BPInsights: February 25, 2023

Rethinking Bank Liquidity Regulation

A key part of bank oversight focuses on the natural tension between banks funding themselves largely with demand deposits and making longer-term loans. Regulators—and their examiners on the ground—oversee how well banks manage that liquidity risk and want to ensure they plan ahead for any potential liquidity shortfall.

  • How things have changed: Before the Global Financial Crisis, regulators viewed bank liquidity supply more broadly. Now, liquidity rules define liquidity supply more narrowly: a bank’s stock of high-quality liquid assets – reserves, Treasuries and, to some degree, agency mortgage-backed securities. The goals of this changed approach were to prevent a freeze in short-term funding markets from destabilizing the financial system and to decrease interconnectedness.
  • Three bad consequences: While banks’ liquidity profiles have strengthened, the narrower liquidity approach has had three important costs:
    • Banks have had to commit more balance-sheet space to HQLA rather than loans to businesses and households, reducing economic growth and pushing financing into the nonbank sector.
    • The narrow focus on HQLA has left banks unwilling to use this layer of safe assets in times of stress when it is needed to support the economy, for fear of falling below regulatory minimums.
    • The increased demand for reserve balances has made the Federal Reserve grow bigger and stay big.
  • It doesn’t have to be this way. Policymakers can preserve the benefits of more liquid banks while reducing the social costs of narrow liquidity regulation.
    • How? Returning to a broader conception of the supply of contingent liquidity, with an emphasis on maintaining diversified sources of funding, can achieve the same benefits with fewer costs. Liquidity regulation should enable banks to assume that they can access funds from other financial institutions and the central bank during periods of stress.
  • Bottom line: The Fed is currently undertaking a holistic review of capital requirements. The time is ripe for a similar review of liquidity requirements, too.

Five Key Things

1. Large Bank Supervisory Standards May Still Be a Mystery

The Federal Reserve’s release of its blueprint for supervising large banks was supposed to shine more light on bank supervision — but banks and the public may remain mostly in the dark after the Fed’s newly released Large Institution Supervision Coordinating Committee manual provided little detail, according to a Bank Reg Blog post this week. “[T]his all sort of reads like an introduction to the LISCC Program Manual, with the real details … found in other manuals not published yesterday,” the blog said. Subject to certain caveats, “it is pretty hard to believe that either former Vice Chair for Supervision Quarles or Governor Bowman would think this version of the Manual would ‘demystify’ or provide additional clarity on much of anything. I therefore wonder if something got lost in translation here, and whether the LISCC Manual that they at one point imagined being published is not in fact what was published yesterday.”

2. Are Nonbanks Fair-Weather Lenders? New Research Offers Evidence

Nonbanks curtail syndicated credit by much more than banks during crises, according to a recent BIS working paper. The differences in the value of lending relationships explain most of the gap, according to the paper: Relationships with nonbanks do not improve borrowers’ access to credit during crises. The rise of nonbanks could therefore result in a shift from relationship lending toward transaction lending and exacerbate the damage of financial crises.  

3. Fed Denies Custodia’s Bid to Reconsider Application

The Federal Reserve this week announced that it denied crypto firm Custodia’s request to reconsider its application for Fed membership. The central bank announced its rejection of Custodia’s membership application in January. All six Fed governors voted to deny the request to reconsider.

4. Why Are Credit Scores So Low in the American South?

Credit scores are notably lower in the South than other parts of the U.S. A recent Washington Post article examines why. The defining factor is not income, race or rural vs. urban settings – the article highlights poorer health conditions and the lack of expansion of Medicaid coverage as potential explanations.

  • Context: The Post piece analyzes an infographic from a 2022 economic paper on credit card rewards.

5. Treasury Unveils Fresh Round of Russia Sanctions

The U.S. imposed new sanctions on Russia this week as the world marked the one-year anniversary of Russia’s invasion of Ukraine. The actions target Russia’s metals and mining sector, several Russian banks, and people and firms linked to Russian sanctions evasion. They also aim to prevent Russia from accessing high-tech equipment.

  • Europe: Meanwhile in Europe, the EU’s new sanctions envoy, David O’Sullivan, expressed concerns recently that sanctioned products are entering Russia through neighboring countries.
  • China: Chinese firms that support Russia may face sanctions, Deputy Treasury Secretary Wally Adeyemo warned. “They have a choice between doing business with the countries of our coalition, which represent 50% of the global economy, and doing business with Russia, an economy that is becoming more isolated each day,” he said.

In Case You Missed It

What’s New in CBDC

Here’s what’s new in CBDC.

  • ‘Unified ledger’: Bank for International Settlements chief Agustin Carstens laid out an updated vision for the future of currency in a speech this week. A “unified ledger” would link CBDCs and tokenized deposits, separated by a partition. “Because they share a common ledger, they can be brought together and used in an efficient way, through smart contracts,” Carstens said. “This would facilitate inclusion and lower transaction costs. Other partitions of the ledger could be used for other assets.” He gave an example of simplifying the escrow process in home-buying. Such a system would preserve the partnership between the central bank and the private sector. Carstens’ vision suggests a more nuanced approach than the frenetic race toward CBDC that has gripped global central bank discussions in recent years.
  • Unstable: Carstens also said “the past year’s events have cast serious doubts on the ability of stablecoins to function as money.” Stablecoins do not benefit from the regulatory safeguards applying to bank deposits, and cannot “guarantee the singleness of money” – the fact that private monies issued by different banks and central bank money all trade at par value.
  • Slouching toward Britcoin: The U.K. is consulting on a digital pound, but does anyone need it? That’s the question at the heart of this Financial Times Alphaville piece. “If you build it, maybe they will come, maybe not,” the article opens. “Or maybe you don’t care, and you just want to build it anyway.”

The Crypto Ledger

The SEC may take enforcement action against Paxos over the Binance BUSD stablecoin, but stablecoins are a Rorschach test for regulators – are they securities, are they more like money market funds or banking products? A recent Wall Street Journal article explores that debate. Here’s what else is new in crypto.

  • Singing in unison: The federal banking agencies released a joint statement this week warning of liquidity risks to banks presented by crypto assets. The statement cautioned banks that deposits from a crypto-related firm for the benefit of that firm’s end customers may be vulnerable to volatile swings. It also warned that deposits that constitute stablecoin “reserves” may be susceptible to rapid outflows.
  • Custodia: Crypto firm Custodia accused the Federal Reserve in an amended federal court complaint of unfairly singling out its master account application as part of a “coordinated” campaign. The central bank recently denied the firm’s Fed account and membership application.
  • Europe: Capital rules for banks’ cryptoasset holdings should be fast-tracked in the EU to avoid missing the Basel Committee’s January 2025 deadline for implementing bank capital requirements for crypto, according to a European Commission document. The document suggested banks would benefit from clarity on requirements for crypto exposures.
  • FOMO: Unregulated crypto firms are exploiting consumers’ “fear of missing out” with advertising devoid of the stringent marketing restrictions that apply to traditional financial firms, according to a POLITICO article focused on Europe.

U.S. Bank, Wells Fargo, BofA Boost New Mexico Customers With Affordable Small-Dollar Loans

A recent article in the Santa Fe New Mexican highlights small-dollar loans from U.S. Bank, Wells Fargo and Bank of America that are providing benefits to local customers. “They are doing what ruthless storefront lending companies claimed was impossible,” Milan Simonich writes. “The banks are providing small loans to New Mexico customers at reasonable rates, all at a rapid clip.” 

  • Filling the void: “Banks are filling the void in a way they never have before. They’re offering customers small loans with time to repay them. And the price is low in dollar terms,” Alex Horowitz, a senior officer of the Pew Charitable Trusts, says in the story. With products like Wells Fargo’s Flex Loan, the banks are offering more affordable alternatives to higher-cost credit providers.

BofA, University of Memphis Launch Career Fellows Program for Black Students

Bank of America and the University of Memphis’ Fogelman College of Business and Economics this week announced the launch of the FCBE Career Fellows Program. The initiative is designed to engage, educate and prepare Black business school students for professional success.

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.