settlements, which coordinates worldwide financial regulations from its headquarters in Basel, Switzerland, have said the new ratio requirements will not begin until at least 2015 and 2018 respectively.
Economics of Contempt noted April 6 that Basel regulators have agreed in the meantime to consider changing the way the two liquidity ratios will be calculated:
The liquidity requirements are a massive deal for banks, although you wouldn’t know that from reading the financial press, which hardly ever mentions them. The Basel Committee’s “quantitative impact study” showed that banks face a shortfall of liquid assets of $2.48 trillion for just one component of the liquidity requirements, which is over three times the size of the banks’ capital shortfall under Basel III.
The liquidity requirements are by far the most important outstanding aspect of financial reform, so the fact that the Basel Committee is open to tweaking them even a little is a big deal.
About the liquidity coverage ratio, Economics of Contempt said:
Broadly, the liquidity coverage ratio requires internationally active banks to maintain a stock of “high-quality liquid assets” that’s sufficient to cover cash outflows in a 30-day stress scenario. In other words, banks are required to have enough cash or cash-like instruments on hand to survive a really horrible, financial-crisis-level 30 days, in which the funding markets all but shut down.
Still unresolved are two key issues, according to Economics of Contempt: How much liquid assets need to be maintained for derivative transactions and how much for “clients that they’re not technically required to provide, but likely would anyway.” That second point describes what happened when Citigroup and others decided to bail out their off-the-books trusts and hedge funds in 2007-2008 to save their own reputations, said Economics of Contempt.
Those are two pretty significant unresolved areas.
About the net stable funding ratio, Economics of Contempt says:
… the Net Stable Funding Ratio isn’t scheduled to be implemented until 2018, if it’s ever implemented at all (and I have serious doubts about whether it’ll ever be implemented in anything like its current form, which is barely even coherent).
The problem with both of these ratios is that they may strengthen individual firms but they do little to strengthen the sytem as a whole, as noted by the International Monetary Fund’s Global Financial Stability Report issued in early April.
From Chapter 2 of the report:
The financial crisis highlighted the lack of sound liquidity risk management at financial institutions and the need to address systemic liquidity risk—the risk that multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding through widespread dislocations of money and capital markets.
Under Basel III, individual banks will have to maintain higher and better-quality liquid assets and to better manage their liquidity risk. However, because they target only individual banks, the Basel III liquidity rules can play only a limited role in addressing systemic liquidity risk concerns.
Larger liquidity buffers at each bank should lower the risk that multiple institutions will simultaneously face liquidity shortfalls; but the Basel III rules do not address the additional risk of such simultaneous shortfalls arising out of the interconnectedness of various institutions across a host of financial markets.
More needs to be done to develop macroprudential techniques to measure and mitigate systemic liquidity risks.