Measuring the impact of LCR and other liquidity regulation on banks – a new study by the Bank of England

The Bank of England has released a first-of-its-kind study on the empirical impact of liquidity regulations (LCR, and in the UK, Individual Liquidity Guidance or ILG) on bank activities. In a Bank of England Working Paper, authors Ryan Banerjee of the Bank for International Settlements and Hitoshi Mio of the Bank of Japan took a group of banks that were impacted by liquidity regulation in 2010 vs. a control group that was exempted. The results suggest how this specific regulation has impacted banks and gives ideas about future liquidity regulation.

As the authors note, the 2010 Individual Liquidity Guidance regulation in the UK told banks to meet liquidity directives but not how to do it. This left room for each bank to adjust as they saw fit. We’ve seen this on a global scale as well as the LCR moves from a concept to an actual reported figure. From the report:

Banks can respond in a myriad of ways to meet the ILG requirement which are likely to have different welfare implications. For example shrinking the size of a bank’s balance sheet by cutting lending to the non-financial sector would increase the ratio of HQLA to stressed liability outflows, as would increasing the size of balance sheets by issuing equity to acquire HQLA. Alternatively, a bank could also meet the regulation without changing balance sheet size but by changing the composition of assets or liabilities. In short, there are many possible ways for banks to meet tighter liquidity requirements.

Here’s what happened in practice:

On the asset side of bank balance sheets, banks subject to the ILG increased the share of HQLA to total assets by 12 percentage points on average relative to those with exemptions. Within the possible menu of HQLA, cash and central bank reserves constituted around 75% of the increase with 25% in UK T-bills and longer-maturity gilts. The increased share of HQLA was matched by an almost equal reduction in the share of short-term intra- financial loans.

Other important findings were that banks reduced their reliance on short-term wholesale funding markets (ie, repo) and did not raise interest rates on loans to the non-financial sector. Banks saw lower profitability “primarily through the substitution towards lower yielding HQLA and more expensive non-financial deposit funding” and could not make this up from higher fees to non-financial clients.

The authors find that the introduction of the UK’s ILG did not impact bank balance sheets. What it did was change the composition of bank assets by increasing HQLA, 75% of which was in central bank reserves. This was offset entirely by reductions in short-term loans to financial firms. The upshot here is that liquidity regulation worked by taking short-term investment activity financing out of the bank’s assets and liabilities and replacing them with HQLA. This is what regulators wanted.

The downside to this regulation that we’ve been writing about in Securities Finance Monitor is that movement away from short-term lending to the financial sector in favor of putting cash into central bank reserves impacts market functioning. The reductions in bank liquidity have resulted in higher volatility and less liquidity for investors. This may be the new unleveraged normal, but it may not actually work the way regulators want it to. This issue was not explored in the working paper but is worth a follow up.

The full paper can be found at Bank of England’s Staff Working Paper No. 536, “The impact of liquidity regulation on banks.”

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