The Basel Committee’s liquidity coverage ratio is an impressive, even noble effort to build an international consensus where none existed before. Regulators the world over now have a unified framework for monitoring banks’ ability to get their hands on cash at short notice.
But how much safer does it make the banking system? When the next crisis comes, the LCR may resemble a suit of armour in a gunfight: affording some protection from ricochets, but not enough to save anyone who takes a direct hit.
The collapse of Northern Rock in 2007, at the start of the financial crisis, revealed a gaping hole in the architecture of bank regulation. During the long decades of financial stability in much of the developed world, knowledge of what a liquidity crisis was and how it interacted with banks’ asset quality had been lost.
In the Basel I and II accords, liquidity was too easily assumed to be ever-present, and banks were expected to be able to keep going, as long as credit losses had not exhausted their capital. Northern Rock showed that the market could kill a bank by depriving it of liquidity, long before any asset problems were even apparent.
It was entirely right that regulators should address this lack when designing the new banking architecture, Basel III. And how appropriate that Mervyn King, the Bank of England governor who steered the UK’s response to Northern Rock, should be the one to present the LCR to the world.
Pious hope
By obliging banks to hold a stock of high quality liquid assets big enough to cover all their expected outflows over the coming 30 days, regulators will give them each a buffer. If a bank runs short of cash, it can sell or repo these assets and keep going. The amount of assets required is based on a model designed to reflect how customers of all kinds would pull money out of the bank if it was under financial stress.
A fine idea. But is it only as useful as a chocolate teapot? When a liquidity crisis strikes, it’s savage. A strong, investment grade-rated institution with billions of capital and a cupboard full of awards can be toast in weeks. When other financial firms fear lending to one of their own, the victim is as good as finished.
No one has put this plight better than the Renaissance poet Sir Thomas Wyatt: “They flee from me that sometime did me seek... all is turned... into a strange fashion of forsaking.”
Danger zone
King has emphasised, in print and in Monday’s press conference, that the LCR reserves are not supposed to be kept intact and never touched, but are there to be used when the need arises. “The purpose of the LCR is to make it that much less likely that banks will have to rely on the central bank for access to liquidity,” he said.
But it is hard to imagine a bank dipping into its LCR reserves and then returning to independent liquidity without central bank help. Any financial firm that can still borrow from its peers would be unlikely to run down its LCR buffer — to do so would require the supervisor’s permission, for a start.
And once the bank did cross that red line and start selling LCR assets, the market would probably get wind of it quickly, confirming lenders’ suspicions that this firm was a basket case.
Even if the asset sales remained secret, the ability to last another 30 days before defaulting would be unlikely to cure the underlying problem that caused the firm’s lack of liquidity in the first place.
King said regulators should not make banks hold “buffers upon buffers”, in other words more assets above the LCR requirement — but in practice, banks are likely to feel they have to, so that they never have to draw attention to any liquidity problem. It is arguably only the extra assets on top of the LCR that would really give a firm financial flexibility.
It is an irony of regulation, which applies also to the Basel III capital requirements, that in trying to cure a problem you can end up merely changing the level at which the market considers failure to begin. In the process, costs are added to the system for everyone.
Running through your fingers
This is particularly the case with liquidity, which by definition is slippery and ungraspable, there one day and gone the next. Once it starts to ebb, the draining of liquidity tends to accelerate.
That is why the only protection against a liquidity shortage is a much bigger organisation that is not worried about self-preservation and is willing to look beyond the struggler’s short-term problems to ensure its survival. For ordinary companies, this means a bank; for banks, it means the central bank.
The Basel Committee does not hide the fact that central banks will remain the lenders of last resort. Its urge is to avoid central banks becoming “lenders of first resort”. But a reserve covering a month’s outflows is a tissue-thin protection between the two.
The main benefit of the LCR may be to concentrate banks’ minds on the permanent reality of liquidity risk. But when a crisis comes, it will play out exactly like the last one. Big banks may rescue smaller ones, but when fear of contagion to big banks strikes, the central bank will respond quickly and with massive force.
Liquidity is of great use to financial markets, and hence ultimately to the economy. But it is an inherently dangerous attribute — the thing that makes bubbles self-perpetuating, and crashes swift and devastating.
Only anti-liquidity — such as immovably robust institutions willing to take mark-to-market losses — can cure its excesses.