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You Call That Liquid? New Basel III Liquidity Rules Ineffectual

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How do you get 27 countries with different cultures and political systems, often at different points of the credit cycle, to agree on a reform plan for the global financial system? 

Answer: By watering it down.

After years of lobbying by banks, politicians and even some financial regulators, the Basel Committee announced Sunday that it would allow an array of equities, corporate bonds, and residential mortgage-backed securities (yes, remember those) to be counted toward Basel III's Liquidity Coverage Ratio. Too-big-to-fail banks and their numerous supporters, especially in Europe, have already been cheering.

Every year that passes, politicians, bankers and even some financial regulators forget how illiquidity helped the 2008 financial crisis spread like wildfire from Wall Street to Main Street and from the U.S. to the farthest reaches of the globe. With every part of Basel III that is gutted, we are increasingly back where we were at the eve of the crisis. 

The bankers had argued that the stricter requirements of the originally proposed LCR would have constrained credit availability. But there is no guarantee that a weaker LCR will embolden banks to lend more. Given the amount of liquidity that monetary authorities in the U.K., Europe, and the U.S., have injected, banks have had plenty of opportunity to lend to the real economy.

Given how quickly the 2008 credit crisis turned into a liquidity crisis, one of the biggest improvements in Basel III was supposed to be the inclusion of a liquidity buffer which was completely absent in Basel II. 

The first part of the liquidity standards is the LCR, requiring banks to demonstrate they have sufficient high-credit-quality, very liquid, unencumbered assets to survive in a period of stress for at least 30 days. ("Stress" scenarios would include unexpected significant withdrawals of deposits, lines of credit, or other wholesale funding vehicles.) The original suggested start date for the LCR was 2015 while many other enhanced and new buffers were supposed to start this year.

The second part of the liquidity standards is the Net Stable Funding Ratio, which will probably be the next point of focus for the Basel Committee.  Its purpose is to establish a minimum acceptable level of stable funding over a one-year time frame, based on the liquidity characteristics of a bank's assets and activities, and to insure that long-term assets are funded with at least a modicum of stable liabilities.

For the LCR, the numerator, until Sunday, consisted of Level I assets: Cash, central bank reserves, and sovereign and supranational securities which are assigned a 0% risk weight under the standardized method (in other words, they had to be rated AA to AAA).   

Even before it was softened, a problem with the LCR was that even if a sovereign security was not in the upper echelon of ratings, it could still be considered a Level I asset as long as it was denominated in the sovereign's own currency. Given the current fiscal condition of a number of European countries, it was already questionable how liquid these securities really are. Level II assets – sovereign, supra, corporate, and covered bonds that were rated AA-minus – could also be part of the numerator with a 15% haircut.

Under the revised LCR announced Sunday, the numerator can also include corporate bonds rated BBB-minus to A-plus; unencumbered equities; and residential mortgage-backed securities. 

At least these assets have what some would consider a significant haircut (25% for the mortgage bonds, 50% for the others). But it is important to remember how volatile and illiquid even highly rated sovereign securities can become, not to mention the above assets. Also, yet again, the market will be relying on public ratings that are paid for by the issuer – a conflict of interest that led to dicey securities receiving high grades during the boom years.

The Basel committee also eased its recommended stress scenarios in many instances.  For instance it reduced the outflow stress levels on certain fully insured retail deposits, non-financial corporate deposits, and committed liquidity facilities to non-financials.

Instead of needing a 100% LCR by 2015, banks now are expected to have just a 60% ratio by then. The remainder would increase incrementally until 2019, when banks would have to be fully compliant. It is important to remember, however, that the Basel Committee has no legislative or enforcement powers anywhere. Hence, it is quite likely that any jurisdiction could water down the LCR or delay it further depending on its views and needs.

One summer in Moscow, as an undergraduate majoring in Russian and Soviet studies, I learned a quintessentially Soviet joke: "we pretend to work and they pretend to pay us." Similarly, in today's financial world, regulators pretend to supervise while banks pretend to be liquid. 

Mayra Rodríguez Valladares is a managing principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm. She also teaches at New York Institute of Finance. She can be reached by email at MRV@Post.Harvard.Edu or Twitter: @MRVAssociates.   

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Comments (10)
She's clueless
Posted by rose1 | Monday, January 07 2013 at 1:08PM ET
She's clueless
Posted by rose1 | Monday, January 07 2013 at 1:08PM ET
Danged if you do, darned if you don't. If we pass the rules to be implemented fully in 2015 and banks tighten credit even more to account for the new liquidity buffer, Washington cries foul and that banks are restricting credit to the needy (aka. not credit-worthy). If we extend the rules til 2019 to give banks more time to build those reserves, Washington cries foul and that banks are pushing off needed reforms. When you're the public whipping post there is no right way to do something.
Posted by BankerBud | Monday, January 07 2013 at 2:57PM ET
Banks didn't fail beacuse they were illiquid: they were insolvent.
If the price of mortgage securities can plummet 50% in the blink of a computer screen, how is that "liquid?"
Posted by kvillani | Monday, January 07 2013 at 3:12PM ET
It is much worse than that. Liquidity requirements based on perceived risk add a new layer of regulatory subsidy to The Infallible which translates into a regulatory tax of "The Risky", precisely those on the margin the most important actors in the real economy.


The Basel regulatory mantra persist being save the banks above all and do not care one iota if everything else goes under.


http://teawithft.blogspot.com/2013/01/basel-keeps-tightening-noose-around.html
Posted by Per Kurowski | Monday, January 07 2013 at 3:35PM ET
In a very roundabout way, the author gets to her point. Or if it isn't her point, it is the point that her arguments make. How do you get to a liquidity rule that fits 27 different nations? Better not to try,because it will start out as a bad fit, and it doesn't get any better by trying to fix it. The Basel liquidity rule is an effort to create a universal shoe, and it doesn't fit anyone.

Emphasizing sovereign instruments was a bad idea as we discovered how risky Greek and Italian and Spanish sovereign instruments could become. Anyone willing to bet that those are the only nations that will have sovereign risk issues in the future? So the Basel folks responded by adding some other instruments. But, they have potential risk problems, too. We come to the recognition that liquid instruments are liquid until they aren't. How about some AAA mortgage securities? Can you get any safer than that? It seems in this world there is risk everywhere, and the Basel liquidity rule writers seeking safe and highly liquid instruments are chasing chimeras.
Posted by WayneAbernathy | Monday, January 07 2013 at 5:27PM ET
It seems to me the whole problem dates back to banks' resentment over FDR-era efforts to protect Main Street from absorbing all the consequences of the risks banks periodically unwisely leverage up to increase profits.

FDIC insurance premiums, and regulations to stabilize the economy and family finances when banks misbehave, reduced potential profits. To attract deposits above FDIC-insured limits, banks had to set up a parallel "insurance" scheme, now known as "repo". The more things change, the more they stay the same, and the financial crisis in a nutshell was a classic run on the banks' repo sides.

Actual bankers here will likely dispute my simple analysis with a bunch of technical stuff, but I think honest bankers will agree it's a fair description of the situation to use when talking to the layman.

In a just system, repo depositors and banks would have ended up bald! And given the level of abuse of privilege, maybe even headless. In the unjust system we have, government instead has torn Main Street's hair out by the roots to make elegant wigs for Wall Street. By covering up all those bald heads, which would have served to mark the miscreants for public derision, we have radicalized our politics to a point that US sovereign debt was downgraded by the very ratings agencies who cooperated with the fraud (and I use that term advisedly due to the massive list of settlements entered into by mega-banks).

I agree with Sheila Bair - complication in regulation simply invites higher levels of gaming. If I had my way, a financial crisis would serve as prima fascia evidence of widespread fraud (heck, it has always turned out to be the case after years of sorting through the mess!) and result in immediate nationalization of the whole banking system until every transaction is investigated and unwound.

And suppose the only clearing and settlement system allowed for any financial transaction were through the Federal Reserve. All the "proprietary information" dodges that delayed resolution of counter-party fears would've been moot, as the Fed would be entitled to every speck of information under its confidentiality rules.

@BankerBud
I remember proposals to establish direct government lending for the "needy" in service of the idea that home ownership would help stabilize communities. It was the bankers who howled about unfair competition for a market they red-lined habitually. Sorry, no sympathy here! But there is, indeed, a right way to do business. The problem is that it isn't as profitable as Wall Street wants.

I don't sell homeowners repairs they don't need, or cut corners on quality to increase my profit margins. My prices are not low, but I'm often called back to redo work folks had done on the cheap that didn't solve the underlying problem I warned them about. Neither do I dump paint thinner out on their lawns, or bury rubbish in their gardens, or leave termite-attracting trash in the crawl space they'll never enter. Many of my competitors do all of that.

All I want is my banker to treat me the same way. Not one ever has.
Posted by Tygerrr | Tuesday, January 08 2013 at 12:01PM ET
The best and most apt summary of what it's like to try to get a true picture of the Banks answers is from lyrics of one of Don Henley's (formerly of the Eagles) songs:

"Today I made and appearance downtown.

I am an expert witness, because I say I am.

And I said, 'Gentleman....and I use that word loosely...I will testify for you; I'm a gun for hire, I'm a saint, I'm a liar - Because there are no facts, no truth, just data to be manipulated.

I can get you any result you like....what's it worth to ya?

Because there is no wrong, there is no right; And I sleep very well at night;

No shame, no solution No remorse, no retribution.

Just people selling t-shirts just opportunity to participate in this pathetic little circus

And winning, winning, winning' "

Richard Isacoff
isacofflaw@msn.com
Posted by riisacoff | Tuesday, January 08 2013 at 2:42PM ET
Thanks to those of you who made useful comments to my article. In the decade that I have worked globally on Basel issues with regulators and bankers, it is clear that the Basel accords are imperfect in great part because it is very difficult to get agreement from the growing number of member countries. There are now 27 countries each with different cultures, banking systems and which are at different points in the credit cycle. Ever y rule that gets finalized ends up being very different from what is proposed. Watering down the liquidity coverage ratio happened primarily because European bankers, politicians, and regulators did not want European banks to have to abide by stringent liquidity rules at a time that they are still being impacted by the Eurozone crisis. Yet, allowing for more assets such as RMBSs, corporate bonds, and equities, even with haircuts, to be part of the liquidity numerator hides the true liquidity level of a bank. And since Pillar III, transparency guidance, is still not fully in effect in a uniform manner, understanding the true nature of a bank's on and off-balance sheet, makes it even harder for investors and rating agencies to evaluate banks true state. Mayra Rodriguez Valladares
Posted by MRVAssociates | Friday, January 11 2013 at 9:33AM ET
No question, there has been strong lobbying for an adjustment of the original LCR formula which makes it easy to lable the new compromise a "watering down" result. However, from my point of view this apraisal appears to be too simplistic. In fact there are sound arguments for an extension of the class of "eligible assets". Even without an LCR we have observed in the past - not only but in particular as a result of the financial crisis - significant "crowding out" effects which would have been further intensified by restricting eligibility to Cash, central bank reserves, and sovereign and supranational debt.

Assuming that only public debt is "good debt" (the paradigm of the original formula) was as misleading as the cornerstone of the original Basel accord dating back to 1988 which asigned a zero risk weight to sovereign debt. As we know, the latter did have a significant impact on portfolio composition and the balance sheet problems banks are facing as a result of the current sovereign debt crisis are - at least in part - also a result from false regulatory assumptions. Where to "draw the line" in terms of eligibility and which haircuts should be assigned, is a different but indeed valid question.
Posted by diogenes | Saturday, January 12 2013 at 10:56AM ET
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