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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