Not for the first time, the Basel Committee on Banking Supervision has retreated from its mission to build a safer global financial system. Its final liquidity rule is far less rigorous than the committee had said it wanted and financial markets had been expecting. This is a shame, though it’s not the biggest mistake the committee has made. The failure to set effective capital-adequacy ratios is a greater cause for concern. The liquidity rule announced on Jan. 6 merely confirms the main point: The Basel project is failing.
The committee issued its draft liquidity rules in 2010. The idea was to lay down the quantity and quality of liquid assets (in theory, assets that can be sold quickly without driving down prices) that banks must hold to cover a run on deposits or some other interruption in short-term funding. Under pressure from banks, especially those in the U.S., most aspects of the draft proposal have been weakened in the final document.
The new rule says liquidity must be enough to cover the withdrawal of 3 percent of insured retail deposits over 30 days, vs. 5 percent under the proposed rule. It also expands the range of corporate debt securities that qualify as liquid to BBB- (the lower boundary of investment grade); previously, the committee said nothing less than AA- should be eligible. High-quality mortgage-backed securities will also count. This broadening of qualifying assets means almost all banks already satisfy the rule.
As guttings go, this is pretty thorough. Bear in mind, too, that designing rules for liquidity is harder—and less important—than designing rules for capital. In practice, a bank’s need for liquidity can’t be measured in isolation: It depends on its central bank’s willingness to lend in an emergency. Indeed, a liquid asset could be defined as anything a central bank will accept as collateral in a panic.
Here’s another complication. If a bank is told to hold cash, central bank reserves, and high-grade liquid securities in case of a run, it has less money to devote to ordinary lending. Many banks, especially in the U.S., hold enormous quantities of cash and excess central bank reserves (the purest forms of liquidity), and face criticism for hoarding these assets instead of lending to finance investment or refinance mortgages. The Basel supervisors have taken care, in effect, to deflect blame for the lending drought away from themselves.
Banks, too, have made this argument against tighter rules on capital—namely, that more capital means less lending. In contrast with the liquidity case, however, this argument is false. Capital is a source of funds for banks, not (like liquidity) a use of funds.
Requiring banks to finance themselves with more equity and less debt doesn’t restrict their lending. True, it will reduce return on equity, but that’s the counterpart of less risk, which is the whole idea.
Capital is the ultimate safety cushion in a banking crisis. Basel’s failure to ensure banks have enough is a serious concern.