The Wall Street Journal reported on Friday that global regulators were again talking about loosening up the rules that govern the Liquidity Coverage Ratio. This is the next round of conversation that was first reported by Bloomberg News on December 6, 2012 and by us the following day. Now that we know the conversation is going on, let’s take up the WSJ article and ask the question: should LCR rules be loosened or not?
First, what’s at stake here? Currently, Basel III requires that banks must have at least 60% of Level 1 assets, including cash and government bonds, and up to 40% of Level 2 assets, including agencies and the highest rated corporate bonds, to meet the numerator of the Liquidity Coverage Ratio (LCR). The new conversation centers on the possibility of stretching the definition of Level 2 assets and/or increasing the percent of Level 2 assets acceptable in the numerator of the LCR. There are many variations on what could happen to the LCR calculation, particularly around the inclusion of corporate bonds and equities as high quality assets. There are so many in fact that we at Finadium wrote an entire report on this topic back in March 2012.
Leaving the technicalities aside, is loosening up the LCR a good idea? A strict LCR means less leverage in the global financial system, smaller banks and more business transitions (and layoffs) as banks get ready for final LCR reporting. The potential changes for banks are significant. According to the Basel Committee on April 12, 2012, the committee “assessed the estimated impact of the liquidity standards. Assuming banks were to make no changes to their liquidity risk profile or funding structure, as of June 2011, the weighted average Liquidity Coverage Ratio (LCR) for Group 1 banks would have been 90% while the weighted average LCR for Group 2 banks was 83%. The aggregate LCR shortfall is €1.76 trillion which represents approximately 3% of the €58.5 trillion total assets of the aggregate sample. The weighted average Net Stable Funding Ratio (NSFR) is 94% for both Group 1 and Group 2 banks. The aggregate shortfall of required stable funding is €2.78 trillion.” Ouch. A looser LCR means that banks have a lot more flexibility in their businesses.
Even that stalwart supporter of more Shadow Banking regulation, Fed Governor Daniel Tarullo, was quoted by the WSJ: “Federal Reserve governor Daniel Tarullo also recently called for the liquidity rule to be eased. It “may have the unintended effect of exacerbating a period of stress by forcing liquidity hoarding,” Mr. Tarullo said in Senate testimony this month.” Here’s Tarullo’s speech from June 6, 2012, where this came out.
The EU has already back tracked on the LCR. The discussion there (from a consultation paper on the Capital Requirements Directive IV) is to bump up Level 2 assets to 50% of the LCR numerator.
The WSJ cites a lone academic as supporting the Basel III rules as they stand, but he seems about alone in wanting banks to stick to the first round of rules.
We think that yes, it does make sense to loosen the LCR. There is a gold standard for regulation and perhaps the LCR can be tightened eventually, but we think requiring the current Level 1 and Level 2 rules would put too much more strain on the global economy than would be worth the benefit at this time.
We’d like to hear from our readers on this matter. We figure that the majority of you would like looser LCR rules but how should this be accomplished? Please comment below or email us at email@example.com.