The banking system is both stronger and more resilient than the sum of its parts, that is, individual banks. Current regulatory proposals, in the form of the combination of the liquidity coverage ratio and the supplemental leverage ratio, among others, risk weakening the overall system in the quest to strengthen individual institutions.
While it is undoubtedly possible to create standalone institutions that can weather almost any financial storm, the capital and liquidity levels of those institutions will seriously limit their usefulness as engines of economic growth. Further, the banking system that will result from Dodd-Frank, Basel III or other regulatory enhancements under consideration will not be that robust. Significant asset price fluctuations and the potential accompanying systemic loss in confidence will eventually overwhelm currently contemplated standards, as has occurred with respect to past standards.
At this juncture, the interplay among the Volcker Rule, new capital rules, proposed capital and liquidity rules, and yet-to-be proposed rules is anything but clear. As regulators move forward to finalize rules that affect capital and liquidity, they must keep in mind the strength of individual institutions expected to result from those rules and the strength of the overall banking system and financial markets more broadly.
A look at the role of liquidity in our banking system will illustrate this point. Maintaining the liquidity of banks in times of stress can mean the difference between long-term viability and near-term failure of banks. Without access to market sources of liquidity, a bank may be forced to liquidate hard-to-value assets at fire sale prices that erode the bank's capital, turning a liquidity issue into a failure issue.
Far more importantly, avoiding failure of individual, otherwise viable, banks in times of severe economic stress can mean the difference between a manageable problem in the financial system and a panic that threatens the economy as a whole and that is only contained by federal intervention. This occurred recently with the Troubled Asset Relief Program and in the 1930s with the Reconstruction Finance Corporation.
Historically, a key line of defense against liquidity problems has been the banking system. This has been true for commercial companies as well as for financial services companies of all types, especially banks. The idea of banks supporting banks was, and is, the underlying concept of central banks, including in particular the Bank of England as memorialized in Bagehot's Lombard Street and the creation of the Federal Reserve System. It is also the last line of defense before putting taxpayer money directly at risk.
Banks' ability to provide liquidity is a function of their funding in the form of deposits and access to interbank funds as banks with excess liquidity sell it to other banks. Banks' ability and willingness to provide liquidity to each other is facilitated by their understanding of each other's business, their access to deposits and their holdings of liquid assets. The importance of the interbank funds market is reflected in the Federal Reserve's technique for conducting monetary policy that focuses on the federal funds rate.
Enter the supplemental leverage ratio. Simply put, this capital requirement either punishes the holding of high-quality liquid assets by imposing the same capital charge as it imposes on lower-quality illiquid assets or it does nothing at all because it is not constraining. Risk-based capital carries the problem of a false sense of precision, but a leverage ratio can be counterproductive and actually encourages risk-taking and discourages liquidity.
The liquidity coverage ratio would require banks to calculate their own liquidity needs and hold specified high-quality liquid assets to meet these needs. Bank regulators have long encouraged a somewhat similar process, but the formalization of this process into a regulatory requirement is likely to encourage the hoarding of liquidity by some and limiting of liquidity to the mandated amount by others.
In conjunction with the supplemental leverage ratio, the liquidity coverage ratio strongly discourages the holding of assets that may be high quality and liquid, but do not meet the regulatory definition. It may be that the regulators will balance these competing provisions perfectly and we will live happily ever after. But given the importance of interbank liquidity to financial stability, let alone monetary policy, the stakes are high.
Finally, other rules or proposed rules, including the Volcker Rule and the proposed Section 165 rules also may discourage the holding or provision of liquidity. We can hope that regulators have considered the interrelationship of all of these rules and have an end vision of a financial system that will be better and stronger.
Oliver Ireland is a co-head of the financial services practice at Morrison & Foerster and a former associate general counsel at the Board of Governors of the Federal Reserve System.