A shameful lack of liquidity constraints March 31, 2010 at 6:06 am

Bloomberg points out something that we should be quite troubled by:

In 2,615 pages of financial reform legislation introduced in the U.S. Congress, there are no rules to ensure that banks keep enough cash-like assets when credit disappears.

Guidelines on liquidity risk management, which were published March 17 by the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corp., also avoided spelling out how much banks need to hold, and in what form, to make sure they don’t collapse if short-term lending dries up…

“They’re assessing the processes and monitoring of liquidity but not addressing the quantities of liquidity that banks need to hold.”

The issue here is regulatory creep. When times are good, banks will reduce their liquidity buffers, and this will seem reason to regulators. They will hold back egregious reductions, but they might be unable to stop a slow trend where banks become less liquid.

The Basel committee had proposed something a lot tougher here: a 100% net stable funding ratio, meaning that all of a bank’s anticipated funding needs over a one year horizon would have to be met by deposits and long term financing. That, of course, would dramatically reduce the profitability of many banks since they make a lot of their money from punting the yield curve – funding short and lending long. The view of the experts polled by Bloomberg is that the Basel proposal will be watered down substantially.

This is shameful. Liquidity risk is a major vector, perhaps the most important vector, of bank failure. Without fixed liquidity rules, banks and non-bank financials will fail more easily: rules like this would have meant that Bear Stears and Lehman could not have got into trouble the way they did. Add in a firm, low leverage ratio, like 15%, and we would have gone a long way towards making the financial system more robust. The failure to address liquidity risk with a fixed net stable funding requirement is a massive missed opportunity and we should decry it.

4 Responses to “A shameful lack of liquidity constraints”

  1. [...] New US liquidity risk guidelines: [...]

  2. Nothing shameful about it. As the Bloomberg piece finally admits a few pars from the end, the reason no national supervisors are implementing their own quantitative liquidity requirements is because they’re waiting for the Basel Committee to come up with a single set of rules that can be used globally.

    The Bloomberg “analysis” of what will happen to the Basel proposals is dire. For what it’s worth, I think the portion of the proposals that deals with liquidity is one of the more likely to survive intact – and if it IS adjusted, I think there’s zero chance that all the quantitative elements will be stripped out.

  3. [...] Deus Ex Macchiato: A shameful lack of liquidity constraints [...]

  4. Interesting perspective, Inky Sooty, thank you for the comment. I hope you are right.