A person needs to consume about eight glasses of liquids a day to replace water that’s used up. Banks have liquidity requirements, too. It’s just that they drink money, not water, replacing cash lost to withdrawals and debt payments. Sometimes the well runs dry. That’s when banks have to tap their reservoirs by selling assets to generate the cash they need. Making sure those pools are deep enough and can be accessed in a hurry has been a focus of rule-making since the 2008 financial crisis, when liquidity dried up and almost brought down the global financial system. Banks are now required to have enough easy-to-sell assets on hand to get them through 30 days of panic, at least in theory. But we may not know whether the plan will spring a leak until there’s another crisis.
In September 2014, U.S. regulators released their final version of the 30-day rule developed by the Basel Committee, a panel that brings together financial regulators from around the world. The next month, Basel regulators finished drafting a related guideline aimed at making sure banks have enough liquid assets to get through a yearlong economic downturn. Both rules are designed to discourage an over-reliance on short-term borrowing of the kind that brought down Lehman Brothers six years before, threatening other banks and freezing credit markets. Under both, the more easily a bank’s funding can dry up, the more safe and easy-to-sell-in-a-hurry assets it will need to sock away, like central bank reserves, government debt or high-rated corporate bonds. The short-term rule, known as liquidity coverage ratio, took effect in January 2015, while the longer one, the net stable funding ratio, won’t kick in until 2018. Regulators estimate that banks worldwide need to acquire roughly $1 trillion of liquid assets to meet the long-term rule and $750 billion for the short-term one. The liquidity directives come on top of a related set of Basel requirements that have forced banks to bolster their capital to offset losses that can increase during an economic downturn.
Bank runs of the kind shown in the 1946 Christmas movie classic, “It’s a Wonderful Life’’ long epitomized the dangers of insufficient liquidity – even banks that were solvent could fail if they couldn’t produce enough cash when needed. As anxious depositors throng George Bailey’s building and loan association, the young banker tells them, “You’re thinking of this place all wrong, as if I had the money back in the safe. The money’s not here, it’s in Joe’s house … and a hundred other houses.” Deposit insurance has for the most part ended that kind of panic, although a run forced the nationalization of Northern Rock in the U.K. in 2007. Banks also depend less on depositors now and more on short-term loans from money-market funds and other big investors, which can also disappear fast. Whether for George Bailey or JPMorgan Chase, the underlying problem is the same: banks are businesses that borrow short-term and lend long-term, and anything that panics their lenders can put banks out of business if they can’t come up with cash fast. There’s also the fire-sale problem – assets that a bank might sell often plunge in value during a panic if they are at all risky.
The Basel liquidity rules were softened during four years of negotiations – banks would have had to raise $2.3 trillion in liquid assets to meet the original version of just the 30-day rule. Still, bankers complain that having to keep a lot of super-safe — and low-yielding — assets on their books will hurt profitability, which they say will lead to higher borrowing costs for companies and consumers. Some investors gripe that combined effect of post-crisis rules is making banks less able or willing to perform their traditional role of providing liquidity to the rest of the market by being willing to buy a broad range of assets during a downturn, as happened in an October 2014 market drop. Others are skeptical that liquidity rules will actually work. One of the lessons of Lehman, they say, was that it doesn’t matter how liquid a bank is if markets and creditors question its solvency. They see the solution as being much higher capital requirements than the new rules require.
The Reference Shelf
- A FAQ by the U.S. Federal Reserve on the difference between liquidity and capital.
- A 2010 Bloomberg News article on why liquidity matters.
- A September 2014 Bloomberg News article on banks and the short-term liquidity rule.
- A discussion on the Zero Hedge blog about why the liquidity rules won’t work.
- In this video, Morgan Stanley CEO James Gorman says liquidity matters more than anything else.
First published Nov. 12, 2014
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