A new regulation aimed at making sure banks have enough money on hand in times of crisis would seem quite important. So why are senior central bankers so keen right now to change it in ways that could weaken it?
The regulation is part of the package of new international rules that banks in most countries must adopt. Called the liquidity coverage ratio, it was proposed after the financial crisis, as part of the so-called Basel III overhaul, and is scheduled for introduction in 2015.
The ratio attempts to address a big weakness that flared up in the financial crisis. Banks suffered heavy outflows of cash as nervous depositors and creditors withdrew money. The ratio requires banks need to have a stockpile of cash and high-quality, easy-to-sell assets to meet such withdrawals. If all works according to plan, a virtuous circle could come into existence. Seeing the stockpile of liquid assets, bank depositors and creditors will be less likely to head for the exits whe n financial instability occurs.
But some regulators see a vicious circle instead.
In Europe, central bank officials think banks preparations' for the ratio could be making it even harder for banks to fund themselves. The incentives baked into the rule effectively deter banks from borrowing for short periods from, say, money market funds and other banks.
At the end of June, Christian Noyer, governor of the Banque de France, the country's central bank, said that the Basel III liquidity ratios “cannot be applied as they stand†because of possibly adverse consequences. Then last week, Mario Draghi, president of the European Central Bank, sounded even more intent on changing the ratio, saying bank liquidity regulations must be “recalibrated completely.â€
The E.C.B. didn't respond to a request for comment; the Banque de France declined to comment. Changes to the ratio will be introduced by the end of the year through the Basel process.
But are the regulators are overreacting, and placing too much blame on the ratio? After all, there are a lot of other reasons why banks are finding it harder to borrow in markets. Europe's sovereign debt crisis is far from being resolved, bank balance sheets are still viewed as opaque and many of the Continent's lenders, particularly French banks, are still very dependent on shorter-term market borrowings. Lastly, banks have a low incentive to borrow in the markets when, like now, they can borrow easily and cheaply from central banks.
Ove rall, it seems that regulators involved in the Basel process want to try and keep the ratio mostly intact. This is the first attempt at crafting an international liquidity rule, so they see the need to be flexible.
In June, a Federal Reserve governor, Daniel Tarullo, suggested some modifications that, on the face of it, probably wouldn't gut the ratio, and may even improve it. For instance, the Fed wants to make sure that the high-quali ty assets are indeed liquid. Now, the credit rating of the asset plays a big role in defining what a high-quality asset is, but the European situation shows that sovereign bonds with high ratings can be illiquid. The Fed also wants to look at whether the ratio has underemphasized the potential liquidity drain from banks' trading operations.
One area where the Fed may want to dilute the rule is by tweaking assumptions about how quickly certain types of bank funding may disappear in a crisis. If those assumed time periods are extended, the ratio becomes less burdensome for banks, but could also leave them with less protection in a crisis.
The danger of loosening the rule too much is that it unnerves bank creditors still further, exacerbating liquidity problems, rather than easing them. And with Mr. Draghi pushing for liquidity ratios to be “recalibrated completely,†bank creditors may have even less reason to stick around.
