The Basel III liquidity coverage ratio and financial stability.

• Author: Hartlage, Andrew W.
• Position: NOTE

INTRODUCTION

Among the most dramatic and consequential events of the recent financial crisis was the panic in U.S. credit markets in September 2008. Spooked investors, unable to determine the health of financial institutions and fearing the worst after the Lehman Brothers bankruptcy, rushed to withdraw their money and sought refuge in the safest assets, the modern equivalent of hiding cash inside mattresses. A shortage of "liquid" assets-cash and assets readily convertible into cash (1)--precipitated a massive credit contraction that threatened poorly managed and well-managed banks alike with failure. Extraordinary measures by U.S. financial regulators and Congress avoided a systemic collapse, but the crisis propelled the economy into a recession, followed by a period of stagnation from which the country has yet to emerge.

The crisis revealed the extent to which firms at the center of the financial system had relied on short-term borrowing to finance their activities. When managed prudently, the process of taking on short-term debts to finance longer-term loans, such as mortgages, is a useful and productive activity at the heart of the modern financial system; however, this utility comes at a price--banks fail when this short-term funding disappears. (2) Failures at individual firms can spread to envelop the entire financial system through connections between financial institutions and other transmission channels. Effective regulation, then, seeks to balance the salutary effects of longer-term lending with the risks and costs of system-wide failure.

In the aftermath of this crisis, world governments acted to reduce systemic risk in the financial system by strengthening liquidity regulations. In December 2010, the Basel Committee for Banking Supervision--a college of central bankers and other financial regulators from the United States and other advanced economies--proposed new liquidity requirements meant to promote the resilience of the banking sector. (3) This Note examines one of these new requirements: the Liquidity Coverage Ratio ("LCR"), the Basel Committee's newly proposed minimum threshold for short-term liquidity. The LCR is designed to measure a bank's resilience over thirty days if faced with a crisis-like situation where some classes of creditors (e.g., other financial institutions) suddenly withdraw from credit markets. (4) The Basel Committee will accept comments on the proposal and announce amendments, if any, by mid-2016 at the latest. (5) The standards will go into effect, with any amendments, by January 1, 2018. (6)

This Note argues that the LCR as proposed may work to undermine the stability of the financial system rather than reduce systemic risk. Part 1 introduces the concept of maturity transformation, the risks it creates, and the regulatory responses it has provoked. Part lI uses a simple model of bank liquidity to demonstrate how certain strategies for complying with the LCR may cause banks to increase borrowing to unsustainable levels, and argues that the LCR will likely push banks to engage in regulatory arbitrage, resulting in reduced financial stability. Finally, Part III reinforces this conclusion by presenting evidence of market distortions brought about by a rule similar to the LCR, which was enacted in the Republic of Korea after its financial crisis in the late 1990s.

1. LIQUIDITY, BANK PANICS, AND LIQUIDITY REGULATION

   Modern societies rely on the financial system to help spread capital efficiently throughout the econoiny. A modern financial system performs several crucial roles in spreading capital, including transfelTing resources across time and space, managing risk, clearing and settling payments, poohing resources, and providing information, (7) Banks are key players in the financial system, and they help mitigate the significant informational costs of assessing and monitoring the creditworthiness of borrowers. (8) Another important function of the modern financial system, and one traditionally performed only by commercial banks, is "maturity transformation" (9)--the process by which banks accept short-term debts, such as deposits payable on demand, and use these funds to make longer-term loans to borrowers. (10) Section 1.A explains the nature and inherent risks of maturity transformation, and Section I.B describes the regulatory responses to these risks. This discussion frames the detailed analysis of the LCR in Part II.

   1. Maturity Transformation and Financial Instability

      The following example illustrates the maturity transformation process: A bank accepts $1,000 in demand deposits from each of 1,000 depositors. By the terms of the contracts between each depositor and the bank, a demand-deposit holder has the right to withdraw his or her funds "on demand"--that is, at any time. These deposits appear on the bank's balance sheet as a $1 million liability: the demand-deposit contract sets up a creditor-debtor relationship between the bank and the depositor, with the bank as debtor and the depositor as creditor. Depositors withdraw and add money to their deposit accounts as they save and consume. In this way, the $1 million liability on the bank's balance sheet fluctuates over time.

      However, if the depositors' additions to and withdrawals from the accounts are random, there forms within the demand deposits a portion of funds that is statistically stable. (11) Returning to the example in the previous paragraph, assume the bank has determined that $800,000 of the $1 million deposit is stable. The bank then makes $800,000 in mortgage loans to individuals and keeps the remainder of the money as cash in its vaults or securities that are readily convertible into cash, such as U.S. government debt. The mortgage borrowers agree to pay back principal and interest over thirty years. The bank uses the cash and liquid securities to satisfy day-today customer withdrawal requests. The bank's common stockholders invest cash in the amount of $32,000 to absorb losses from bad mortgage loans. This amount appears on the bank's balance sheet as $32,000 in shareholders' equity. The balance sheet of the example bank is given below:

      Table 1 Example Bank Balance Sheet Assets Cash and Liquid Securities = $232,000 Thirty-Year Mortgages = $800,000 Total = $1,032,000 Liabilities and Shareholder's Equity Demand Deposits = $1,000,000 Common Stock = $32,000 Total = $1,032,000 Through this process, the bank has transformed short-term obligations (demand deposits) into long-term obligations (thirty-year mortgages). This insight--that in normal times, stability emerges from the random, independent interactions of a large collection of depositors--forms the basis for the maturity transformation process.

      This process accrues benefits not only for the bank but also for the economy. The bank earns interest income equal to the interest collected from borrowers minus the interest paid to depositors. Provided that long-term interest rates are higher than short-term interest rates, (12) banks profit from maturity transformation by charging borrowers an interest rate keyed to higher long-term rates while paying interest at a rate keyed to lower short-term rates. But banks are not the only beneficiaries of maturity transformation: long-term borrowers benefit through an increased supply of long-term loans, and thus the improved affordability of long-term asset financing. For example, in the case of residential homebuyers, who must decide between leasing or purchasing a home, longer-term loans can help lower monthly mortgage payments and thus make home ownership more attractive vis-a-vis home rental. (13) Moreover, banks' comparative expertise in determining and monitoring creditworthiness (14) implies that borrowers for whom determining creditworthiness is expensive (e.g., individuals) have few alternatives to bank credit. To the extent that banks can offer longer-term loans, this does much to increase the supply of long-term financing to such borrowers.

      However, maturity transformation also exposes banks to liquidity risk. As mentioned above, the maturity-transformation process depends on the probabilistic stability of short-term debt. If the assumptions regarding depositor stability fail to hold, banks risk defaulting on their debt due to a lack of available cash to satisfy withdrawals. Scholars refer to this type of sudden demand by the depositors of a single bank as a "run." (15) Returning to the example bank discussed above, if 500 of the bank's depositors simultaneously lost confidence in the bank and suddenly withdrew their funds, totaling $500,000, the bank could satisfy only $232,000 of this demand with its cash and liquid securities. Moreover, it could not easily turn its thirty-year mortgage loans into cash. (16) It could attempt to borrow more money, but it would likely incur difficulties in the face of depositors' general lack of confidence. Thus, this sudden withdrawal could lead the bank to default on its obligations and, in the worst case scenario, to fail.

      Runs can quickly become "panics"--system-wide demands on banks--and ultimately adversely affect the real economy. Depositors might run on their bank without specific concerns about that bank's health: they could be fearful generally of banks due to macroeconomic conditions (17) or they could run on the bank irrationally. (18) Once some depositors begin to withdraw funds, the remaining depositors could rush to withdraw as well, before the limited resources available to the bank to satisfy creditors are depleted. (19) Credit would become scarce, scuttling long-term asset purchases such as real estate. (20) Historically, financial crises usually precede significant declines in economic output and employment. (21)

      The ineluctable two-sided nature of maturity transformation has real consequences for policymakers. Regulators cannot hope to eliminate the possibility of bank runs or systemic panics without discarding the benefits of maturity...