WASHINGTON — Federal Reserve Board Gov. Jeremy Stein said Friday that policymakers should consider reducing a bank's reliance on central bank lending to meet a liquidity requirement under Basel III.

In a speech at a conference hosted by the Federal Reserve Bank of Richmond, Stein said regulators must carefully weigh how much liquidity from a central bank should be allowed to count toward a global liquidity requirement.

"Policymakers should aim to strike a balance between reducing reliance on the [lender of last resort] on the one hand and moderating the costs created by liquidity shortages on the other hand — especially those shortages that crop up in times of severe market strain," said Stein, in prepared remarks.

One way to achieve that is by requiring banks to pay for such access, said Stein.

"It makes no sense to allow unpriced access to the central bank's LOLR capacity to count toward an LCR requirement," said Stein, in prepared remarks.

Citing Australia as an example, he said the government there has agreed to use a "Committed Liquidity Facility," where a financial institution can pay the country's central bank an up-front fee for what would effectively serve as a loan commitment that can be counted toward its highly-liquid assets.

Doing so, he said, would "not be at odds" with the intent of the liquidity regulation and it would also serve as a tax to deter such reliance on Fed funding as a lender of last resort.

To Stein, the new liquidity rules were aimed at reducing dependence on the central bank during times of crisis, but the fact that there is still some role for the central bank raises a pressing concern about how it should coexist with the proposed liquidity regulation.

"Again, the whole point of liquidity regulation must be either to conserve on the use of the LOLR or in the limit, to address situations where the LOLR is not available at all — as, for example, in the case of broker-dealers in the United States," said Stein.

When a central bank acts as a lender of last resort in a crisis, it unnecessarily takes on some credit risk, and if losses are experienced then it ultimately falls on taxpayers, he said. Additionally, the use of a lender of last resort to support banks in trouble can lead to moral hazard problems.

"If it were not for these costs of using LOLR capacity, the problem would be trivial, and there would be no need for liquidity regulation: Assuming a well-functioning capital-regulation regime, the central bank could always avert all fire sales and bank failures ex post, simply by acting as an LOLR," said Stein.

The liquidity coverage ratio requires each bank to hold a sufficient amount of highly-liquid assets to cover total outflows for more than a 30-day period. An institution meets that requirement when its ratio equals or exceeds 100%.

In January, the Basel Committee on Banking Supervision revised the liquidity coverage ratio after concerns were raised on the initial proposal released in December 2010 alongside the entire package of rules.

Under the revised proposal, banks would be allowed to use a broader range of assets that could be considered highly-liquid. It also made changes to some of the assumptions that govern the modeling of net outflows in a stress scenario and agreed to gradually phase-in the requirement with an effective date of January 2019.

Stein said that U.S.' proposal to implement the rule would be due out later this year.

"On the domestic front, the Federal Reserve expects that the U.S. banking agencies will issue a proposal later this year to implement the LCR for large U.S. banking firms," said Stein.

Stein also noted another critical issue that still remains unresolved: encouraging banks to draw down on their liquidity buffer as opposed to fire-selling other less liquid assets.

"A number of observers have expressed the concern that if a bank is held to an LCR standard of 100% in normal times, it may be reluctant to allow its ratio to drop below 100% when facing large outflows, even if regulators were to permit this temporary deviation, for fear that a decline in the ratio could be interpreted as a sign of weakness," said Stein.

The Basel Committee, he said, under the direction of the Group of Governors and Heads of Supervision, plans to continue to work on the issue this year.

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