Terrifying question of the day October 24, 2012 at 8:17 am

(Yes, that is a theme for this week. I’ll get over it after that.)

Can a Basel III liquiidity buffer every be used? The point is that banks have to have this buffer at all times, which means that they can never use it without triggering supervisory intervention. So do they in fact have more liquidity risk than prior to Basel III?

4 Responses to “Terrifying question of the day”

  1. Maybe the bank only uses this “buffer” for the benefit of others when it goes bust and is unwound?

  2. Start from a 100% Liquidity Coverage Ratio (LCR). Suppose a bank is in stress and some short term wholesale funding does not get renewed. It has lost that funding. That means there are more assets than liabilities and the LCR is >100%, so the bank sells down the liquid asset buffer. It can use it. Seems like no problem.

    But then suppose in a more realistic stress, the bank is forced to replace maturing long term funding with short term funding ( 100% the bank needs to increase the size of the liquid asset buffer, ie shift the composition of assets towards more liquid stuff. That obviously has a P&L consequence, but it should improve overall asset quality. If the liquidity stress is a consequence of doubts over solvency, improving asset quality should be beneficial.

    The challenge will be for a regulator to have the stomach to allow a bank to have LCR < 100% when it is in recovery mode. Seems like the same issue as with letting banks run down countercyclical capital buffer and capital conservation buffer in bad states of the world.

  3. QM – There is gearing in the rule though. If you start with LCR closes to the edge, and you lose some short term funds, you can’t entirely replace that with the buffer as your required LCR will often be similar before and after the funding loss. This is because the assumed loss rate in the LCR calculation is less than 100% for many categories of funds, so the amount you assume that you would lose is less than the amount you already have lost. Losing (in the Basel III language) ‘Unsecured wholesale funding provided by other legal entity customers’ is fine – losing deposits isn’t.

    You can’t replace maturity long term funding with short term wholesale funding either as that increases the LCR requirement, so you need to put any funds you raise straight into the liquidity buffer.

  4. Right you are. But does this not get a little crazy? Say a bank at 100% LCR loses retail deposits. It meets the demands with cash from selling down the liquidity buffer. But then to restore the LCR the bank can’t use short term wholesale funding with a 100% outflow factor. So go raise some long dated funding in a stress, presumably at horrific cost which is a distress signal of its own. Yuck!

    The saving grace may be that in future, retail balances should be stickier thanks to higher deposit insurance and required rapid payout.

    Either that or banks have to fund the liquidity buffer with long dated funds (and then scalp punters for the -ve carry).