Basel III Liquidity Rules May Kill Short-Term Deposit Market

In December 2010, the Bank for International Settlements declared its intention to impose two new measures of liquidity for large financial institutions.  "Both the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) will be subject to an observation period and will include a review clause to address any unintended consequences," the BIS declared with its usual confidence.

Since then, banks and their advisers have heard precious little from the BIS on the measurement of liquidity risk.  The issue of liquidity is not even addressed in the current Basel III proposal, perhaps because doing so is impossible, in practical terms. 

Either you have liquidity or you don't, to paraphrase the chief risk officer of one of the largest U.S. banks. But as with the rest of Basel III, the fact that actually measuring liquidity is problematic does not dissuade the economists who inhabit the BIS and the Federal Reserve Board from trying anyway.

One of the reasons that the BIS is focused on liquidity risk is the fact that firms such as Bear Stearns, Lehman Brothers and many other near-bank financial institutions failed due to a change in the liquidity available to them in the markets. (By "near-bank" I mean broker-dealers or specialty finance companies that were traditionally funded with commercial paper but now rely increasingly on FDIC insured deposits.) The BIS has decided that the reason for these horrific events was a lack of liquid, high-quality assets on the balance sheets of these firms.  But this position flies in the face of the facts we all know, namely that virtually no assets were liquid during this period.

In order to protect the financial system from future contagion, the BIS decided to use measures such as the LCR and NSFR as a means of determining whether a financial institution meets the requirements of Basel III for liquid assets.  The BIS has no way of actually measuring the liquidity of these assets and liabilities other than the same, failed mechanisms that prevailed prior to the crisis, namely third-party ratings and meaningless accounting values.

All of this would be funny were the issues involved not so important.  Most readers of American Banker know very well that the funding choices available to U.S. financial institutions have grown progressively fewer since the subprime crisis exploded in 2007.  In particular, the disappearance of the commercial paper market for small and even midsized banking firms makes any changes to the Basel III liquidity rules crucially important to banks and broker-dealers. 

For this reason, the prospect of the BIS constraining the use of funding sources like sweep accounts, and other types of "brokered funds" broadly defined, by excluding them from "Net Stable Funds Ratio" calculations, is causing great uneasiness at a number of U.S. banks.

While many regulators understand that today's brokered-funds market is stable and, indeed, barely budged during the liquidity crisis that began in 2007, there remain reactionary elements inside the Fed and FDIC who believe that all brokered deposits are acts of Satan.

Back in the 1980s, there were a number of financial institutions (mostly savings and loans) that used brokered funds to grow in an unsafe and unsound manner.  Many of these institutions failed.  But the funding crisis seen in 2007 is fundamentally different from the crisis of the 1980s and did not involve deposit funding as the primary driver for imprudent management practices.  In fact, firms like Washington Mutual, Bear, Lehman and Countrywide all would have violated the Basel III NSFR rule because so much of their funding was not deposit-based funding, but market-based financing.  Whereas in the past many near-banks relied upon commercial paper and other market sources for financing, today many of these same institutions use stable bank deposits for funding.