Liquidity requirements are a cornerstone of prudential frameworks. The regulatory instrument which has been more directly challenged by the banking turmoil (in the US related to Silicon Valley Bank last year) is the liquidity coverage ratio (LCR), said Fernando Restoy, chair of the Financial Stability Institute, in a recent speech.
LCR is designed to ensure that banks have a sufficient amount of high-quality liquid assets (HQLA) to face a liquidity stress scenario characterized by the runoff of a portion of liabilities with a maturity of less than 30 days. The runoff rate for each type of liability is a function of its perceived instability: eg low for fully insured deposits and high for funding from other banks or corporates.
Recent episodes show that the calibrated runoff rates for specific liabilities in the LCR are considerably lower than the ones actually observed. For example, the deposits that Silicon Valley Bank lost in a single day were still higher than what the stress scenario underlying the LCR calibrations would assume for a whole month.
At the same time, the definition of HQLA has been subject to some controversy. As you all know, the current eligibility criteria do not consider the accounting treatment of the instruments. Thus, the conditions for debt instruments in the amortized cost (AC) category to be eligible as HQLA are the same as similar instruments in fair value (FV) categories.
Dysfunctional repo markets
The argument has been made than AC instruments would not be as readily available as FV instruments to cover liquidity outflows, as the sale of AC assets would often imply the need to recognize potentially sizeable capital losses in both the profit and loss account and regulatory capital.
That does not happen when AC instruments are used to obtain liquidity via repo transactions with private counterparties or the central bank. Yet, private repo markets are often dysfunctional in stress situations, and a large reliance on central bank liquidity could carry some stigma.
Against that background, some regulators are considering reviewing the runoff rates assumed for specific liabilities in the calibration of the LCR and also introducing constraints on the eligibility of AC instruments as HQLA. The Basel Committee on Banking Supervision has those issues on its analytical agenda, although no policy adjustment has been proposed so far.
The temptation to strengthen regulatory requirements in the aftermath of such episodes is understandable. However, there is a limit on what regulatory requirements can achieve and on the degree of regulatory stringency that can be imposed without impairing banks’ intermediation business.
Thus, minimum liquidity requirements are inherently narrow in scope and cannot anticipate all possible scenarios of liquidity stress. Importantly, regulatory requirements are not and should not be designed to ensure that all banks (not even all solvent banks) would be able to address any conceivable run of deposits or other liabilities.
LCR adjustments
Going back to the case of the Silicon Valley Bank failure. That bank suffered the withdrawal of 25% of its deposits, with another 60% expected for the following day. Arguably, any bank required to hold a sufficient amount of safe and liquid assets to cover that extreme liquidity stress would have been unable to conduct any meaningful commercial activity.
Therefore, targeted adjustments to the LCR may be warranted, provided that such changes are supported by sufficient evidence on their effectiveness and proportionality. However, there appears to be no compelling case for a complete overhaul of existing liquidity requirements. That would not be the most effective way to address all challenges posed by the apparent reduction in the degree of deposit stability that can be expected in weak banks.