A speech made on April 19, 2013 by Fed Governor Jeremy Stein entitled “Finding the right balance” at the 2013 Credit Markets Symposium, sponsored by the Federal Reserve Bank of Richmond looks at, among other things, the Liquidity Coverage Ratio (LCR) and its relationship with Fed Lender of Last Resort (LOLR) facilities. It is a fascinating speech and is the next step in our ongoing work on liquidity risk.
Stein said upfront, “…First, to what extent should access to liquidity from a central bank be allowed to count toward satisfying the LCR?” This has always been an interesting question to us. In essence, banks under LCR will be obliged to hold enough High Quality Liquid Assets (HQLA) to cover 30 days of outflow. When combined with additional collateral needed for cleared and non-cleared swaps, the amount of paper needed reaches into the trillions. Yet why can’t, for example, banks with access to the Fed Discount Window and eligible collateral (which is defined in terms somewhat broader than HQLA) rely on the Fed for liquidity when under stress? Why are LCR rules necessary? A liquidity squeeze doesn’t necessarily imply that a bank’s assets are bad, just that they cannot be monetized at the moment.
Well one problem that Stein noted (in a great quote) “…the line between illiquidity and insolvency is far blurrier in real life than it is sometimes assumed to be in theory…” We couldn’t agree more – you just don’t know what those assets are going to be worth. In the sub-prime debacle, opinions based on ratings got tossed out the window and no one knew if an asset was “money good.” In securities lending, beneficial owners were told that their collateral was “money good” (this has largely proven to be true) but had to take the statement on faith. Ultra-worst case scenarios morphed into likely outcomes. Liquidity is one thing, solvency another – but during the fog of war, it is hard to tell the difference.
The other issue is politics. The optics of advocating LOLR conjures up visions of bail-outs. Stein may have hinted at that when he said “…The introduction of liquidity regulation after the crisis can be thought of as reflecting a desire to reduce dependence on the central bank as a lender of last resort (LOLR), based on the lessons learned over the previous several years…” and “…when the central bank acts as an LOLR in a crisis, it necessarily takes on some amount of credit risk. And if it experiences losses, these losses ultimately fall on the shoulders of taxpayers. Moreover, the use of an LOLR to support banks when they get into trouble can lead to moral hazard problems, in the sense that banks may be less prudent ex ante. If it were not for these costs of using LOLR capacity, the problem would be trivial, and there would be no need for liquidity regulation: Assuming a well-functioning capital-regulation regime, the central bank could always avert all fire sales and bank failures ex post, simply by acting as an LOLR.”
Stein asserts that unpriced or free access to the LOLR makes no sense. Banks would substitute official sources of liquidity for prudent liquidity management. But when it is priced, the situation changes. Stein looks at the Australian Committed Liquidity Facility (CLF) as an example (and we wrote this up in our March 2012 report, “Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets“). Australia, facing a shortage of HQLA, created a way for their banks to satisfy LCR by buying a committed lending facility from the Reserve Bank of Australia (RBA) and counting the face amount of the facility toward LCR. The RBA can price the CLF such that banks will first use HLQA toward their LCR requirements. (Please don’t call the acronym police about that last sentence.)
But Stein goes farther. He suggests that a CLF-like facility could play an interesting role; imagining a CLF facility that kicks in during a crisis. This would not just be for countries like Australia where there is a known HLQA deficiency, but for others as well. During a time of stress HLQA, according to Stein, should be used – the assets drawn down to provide liquidity – but that could leave the bank LCR non-compliant. A CLF could make up the difference. Stein said, “…One situation where liquid assets can become unusually scarce is during a financial crisis. Consequently, even if CLFs were not counted toward the LCR in normal times, it might be appropriate to count them during a crisis…”
The cost of holding HQLA – think the cost to repo the paper in or the yield on holding it outright — varies with market conditions. That uncertainly is difficult to manage, although it is reasonable to say that when markets are in crisis, the (relative) cost of maintaining the HLQA buffer goes up. Stein says “…If a scarcity of HQLA-eligible assets turns out to be more of a problem than we expect, something along those lines [CLF] has the potential to be a useful safety valve, as it puts a cap on the cost of liquidity regulation. Such a safety valve would have a direct economic benefit, in the sense of preventing the burden of regulation from getting unduly heavy in any one country…”
We think this kind of out-of-the-box thinking is both refreshing and exciting.
A link to the speech is here.