Basel’s art and science of measuring liquidity risks in global markets

The Bank of International Settlements in Basil, Switzerland.
The Bank of International Settlements in Basil, Switzerland.
Image: Getty Images / Harold Cunningham
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The liquidity work going on now in the Basel Committee on Banking Supervision is important because the financial crisis brought into sharp relief the inadequacies of many banks’ liquidity risk-management practices. Banks’ liquidity — their ability to meet obligations when they come due without incurring unacceptable losses — was greatly impaired amid the uncertainty and market instability that began in late 2007. Seemingly overnight, previously reliable short-term secured sources of funding became more expensive to access even for well-capitalized, healthy market participants, and markets seized up. While liquidity pressures have eased considerably in the intervening years, governments around the world have continued to work to strengthen bank liquidity via legislation and regulation; Basel is where their efforts converge.

The Basel Committee adopted the first global framework for bank liquidity regulation at the same time as it announced the Basel III capital regime, which was unveiled in December 2010. A cornerstone of the liquidity framework is the Liquidity Coverage Ratio, a measure aimed at gauging whether banks would maintain adequate levels of high-quality assets relative to net cash outflows during 30-day periods of significant stress. However, like many policies implemented amid economic turmoil, the liquidity framework has been the subject of continuing debate, even within the Basel Committee. And with good reason: Requiring banks to ramp up balance sheet liquidity has the direct and inevitable consequence of constraining their ability to lend. Throughout 2012, the committee has been studying the potential impact of the liquidity framework and fine-tuning its plans.

This week, the Basel Committee considered the recommendations of its Working Group on Liquidity and decided to put them before its governing board, which meets in early January. This means that critically important decisions about global bank liquidity requirements may still be unresolved within the Basel Committee members, but could be decided in a matter of weeks, after discussion at a higher level. The primary changes under consideration include expanding the pool of liquid assets, and recalibrating assumptions about deposit run-off and expected draws on lines of credit to align these assumptions more closely with actual experience during the crisis.  It is also possible that the implementation of the LCR will be postponed by 2015 to 2016.  The proposed changes are controversial because national jurisdictions are affected by each of the proposed changes and banking systems in certain regions, particularly Europe, are still experiencing vulnerabilities that may be exacerbated by the need to hold increasingly higher levels of high quality, liquid assets.

The probability of the Basel Committee moving forward with the liquidity framework and finalizing its guidance early next year is high.  Walking away from the framework now would suggest that global policy makers do not continue to subscribe to one of the principal lessons learned during the financial crisis – liquidity risk management requires a stronger global standard.

It is a safe bet that the outcome will be that public policy leaders will change the paradigm for liquidity risk management based on lessons learned from the last financial crisis.  In conjunction with other national and international efforts, the Basel III liquidity framework promotes the use of strategies that rely upon long-term stable sources of funding.  This new framework will drive the behavior of banks and customers in the design and use of bank products and services, as regulatory capital has done over the past 25 years.

As the Federal Reserve noted in a “Supervision and Regulation Letter” (SR 12-17) issued on December 17, the US supervisors have enhanced their supervisory programs for the largest banks by increasing the focus on resiliency of individual financial institutions and stability of the financial system more broadly.  Capital and liquidity are the cornerstones to this stronger supervisory foundation.

Establishing a sound liquidity framework requires thoughtful consideration of which aspects of the framework should be hard-wired and which aspects will benefit from a degree of national supervisor discretion. This is art as much as it is science, but if the end result is well-reasoned global standard for liquidity risk measurement, the final outcome is better for banks, better for bank customers, investors and counterparties and better for economies.