An idea about solving the LCR eligible asset problem

An article published by Bloomberg on August 28, 2012, written by Jim Brunsden, “ECB Said To Urge Weaker Basel Liquidity Rule On Crisis Risks“ looks at efforts to water down the liquidity coverage ratio (LCR) rules. Faced with an estimated $2.2 trillion shortfall in eligible asset holdings, its no surprise that there is an uproar. We have an idea to share.

The rules were designed to insure that banks held enough high quality assets that could be monetized in the event of a liquidity crisis. Basically, LCR looks at a 30 day projected cash outflow scenario and requires 100% coverage. There has been a lot of debate about what really should be eligible for the high quality asset numerator. 

We have written about the issue before, most notably in Finadium’s March, 2012 paper “Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets”. A link to the synopsis is here. Various SFM blog posts take a look at LCR. Links are here, here, here, and here. OK, we are a bit LCR obsessed.

The ECB (and others) fear banks hoarding eligible assets in order to satisfy the LCR requirements. Critics claim that this will create dislocations, safe asset shortages, and curtail lending. Their solution is to expand what is considered an eligible asset to include instruments that are less liquid and/or less creditworthy. U.S. regulators were singled out as being not so enthusiastic about this approach.

The ECB comes at the problem with their LTRO experience fresh on their minds. The LTRO financed all sorts of weird and wonderful collateral, including some formerly safe sovereign securities. In theory, if the ECB is willing to give liquidity against those assets, then it stands to reason that they ought to be included as assets which could provide liquidity in the event of a crisis. We admit there is a logic there, although the ECBs on-again-off-again role as lender of last resort would have to be carved in stone for us to really embrace the idea.

It has always been simpler to specify which assets will retain their liquidity in a crisis (despite a mixed track record on that particular crystal ball) than it was to take the approach that any and all assets that can be monetized at the central banks should be eligible. Hence most of the discussions have been about including corporate paper, equities, etc. for all or a portion of the eligible assets in the LCR calculation. Taking the approach that “if the central bank will re-discount it, then it is eligible” flies in the face of the folks who, in the U.S. at least, have “no more bailouts” and “remember moral hazard” tattooed (at least metaphorically) on their biceps.

One idea we have heard about that might help, at least in the U.S., is to include those assets which are FRB discount window eligible in the LCR numerator. Banks can tap the FRB discount window using the following:

  • Commercial, industrial, or agricultural loans
  • Consumer loans
  • Residential and commercial real estate loans
  • Corporate bonds and money market instruments
  • Obligations of U.S. government agencies and government-sponsored enterprises
  • Asset-backed securities
  • Collateralized mortgage obligations
  • U.S. Treasury obligations
  • State or political subdivision obligations

So you don’t think we are making this up, a link to the FRB web page on the discount window is here. Hey, it might even encourage banks to make loans if they are eligible for the LCR.

At the risk of the regulatory fundamentalists changing what constitutes eligible discount window assets (we really don’t want to give anyone ideas here…) then it seems that the intellectually honest approach is to synchronize the Discount Window with the LCR and sidestep the whole “in a crisis, this asset is better than that asset” thing. Just a thought.

A link to the Bloomberg article is here.

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