Liquidity Regulation is Back

Modern bank regulation has two complementary parts: capital and liquidity requirements. The first restricts liabilities given the structure of assets and the second limits assets based on the composition of liabilities.

While capital regulation―especially in its risk-based form―is a creation of the last quarter of the 20th century, liquidity regulation is much older. In fact, the newly implemented liquidity coverage ratio (LCR) harks back to the system in place over 100 years ago. In the United States, before the advent of the Federal Reserve in 1914, both national and state-chartered banks were required to hold substantial liquid reserves to back their deposits (see Carlson). These are the reserve requirements (RR) that remain in effect in most jurisdictions today, the United States included.

In this post, we briefly examine the long experience with RR as a way to gain insight regarding the LCR. We draw two conclusions. First, we argue strongly against using the LCR as a monetary policy tool in advanced economies with well-developed financial markets. Like RR, it is simply too blunt and unpredictable. Second, for the LCR to work as a prudential policy tool, it should probably be supplemented by something like a fee-based line of credit at the central bank....

An Open Letter to the Honorable Randal K. Quarles

Dear Mr. Quarles,

Congratulations on your nomination as the first Vice Chairman for Supervision on the Board of Governors of the Federal Reserve System. We are pleased that President Trump has chosen someone so qualified, and we are equally pleased that you are willing to serve.

Assuming everything goes according to plan, you will be assuming your position just as we mark the 10th anniversary of the start of the global financial crisis. As a direct consequence of numerous reforms, the U.S. financial system—both institutions and markets—is meaningfully stronger than it was in 2007. Among many other things, today banks finance a larger portion of their lending with equity, devote more of their portfolios to high-quality, liquid assets, and clear a large fraction of derivatives through central counterparties.

That said, in our view, the system is not yet strong enough. In your new role, it will be your job to continue to fortify the financial system to make it sufficiently resilient.

With that task in mind, we humbly propose some key agenda items for the first few years of your term in office. We divide our suggestions into five broad categories (admittedly with significant overlap): capital and communications, stress testing, too big to fail, resolution, and regulation by economic function....

Making Banking Safe

Professor Mervyn King, our friend, NYU Stern colleague and the former Governor of the Bank of England, has written a wonderfully insightful and thought-provoking new book, The End of Alchemy. His goal is not just to explain the sources of the 2007-09 crisis, but to provide a template for financial reform that would reduce the frequency and severity of future crises. In the end, Professor King proposes a radical structural change intended to make banking safe while preserving the intermediation function that is critical to modern economies.

The alchemy to which Professor King refers in his book’s title is banks’ traditional function of transforming high-risk, illiquid and long-maturity assets into low-risk, liquid and short-term liabilities. But, in the presence of limited liability for the banks’ owners and the government safety net (in the form of deposit insurance and the lender of last resort that remove both solvency and liquidity risk for the depositors), banks’ incentive is to transform too much. Holding assets that are overly risky, insufficiently liquid and too long-term makes banks fragile and run-prone, providing fodder for systemic crises....

Not so fast

GE’s planned sale of its financial division – GE Capital – looks like a home run for systemic regulators. It adds to a string of recent announcements that big intermediaries are responding to improved financial oversight. Deutsche Bank’s decision to shrink its investment banking business and sell Postbank is another example, as is the more general pruning of oversized balance sheets elsewhere: UBS assets are now less than half the pre-crisis level.

If the regulatory reforms in the United States and elsewhere really work to reduce systemic risk, the list of Systemically Important Financial Institutions (SIFIs) would become an historical artifact: either these financial behemoths become safer, or they go out of existence...

Commentary

Money, Banking, and Financial Markets