Editorial Board

Basel’s Diluted Liquidity Rule Compounds Capital Failure

The Basel Committee on Banking Supervision has announced its new rules on bank liquidity, part of the multinational effort to build a safer global system.

Not for the first time, the panel has retreated from its initial demands, and the 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 isn’t the biggest mistake the committee has made lately. The failure to set effective capital-adequacy ratios, which we’ve lamented before, is by far a greater cause for concern. The liquidity rule announced 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.

For instance, the new rule says liquidity must be enough to cover a 30-day run on insured retail deposits of 3 percent, instead of 5 percent as proposed. 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.

Qualifying Assets

This broadening of qualifying assets means that almost all banks already satisfy the rule -- a point that was acknowledged by Bank of England Governor Mervyn King, the chairman of the rule-setting committee. The rules were watered down further by the panel’s decision to delay full implementation to 2019, instead of 2015.

As guttings go, this is pretty thorough. It confirms the committee’s reputation for delay, backsliding and willingness to accommodate the preferences of banks -- the industry it’s supposed to be supervising. If the panel had been mindful of its credibility, it would have issued a draft it was willing to defend in the face of expected pressure from the industry.

In judging the merits, though, bear in mind 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, for example, 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 -- and that’s a fast-moving target lately.

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. At the moment, 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.

Lending Capacity

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, because it represents a bank’s ability to absorb losses. This makes the Basel committee’s earlier failure on capital adequacy much more significant than the new muddle over liquidity, regrettable though that is.

We’ve argued that banks need a simple, conservatively measured capital ratio of 20 percent to provide an adequately strong defense against losses. The committee has called for more capital, but not enough. Again under pressure, it settled on a too-complex formula relying on discredited risk weights, with an overall leverage ratio (of tangible common equity to all assets) of just 3 percent.

The ruling on liquidity ratios is disappointing -- but Basel’s failure to ensure banks have adequate capital is much more serious.