Global capital, local liquidity and the Basel Committee

This week’s announcements by the Basel Committee on changes to the Liquidity Coverage Ratio have been greeted with cheers and sneers, but one important aspect remains the same: the Committee continues to take a one size fits all approach to global regulation. We’ve commented on this in passing recently then read a smart article by Jeffrey Carmichael, of Promontory Financial Group, that spoke more eloquently on the topic than we have. The time has come for a closer look at what’s going on.

First let’s hear from Promontory, which is a consulting firm made up of heavy hitters in the regulatory space. Mr. Carmichael is a former Chairman of the Australian Prudential Regulatory Authority. In “Global Perspectives, Reflections on Basel III,” Promontory provides commentary from various principals of the firm. Mr. Carmichael’s article, “The New Liquidity Standard: The ‘Curse’ of Fiscal Responsibility,” is on page 5. He writes:

“…The flaw in the Basel Committee approach is the assumption that liquidity should be regulated under a prescriptive, one-size-fits-all standard. The reality is that capital and liquidity are very different. Unlike capital, which is a ‘global’ concept, liquidity is a ‘local’ concept…

“Thus there is an overwhelming case to establish a uniform international definition of capital. The same is not true, however, for liquidity. While there are solutions to this challenge, the Basel Committee has shown only limited interest in it to date. In part this may reflect the small number and relative low priority of the countries involved. In part it may reflect the Basel Committee’s focus on bringing banks (and regulators) in the larger countries into line. Whatever the reason, it has created a nervous waiting game for banks in these few countries…”

Mr. Carmichael is writing from the Australian perspective, where the central bank has come up with some creative remedies for helping banks meet their Basel capital requirements owing to low levels of outstanding national debt. We’ve seen the same sentiment echoed around the world though, which makes us think that the problem isn’t just with a few countries but rather most every country that isn’t the US, an EU member state or China.

In our November 2012 research report on CCPs and Collateral Management, we heard, sometimes forcefully, from CCPs in emerging markets that Basel rules put them in awkward positions to atone for the sins of banks in developed economies. From the report:

“This perceived misdirection in regulation creates difficulties for EM CCPs as well as some absurdities. The primary complaint is the impact that requiring a large default fund has on a market with a small concentration of banks. This concentration allows the CCP to have an in-depth understanding of its major counterparties and track risk differently than some of their developed world peers. When CCPs respond to broad brush-stroke mandates for risk management or to regulators newly concerned about CCP balance sheets, CCP management becomes occupied with explaining how their local realities differ from the Basel test case scenarios.” We tend to agree with their arguments.

In the U.S. the same bifurcation can be seen by the plethora of community banks that are caught up in the new rules but don’t have the exposures that the rules were meant to contain. Capital and liquidity rules applied across the board can provide uniformity and transparency. But that strength can also be a weakness when there are blinders to local liquidity.

Clearly, the Basel Committee and local regulators want to create a level playing field and that leads to one set of rules for all players. Pretty much everyone buys into the concept that capital is global. We think though it is time to focus on the “liquidity is local” part of the conversation. How can level playing fields be set that recognize that a great number of banks worldwide live in local markets? We agree with Mr. Carmichael that it is time to address this challenge.

Interestingly, the solution might simply harken back to a September 2012 paper by the Bank of England’s Andrew Haldane and Vasileios Madouros. They argue for a dramatic reduction in complexity to Basel rules altogether, resulting in more principal based regulation that presents a framework rather than trying to account for every variable. We wrote up their paper here. This might be an elegant solution to the very thorny problem of creating equal rules for banks worldwide.

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