Liquidity coverage ratio

Liquidity Regulation is Back

Modern bank regulation has two complementary parts: capital and liquidity requirements. The first  restricts liabilities given the structure of assets and the second limits assets based on the composition of liabilities.

While capital regulation―especially in its risk-based form―is a creation of the last quarter of the 20th century, liquidity regulation is much older. In fact, the newly implemented liquidity coverage ratio (LCR) harks back to the system in place over 100 years ago. In the United States, before the advent of the Federal Reserve in 1914, both national and state-chartered banks were required to hold substantial liquid reserves to back their deposits (see Carlson). These are the reserve requirements (RR) that remain in effect in most jurisdictions today, the United States included.   

In this post, we briefly examine the long experience with RR as a way to gain insight regarding the LCR. We draw two conclusions. First, we argue strongly against using the LCR as a monetary policy tool in advanced economies with well-developed financial markets. Like RR, it is simply too blunt and unpredictable. Second, for the LCR to work as a prudential policy tool, it should probably be supplemented by something like a fee-based line of credit at the central bank....

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Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

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How to Ensure the Crisis Provision of Safe Assets

Changes in financial regulation are having a profound impact on the demand for safe assets—assets with a fixed nominal value that may be converted at all times without loss into the means of payment. Not only is demand for safe assets on the rise, but the ability of the private sector to produce them is being constrained by new rules that limit the extent and nature of things like securitizations.

So far, the fallout from increased demand and constrained supply looks reasonably benign. But for several years now, broad financial conditions have been very calm, with measures of financial volatility and stress at or near long-term lows. What will happen when the financial system comes under stress again? What if there is a drop in risk tolerance (or a surge in risk awareness) and a flight to safety that causes a jump in the demand for safe assets or a plunge in the supply? Or, as in 2008, what will happen if both materialize at the same time? We need to be ready.

As we will explain in more detail, central banks in advanced economies can satisfy the heightened need for safe assets under stress (as well as the precautionary demand in normal times) by offering commercial banks committed lines of credit for a fee against collateral, as the central banks in Australia and South Africa currently do. In our view, this mechanism for ensuring sufficient supply of safe assets in a crisis has important advantages compared to one in which the central bank operates perpetually—in good times and bad—with a very large balance sheet.

To see how this would work, we start with an explanation of post-crisis liquidity regulation....

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The Scandal is What's Legal

If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]

But we're not film critics, The moviealong with some misleading criticismprompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....


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