Liquidity is the new obscenity
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Liquidity is the new obscenity

Defining liquid assets is always going to be a problem; the whole concept is flawed. The best regulators can do is use the Supreme Court’s standard on obscenity – “I know it when I see it”, in the words of Mr Justice Potter. Results otherwise are likely to prove perverse.

If banks can’t be trusted to hold enough liquid assets on their own, regulators need to give them a prod in the right direction. But choosing which direction isn’t easy.

Liquid assets, for this purpose, are assets that can be sold quickly, without moving the price much. Regulators don’t have much reason to care about whether there’s a two-way market, or a futures contract, or hedging tools, or an active repo market, or much shorting.

All they want is for a bank to be able to liquidate assets — meaning a deep pocket of demand.

But this in turn depends on what all the other banks are up to. If every bank has the same set of assets in its liquidity buffer, just how liquid are those going to be in a 30 day stress-period? Liquid enough, if it’s just a single bank that is under funding pressure. But not so much if the stress spreads — as it usually does.

Banks will be forced to run down their liquidity buffers all at once, which will mean selling into a falling market. In such conditions, nobody will want to show bids, so the previously liquid asset will no longer be so.

Even if Basel and the EC had gone over market conditions in the previous five years with a fine-toothed comb and defined a set of assets carefully calibrated on bid-offer metrics, it would not be the right set for the next five years. Past performance, as we’re often reminded, is no guarantee of future performance.

Unfortunately, any consistent and transparent set of rules will encourage banks to converge on the same set of liquid assets. Even righting the most obvious wrongs of the Liquidity Coverage Ratio (widening the asset set as Basel hinted at on Sunday; dropping the pretence that EEA government bonds are equal) doesn’t change this.

Instead, the best liquidity insurance for the system is for banks to have different, diverse assets in their liquidity buffers.

Even better would be going for peer-reviewed discretionary approach. Bank tables liquidity proposal; regulator agrees, thinking all the while about whether the banks in its peer group are acting in the same way, and whether the instrument is likely to be saleable in market difficulties.

Then, at last, you can have grown-up conversations about liquidity. Instead of having pretend rules that offer banks the chance to game the system with inappropriate assets, regulators can encourage banks to hold genuinely liquid instruments, and instruments that might remain so in a market chill.

Granite, the €20bn benchmark bond of the European ABS market, should sit happily in any liquidity book — it may be the most liquid instrument in the European credit universe. But under CRD IV as presently drafted, €300m of BBVA March 2017 4.35% covered bonds do count while Granite does not.

One could demonstrate this difference with bid-offer spreads and volume data (if this actually existed), but that would create cliff effects and herding. Once a particular security dropped out of the “liquid” definition, it would suddenly become much less liquid, as bank treasuries rushed to sell.

Better, overall, to trust judgement. Market participants know which securities are liquid. Traders are rightly expert in sniffing it out. But that isn’t measured. It’s the product of market experience.

They know it when they see it — so why can’t regulators?

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