What Was Just Watered Down in Basel's Liquidity Requirements?

Jan 8, 2013Mike Konczal

Let’s say you were trying to make a personal budget. We can imagine two reasonable ideas you would want to incorporate into this budget. The first is that you want to make sure you can pay your bills if your income suddenly freezes up or you suddenly need cash. You want to make sure your savings are sufficiently liquid in case there is an emergency.

Another rule is that you want your time horizon of your debts to match what you are buying with those debts. You don’t want a 4-year mortgage and a 30-year auto loan; you want a 4-year auto loan and a 30-year mortgage. And for our purposes, you really don’t want to buy either on a credit card, since the payment terms can fluctuate so often in the short term.

These two ideas are behind two of the additional special forms of capital requirements designed by the Basel Committee on Banking Supervision in Basel III. The first is a “Liquidity Coverage Ratio” (LCR), which is designed to make sure that a financial firm has sufficiently liquid resources to survive a crisis where financial liquidity has dried up for 30 days. The second is a “Net Stable Funding Ratio,” which is designed to complement the first rule and seeks to incentivize banks to use funds with more stable debts featuring long-term horizons.

Basel has just introduced some changes into their final LCR rule, so let’s take a deep dive into this capital requirement rule. Before we introduce some headache-inducing acronyms, remember that the basics are simple here. Banks have a store of assets and they have obligations that they have to make. Or, at the simplest level, banks have a pile of money or things that can be turned into money and people and firms who are demanding money. So any watering down of the rule has to impact one of those two things.

Remember that in a crisis it is hard to sell assets to get the cash you need to make your payments. Also, crucially, others will want to take out more from the bank if they are worried about the bank’s assets, like in a bank run. So both of these items are stressed in the rule to get numbers sufficient to survive a crisis. Banks would prefer to count riskier kinds of things as those safe assets, and assume that firms would want to take less in times of crisis. Each allows them to have to hold less high-quality capital.

There are three major changes announced. The first is that the requirements will be slowly phased in each year for the next several years, fully online by 2019. This is to avoid putting additional credit stresses on the financial system right now. There's also a clarification that assets can be drawn down in times of crisis. But how will these regulations look when they are online? The other two changes are the way the actual mechanisms are calculated.

Let’s chart out those last two changes that were just introduced:

Originally there were just two levels of assets, level 1 and level 2. The second change is to create a new level of assets, called “Level 2B.” Level 1 is unchanged, as well as the old Level 2, which is now Level 2A. Level 2B will be no more than 15 percent of total assets, but it will include lower rated corporate debt (BBB- or above) and, more shockingly, equity shares. Equity is not what you want as a liquidity buffer, as its value will plummet and volatility will skyrocket during crises. In a crisis all correlations go to 1, and that’s especially true in a financial crisis. The fact that it might have done well in the 2008 crisis is no excuse because, as Economics of Contempt pointed out on this topic, there were massive government bailouts and interventions in the market, which is what we want to avoid.

On the plus side, rather than just putting equities in “Level 2,” they created a separate bucket with harsher penalties. Equities will receive a 50 percent haircut toward qualifying, much larger than the 15 percent haircut Level 2A assets get.

The third change is the lower outflow rate for liquidity facilities, corporate deposits as well as other sources of outflows. To get a sense of this, stable deposits with a serious system of deposit insurance – think of your FDIC savings account – originally had a 5 percent outflow. A bank would have to be prepared for 5 percent of its deposits to leave during this financial crisis. That has been reduced to 3 percent in the new rule.

These changes are particularly large for liquidity facilities. Instead of the assumption that firms will go gunning for any emergency liquidity that they can find, and as such use up most of these outlines, there are much more financial-friendly outflow estimates. In fact, many of these rates have been cut by more than half, with Basel now estimating that liquidity facilities, for instance, will only be drawn down 30 percent instead of 100 percent.

These are dramatic reductions. If they are predicated on more closely aligning with 2008 numbers, backstopping the entire liquidity of the financial markets was the whole point of the bailouts and the Federal Reserve’s emergency interventions. The numbers should be much worse in this case.

There is finally a global rule declaring a necessary, but not sufficient, minimum level of liquidity in financial firms. Liquidity does nothing if a firm is insolvent, but it by itself can generate panics. However these rule changes almost all entirely benefit the financial system, and call for less liquidity than in the first drafts. Undercounting the liquidity facilities, as well as letting more of the HQLA consist of assets like stocks and MBS, is a major change from the previous version.

The Basel committee notes that its Liquidity Coverage Ratio is an absolute minimum rate, and that “national authorities may require higher minimum levels of liquidity.” Authorities within the United States should take this seriously. Dodd-Frank calls on regulators to put in sufficient liquidity regulations for large financial firms. Basel III provides a baseline, but regulators could go further by themselves if necessary via their Dodd-Frank mandate. Understanding why the outflow assumptions have so dramatically changed will be one point to follow.

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