Liquidity regulation and its consequences

1. Liquidity regulation and its consequences Bill Allen ALMA Annual Conference 28th January 2011

2. Basel 3 Regulators� response to financial crisis. Basel 2 didn�t prevent crisis (perhaps made it worse). Basel 3 includes much higher capital requirements internationally agreed liquidity regulation for the first time.

3. The liquidity requirements Liquidity coverage ratio Stock of high quality liquid assets/net cash outflows over 30 days in stressed conditions > 100% Introduced 1.1.2015 Net stable funding ratio Available stable funding/required stable funding > 100% Limits maturity mismatch Introduced 1.1.2018

4. Observation period begins 2011 �The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.�

5. What the Basel Committee has done Objective Force banks to self-insure liquidity risk, and rely less on official liquidity insurance (lender of last resort). Technique Dictate banks� stock of liquidity policies. Restrict maturity transformation. Once-in-a-lifetime opportunity for regulators.

6. Likely effects of LCR Unsecured interbank market will shrink/die because liabilities < 1m require 100% liquidity backing. Banks will need alternative liquidity sources, including assets. Liquid assets held to meet LCR aren�t liquid! Banks also need liquidity they can use. Strong incentive for asset securitisation Corporate debt Household debt Credit assessment? Rating agencies. Backup liquidity facilities will become prohibitively expensive (LCR) Companies will find it harder to manage liabilities flexibly� �and will need to build up liquid assets.

7. Likely effects of NSFR Intention is to reduce liquidity transformation by banks. But prime mortgage loans are weighted at 65%, so the BCBS have ducked the main issue! The main effect will be on industrial lending, especially SME lending which is hard to securitise. Pressure on longer-term debt markets resulting from supply from banks and corporates. Competition for retail deposits (favourably treated by both LCR and NSFR).

8. The definition of liquid assets for LCR Cash and deposits in central bank Government debt (0% Basel 2 weight) Plus (level 2, subject to 40% limit) Other govt debt (20% Basel 2 weight) Corporate bonds (=15% haircut) Covered bonds (=15% haircut). Corporate and covered bonds must have �proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions�. This is pretty limiting. And the range of acceptable corporate or covered bonds won�t be flexible because it will take time to develop the required track record.

9. Q - What�s wrong with the LCR? A � the definition of liquid assets Heavy concentration on government debt. Large subsidy to government borrowing � remember that the Basel Committee has a conflict of interest. Can and will be abused. Bad choice of private debt instruments. Corporate and covered bonds may be liquid in some conditions but typically have long maturities. Commercial bills of exchange have short maturities and can have intrinsic liquidity, but are not eligible liquid assets. Allowing commercial bills would incentivise banks to generate liquid assets from commercial loans, which is what regulators want.

10. Possible unintended consequences Subsidy to government borrowing is vulnerable to abuse � governments can expropriate depositors. Concentration on government debt is risky - government securities aren�t always liquid or even safe. Potential liquidity problems if a sovereign borrower loses creditworthiness and 0% Basel 2 risk weight. In a budget crisis, the requirement could force central banks to monetise govt debt to avoid bank failures.

11. Possible improvements Many of the consequences of the proposed liquidity ratios are what the regulators want. Definition of liquid assets is dangerously narrow and could aggravate financial instability Should avoid concentration on govt debt. Enable banks to create liquid assets more easily. Bills of exchange � history. Other non-government assets. Monetary policy needs to be integrated with �macro-prudential�.

12. The role of mortgages in bank liquidity Until the 1970s UK banks did hardly any mortgage lending. Not liquid enough. Building societies did it but their liabilities weren�t as liquid as bank deposits. Now Building society shares are just like bank deposits Mortgages are 37% of UK sterling assets of MFIs. Mortgages are the big issue in maturity transformation, not a surprise that they were at the heart of the liquidity crisis. BUT regulators don�t want to retard mortgage lending � therefore only 65% weight for prime mortgages in NSFR. The NSFR puts no restraint on a bank funded entirely with retail sight deposits and all of whose loans are 25 year prime mortgages. Regulators have conflict of objectives.

13. Transitional issues Shift from liability to asset management requires building up of asset stocks. From government? Budget deficit? Is it safer to have assets created by the govt than by the private sector? By converting bank claims on private sector into liquid form? Pressure on bond markets. Effect on economy? Repayment of special facilities (SLS, CGS) will aggravate liquidity squeeze. Liquidity management should now be part of monetary policy. Financial stability is not separate from monetary policy. Adjustment to new world could retard recovery. NIESR suggests not much. BIS says not much. Bank of England thinks shortage of credit is a risk, but won�t extend SLS. How much of the adjustment has occurred already?

14. What else is needed? In Basel 3 regulators assert control over the banks� liquidity management. Required liquid assets are locked up and can�t be used. Regulators can�t have power without responsibility. They must decide when to release liquid assets. Bank directors are also responsible for liquidity. They need to know under what circumstances (a) required liquid assets will be released and (b) emergency liquidity will be provided. Regulators must devise and publish contingency crisis management plans. �Constructive ambiguity� is no longer adequate.

15. Conclusions - 1 The Basel Committee has asserted wide new powers over bank liquidity management. The LCR has the capacity to change banks� business models by making liability management much harder, for both banks and customers. The LCR needs to be improved (a) to avoid subsidising government borrowing and (b) to encourage banks to acquire liquid assets from commercial loans.

16. Conclusions - 2 It is legitimate for regulators to want to reduce the likelihood that emergency liquidity assistance will be required to prevent a crisis. Power has to be accompanied by responsibility. Required liquid assets are not liquid. Regulators need to be ready to release required liquid assets in an emergency. Bank directors too are responsible for the liquidity of their banks. They can�t discharge that responsibility if they don�t know how regulators will behave in a crisis. Therefore regulators should develop and publish contingency plans for dealing with a crisis, including stating under what conditions they will (a) release required liquidity and (b) provide emergency liquidity.