The US implementation of the Basel III LCR was proposed by regulators in November 2013, and was finalized in October 2014.24 The US LCR applies to (1) large, internationally active banking organizations, (2) nonbank SIFIs regulated by the Federal Reserve that do
not engage in substantial insurance activities, and (3) consolidated subsidiary depository institutions with total assets of greater than $10 billion.25
The US LCR requires all covered organizations to maintain a minimum LCR of 100 percent, calculated by dividing a bank’s high-quality liquid assets by its total net cash outflow amount over a 30-day period.26 It is substantially more severe than the Basel proposal. One of the most significant differences between the US LCR and the Basel III LCR lies in the assumed runoff rates for short-term creditors without a specific maturity date, including uninsured retail and wholesale depositors, the primary source of short- term funding for covered organizations.27 The US LCR assumes that these short-term creditors would withdraw their funding immediately on day 1 (essentially, a single day stress scenario), whereas the Basel III LCR implicitly assumes that these funds are withdrawn at a constant rate through day 30.28 The US LCR calculates the total net cash outflow amount based on the single day within a 30-day period with the highest amount of net cumulative outflows, while the Basel III LCR uses total cash outflows over a 30-day period.29
In order for an asset to qualify as a high-quality liquid asset under the Fed’s rules, it must be liquid and readily marketable, a reliable source of funding in repurchase
agreement or sales markets, and not an obligation of a financial company.30 A standard stress scenario would assign specific outflow amounts to different categories of a bank’s funding.31 Importantly, during an idiosyncratic or systemic liquidity crisis, a covered organization would be permitted to convert its high-quality liquid assets into cash as necessary to meet withdrawals by short-term creditors, even if this required falling well below the minimum LCR.32
A Basel Committee Study assuming full implementation of the Basel III liquidity requirements as of December 31, 2013, found that for internationally active banks with over €3 billion in capital, the aggregate LCR shortfall at a minimum requirement of 100 percent is €353 billion, and is €158 billion at a minimum requirement of 60 percent.33 The aggregate shortfall for the NSFR is €817 billion.34 However, “the shortfalls in the LCR and the NSFR are not necessarily additive, as decreasing the shortfall in one
standard may result in a similar decrease in the shortfall of the other standard, depending on the steps taken to decrease the shortfall.”35 The Basel III liquidity requirements,
combined with a growing demand for safe collateral resulting from an increase in central clearing of derivatives,36 will put upward pressure on the prices of liquid assets and cause further increases in funding costs. The liquidity requirements are likely to be expensive and may ultimately have more impact on bank lending activity than capital requirements.
Whatever the virtue of “private liquidity” it can never be a complete substitute for public liquidity through a strong LLR. Indeed it was the shortcoming of the private liquidity system of the clearinghouses in 1907 that led to the creation of the Fed as a public lender of last resort in 1913. Governor Tarullo has stated that while private liquidity can never be considered a complete substitute, it bolsters the stability of the financial system by giving the Fed a breathing room of 30 days to make a determination of whether to provide liquidity but this heroically assumes that private liquidity would
not be exhausted much faster, if runoff rates exceed expectations.37 Further any delay in lending to Bank X by the Fed will incentivize runs on other banks, which the Fed should seek to avoid. And, of course, there could be an immediate run on the shadow banking system that has no liquidity requirements. A recent Federal Reserve paper recognizes this problem by saying that only in the case of runs should the Fed act immediately. The paper thus acknowledges that private liquidity cannot be relied on in a run. Further, if the Fed were to wait 30 days to determine whether a run was taking place and discovered it was, the paper implicitly recognizes that this may be too late. Therefore the breathing space justification seems weak. Furthermore liquidity regulation may decrease lending between financial institutions, thus worsening a weak institution’s options during a crisis. A recent study found that banks have reduced lending to financial institutions as a response to liquidity regulation, but not to nonfinancial institutions.38 Critics of the LCR have also raised concerns that the rule locks up safe debt and increases more risky debt without any reduction of contagion risk.39 William Dudley, President of the Federal Bank of New York, has suggested a willingness to address liquidity concerns through adjustments to
regulation.40
The strongest argument for liquidity requirements is a political one, that bank liquidity requirements allow the Fed to say it will only rescue banks from contagion that have exhausted their own resources first. This is probably smart politics but bad policy insofar as the markets may believe it will in fact delay the Fed’s response to a contagious run, thus causing the markets to run earlier and faster. Like the Dodd–Frank restrictions, it seems to put still another limit on the use of the Fed’s power. In the end, private liquidity is not a substitute for public liquidity.41
Notes
1. Ernest Patrikis, Higher minimum capital standards: Basel Committee on Banking Supervision crowns common equity king, BNA Insights (Nov. 30, 2010).
2. Basel Comm. on Banking Supervision, International framework for liquidity risk measurement, standards and monitoring: Consultative document (Dec. 2009), available at http://www.bis.org/publ/bcbs165.pdf.
3. Press Release, Basel Comm. on Banking Supervision, Report to the G20 on response to the financial crisis released by the Basel Committee (Oct. 2010), available at
http://www.bis.org/press/p101019.htm; Basel Comm. on Banking Supervision, The Basel Committee’s response to the financial crisis: Report to the G20 (Oct. 2010), available at http://www.bis.org/publ/bcbs179.pdf.
4. Basel Comm. on Banking Supervision, International framework 1, 5–19 (Dec. 2009), available at http://www.bis.org/publ/bcbs165.pdf.
5. Id. at 5.
6. Id.
7. Id. at 7.
8. Id.
9. Id. at 9. Under Basel II’s standardized approach for calculating regulatory capital, EU member states’ sovereign debt in domestic currency is assigned a risk weight of 0
percent. Under this regime, even the sovereign debt of an EU state facing a major fiscal crisis (for example, Greece in 2011) would receive a 0 percent weighting. This type of misleading risk-weight may call into question the efficacy of an LCR metric based on a definition of high-quality asset derived from Basel II. Basel II’s weighting of EU
sovereign debt points to a broader potential regulatory conflict, which is also
highlighted by US regulators’ bullish rhetoric in the wake of S&P’s recent downgrade of the country’s credit. While regulators are tasked with developing rules to accurately risk-weight assets (including their own governments’ debt), they must contend with their potentially conflicting interest in avoiding rapid sell-offs of their own sovereign debt in the case of a downgrade or other negative indicator.
10. See Basel Comm. on Banking Supervision, Basel III: The liquidity coverage ratio and liquidity risk monitoring tools (Jan. 2013), available at
http://www.bis.org/publ/bcbs238.pdf.
11. See Basel Comm. on Banking Supervision, Revisions to Basel III: The liquidity coverage ratio and liquidity risk monitoring tools (Jan. 2014), available at
http://www.bis.org/publ/bcbs274.pdf
12. See Basel Comm. on Banking Supervision, Guidance for supervisors on market-based indicators of liquidity (Jan. 2014), available at http://www.bis.org/publ/bcbs273.pdf.
13. Id. at 6.
14. Id. Indeed, in its consultative document on liquidity risk measurement, the Basel Committee has outlined runoff rates for various funding sources (e.g., minimum 7.5 percent for stable deposits, minimum 15 percent for less stable deposits, 100 percent for funding from repo of illiquid assets), but does not explain the methodology used to derive these rates.
15. Basel Comm. on Banking Supervision, Basel III framework: The net stable funding ratio (Oct. 2014), available at http://www.bis.org/bcbs/publ/d295.pdf.
16. Defined as “equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.” Id. at 20.
17. Id. at 20–22.
18. See id. at 21–22, tbl.1.
19. Id. at 22–24.
20. Basel Comm. on Banking Supervision, Basel III framework: The net stable funding ratio (Oct. 2014), available at http://www.bis.org/bcbs/publ/d295.pdf.
21. Id.
22. See id.
23. Basel Comm. on Banking Supervision, International framework 1, 5–19 (Dec. 2009), available at http://www.bis.org/publ/bcbs165.pdf.
24. Liquidity coverage ratio: Liquidity risk measurement, standards, and monitoring, 78 Fed. Reg. 71,818 (proposed Nov. 29, 2013); Liquidity coverage ratio: Liquidity risk measurement standards, 79 Fed. Reg. 197, 61440 (Oct. 10, 2014).
25. Id.
26. Liquidity coverage ratio: Liquidity risk measurement, standards, and monitoring, 78 Fed. Reg. 71,818, 71,833 (proposed Nov. 29, 2013). Id. at 71,822.
27. Id.
28. Id.
29. Id. at 71,833.
30. Id. at 71,824.
31. Id. at 71,833.
32. Id. at 71,822.
33. See Basel Comm. on Banking Supervision, Revisions to Basel III: The liquidity coverage ratio and liquidity risk monitoring tools (Jan. 2014), available at
http://www.bis.org/publ/bcbs238.pdf.
34. Id.
35. See Basel Comm. on Banking Supervision, Results of the Basel III Monitoring Exercise as of June 30, 2011 1, 22 (Apr. 2012).
36. See Dominic Hobson, Collateral Makes the World Go Around …, Fin. News (Sep. 3, 2012).
37. Governor Daniel Tarullo, Liquidity regulation , Speech at the Clearing House 2014 Annual Conference, New York, New York (Nov. 20, 2014), available at
http://www.federalreserve.gov/newsevents/speech/tarullo20141120a%20.htm.
38. See Ryan N. Benerjee and Hitoshi Mio, The impact of liquidity regulation on banks, (Bank of England Staff Working Paper 536, Jul. 2015), available at
http://www.bankofengland.co.uk/research/Documents/workingpapers/2015/swp536.pdf 39. See Mobile Collateral v. Immobile Collateral, Gary Gorton and Tyler Muir, Apr. 27,
2015,
https://www.stern.nyu.edu/sites/default/files/assets/documents/Mobile%20Collateral%20versus%20Immobile%20Collateral.pdf See also Ronald W. Anderson and Karin Joeveer, The economics of collateral (Apr. 21,
2014), available at: http://ssrn.com/abstract=2427231.
40. See William C. Dudley, Regulation and liquidity provision, Remarks at the SIFMA Liquidity Forum, Sep. 30, 2015.
41. See Mark Carlson, Burcu Duygan-Bump, and William Nelson, Whydoweneedbothliquidityregulationsandalenderoflastresort?
AperspectivefromFederalReservelendingduringthe2007-09U.S.FinancialCrisis (FEDSWorkingPaperFEDGFE2015-11).
16 Bank Resolution Procedures, Contingent Capital (CoCos), and Bail-Ins
If capital and liquidity are the wings to address contagion, better insolvency resolution procedures for banking organizations and other financial institutions are the prayer.
Effective resolution procedures are primarily designed to address the TBTF problem by allowing banking organizations or other covered financial institutions to be resolved without public support. Those designing these procedures have recognized, however, that such resolutions must be conducted in a manner to avoid contagion. They seek to achieve this result by assuring all short-term creditors of subsidiaries that they will not lose any money, even if their institution goes into resolution, because resolution will only take place at the holding company or because all longer term creditors are subordinated to short-term creditors if resolution takes place within operating subsidiaries.
For contagion to be prevented by resolution, short-term creditors of an institution that may go into resolution must believe they have no risk of losing their money. If they do not believe this, then it is rational for them to run. Better safe than sorry. Moreover short- term creditors in other institutions, fearing resolution, will run as well. I believe that
shortcomings in the design of the resolution procedures, as discussed below, will not provide such assurances. In any event, prudence dictates that we have strong measures in place if there is a run despite the resolution procedures. It is also important to realize that fear of initiating contagion, particularly if one has poor weapons to fight it, could deter use of resolution in the first place. And if that happens, the primary objective of better resolution procedures, avoiding TBTF, will not be achieved.
In this chapter we turn to the principal components of the new resolution system, CoCos and bail-ins.