Liquidity regulation

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Liquidity regulations are financial regulations designed to ensure that financial institutions (e.g. banks) have the necessary assets on hand in order to prevent liquidity disruptions due to changing market conditions. This is often related to reserve requirement and capital requirement but focuses on the specific liquidity risk of assets that are held.

Contents

These regulations were imposed to negate liquidity risks of banks that played a prominent role in financial crises. Financial banks profit from providing liquidity and maturity transformation, which is the practice by financial institutions of borrowing money on shorter timeframes than they lend money out. In other words, using shorter-term deposits to fund longer-term loans. This can lead to bank runs during which depositors demand repayment of their demandable and maturing deposits, before the borrowers are required to repay the loans. [1] The result could be a liquidity crisis, which refers to an acute shortage (or "drying up") of liquidity.

History

In response to liquidity risks, bank regulators agreed global standards to reduce banks' ability to engage in liquidity and maturity transformation, thereby reducing banks' exposure to runs. Traditionally, the response to this risk was a combination of deposit insurance and discount window access. The former assures depositors not to worry about insolvency, which presumably keeps depositors who thought they might lose their funds entirely, out of the withdrawal line. The latter assures banks have access to short-term liquidity in order to meet the demands of depositors who have an immediate need for cash. These previous regulations were mainly to guard against moral hazard that both programs could create. Over the decades, after the implementation of these regulations, relatively few liquidity problems occurred in the deposit-funded commercial banking system. [2]

Response to the 2007–2008 financial crisis

Over time there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid, but eventually resulted in poorly underwritten subprime mortgages - a classic adverse feedback loop ensued. [2] This led to the fall of the housing market and the 2007–2008 financial crisis. In response to this failure of liquidity regulations, there has been recent progress in developing new measures to further reinforce the core role of liquidity regulation.

In 2010, the UK Financial Services Authority (FSA) introduced a new liquidity regulation known as the Individual Liquidity Guidance (ILG).

In 2013, the Basel Committee on Banking Supervision agreed on a Liquidity Coverage Ratio (LCR), which is similar in design to the ILG but plays a role in an international playing field. The purpose of ILG is to make the banking system more resilient to liquidity shocks by requiring banks to hold a minimum quantity of "high quality liquid assets" (HQLA). These HQLA consist of cash, central bank reserves and government bonds to cover net outflows of liabilities under two specific stress scenarios, lasting 14 days and 3 months respectively. This way it is assumed that banks that are more heavily dependent on short-term wholesale funding, especially from foreign counterparts, would experience greater funding outflows and therefore need to hold a higher ratio of HQLA to total assets, to ensure immediate survival in stressed funding conditions. [3]

The U.S. banking agencies have worked with other regulators in the Basel Committee on Banking Supervision to develop the Net Stable Funding Ratio (NSFR), which is the available amount of stable funding, relative to the required amount of stable funding. It is assumed that this ratio should be at least 100% on an on-going basis. The ratio can be calculated with the following formula:

≥ 100%

In this case, the ‘available stable funding’ is defined as the portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR, which extends to one year. The amount of such ‘stable funding required’ of a specific institution is a function of the liquidity characteristics and residual maturities of the various assets held by that institution, and those of its off-balance sheet exposures. [4] In short, the NSFR will require banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. [4]

Together, the LCR and NSFR are designed to mitigate the risks associated with banks' reliance on unstable funding structures and to encourage them to embrace more resilient funding models. [2] The difference between the two is that the LCR is specifically designed to improve the short-term resilience of banks against liquidity shocks and the NSFR, on the other hand, is designed to limit the risks emanating from excessive maturity mismatches over the medium to long term [5]

Debate

There is some debate on the impact of the LCR and NSFR, since they can at most constrain maturity mismatches within the banking system. The underlying economic core reasons why money suppliers want liquid funds and borrowers want longer-term loans are not changed by these regulations. It is therefore a matter of time until alternative methods of liquidity and maturity transformation will be developed that may result in the next financial crisis. Whether the outcome of these liquidity regulations is a net positive for financial stability is debatable. [1] For further reading on the debatable effects of these liquidity regulations see; [1] [6] [7]

See also

Related Research Articles

In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly. Money, or cash, is the most liquid asset because it can be exchanged for goods and services instantly at face value.

The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

<span class="mw-page-title-main">Fractional-reserve banking</span> System of banking

Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. Fractional-reserve banking differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves.

<span class="mw-page-title-main">Bank run</span> Mass withdrawal of money from banks

A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may fail in the near future. In other words, it is when, in a fractional-reserve banking system, numerous customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it may become a self-fulfilling prophecy: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may acquire more cash from other banks or from the central bank, or limit the amount of cash customers may withdraw, either by imposing a hard limit or by scheduling quick deliveries of cash, encouraging high-return term deposits to reduce on-demand withdrawals or suspending withdrawals altogether.

The Basel Accords refer to the banking supervision accords issued by the Basel Committee on Banking Supervision (BCBS).

Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the central bank on the basis of a specified proportion of deposit liabilities of the bank. This rate is commonly referred to as the cash reserve ratio or shortened as reserve ratio. Though the definitions vary, the commercial bank's reserves normally consist of cash held by the bank and stored physically in the bank vault, plus the amount of the bank's balance in that bank's account with the central bank. A bank is at liberty to hold in reserve sums above this minimum requirement, commonly referred to as excess reserves.

<span class="mw-page-title-main">Cash and cash equivalents</span> Highly liquid, short-term assets

Cash and cash equivalents (CCE) are the most liquid current assets found on a business's balance sheet. Cash equivalents are short-term commitments "with temporarily idle cash and easily convertible into a known cash amount". An investment normally counts as a cash equivalent when it has a short maturity period of 90 days or less, and can be included in the cash and cash equivalents balance from the date of acquisition when it carries an insignificant risk of changes in the asset value. If it has a maturity of more than 90 days, it is not considered a cash equivalent. Equity investments mostly are excluded from cash equivalents, unless they are essentially cash equivalents.

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

A money market fund is an open-end mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a highly stable asset value through liquid investments, while paying income to investors in the form of dividends. Although they are not insured against loss, actual losses have been quite rare in practice.

A capital requirement is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds, not a use of funds.

<span class="mw-page-title-main">Accounting liquidity</span> The measure of a debtors ability to pay their debts as/when they mature

In accounting, liquidity is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the ability to pay short-term obligations.

Capital Adequacy Ratio (CAR) also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements.

A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations in that they are permanently capitalized and have an active management team.

In financial economics, a liquidity crisis is an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

<span class="mw-page-title-main">Diamond–Dybvig model</span> Theoretical description of bank runs and financial crises

The Diamond–Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks' mix of illiquid assets and liquid liabilities may give rise to self-fulfilling panics among depositors. Diamond and Dybvig, along with Ben Bernanke, were the recipients of the 2022 Nobel Prize in Economics for their work on the Diamond-Dybvig model.

<span class="mw-page-title-main">Bank</span> Financial institution which accepts deposits

A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.

The interbank lending market is a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate. A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions during the financial crisis of 2007–2008.

Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing minimum capital requirements, holdings of high quality liquid assets, and decreasing bank leverage.

During the financial crisis of 2007–2008, several banks, including the UK's Northern Rock and the U.S. investment banks Bear Stearns and Lehman Brothers, suffered a liquidity crisis, due to their over-reliance on short-term wholesale funding from the interbank lending market. As a result, the G20 launched an overhaul of banking regulation known as Basel III. In addition to changes in capital requirements, Basel III also contains two entirely new liquidity requirements: the net stable funding ratio (NSFR) and the liquidity coverage ratio (LCR).

A systemically important financial institution (SIFI) is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis. They are colloquially referred to as "too big to fail".

References

  1. 1 2 3 Wall, L. D. (2015). Liquidity Regulation and Financial Stability.
  2. 1 2 3 Tarullo, D. K. (2014). Liquidity Regulation. Federal Reserve System
  3. Banerjee, R. N., & Mio, H. (2014). The Effects of Liquidity Regulation on Banks, (470), 385–411.
  4. 1 2 Basel Committee on Banking Supervision. (2014). Basel III: The Net Stable Funding Ratio. Working Paper, Bank for International Settlemens, (April), 15.
  5. ECB. (2013). Liquidity regulation and monetary policy implementation. Monthly Bulletin, (April), 73–89.
  6. Nicolò, G. De. (2016). Liquidity Regulation: Rationales, Benefits and Costs. National Institute Economic Review, (235), 18–26
  7. Duijma, P., & Wiertsa, P. (2016). The Effects of Liquidity Regulation on Bank Assets and Liabilities, (ii), 385–411.