Unlocking the Liquidity Coverage Ratio

Unlocking the Liquidity Coverage Ratio

The liquidity coverage ratio (LCR) requires certain banks and bank holding companies to hold high quality liquid assets (HQLA) sufficient to meet projected 30-day liquidity needs in a situation of severe idiosyncratic and systemic stress.  The LCR is calculated as HQLA divided by projected 30-day net cash outflows under stress; the requirement is that banks maintain a ratio of at least 100 percent.  A problem recognized in the academic literature (see, for example, McAndrews and Nelson “Supply and Demand for Liquidity under the LCR,” 2011) and by the regulatory community (compare the initial and final LCR proposals) is that the LCR can only help a bank meet its liquidity needs under stress if its HQLA can actually be used (that is, sold or used as collateral to borrow funds).  However, use of the HQLA would cause the bank’s LCR to fall below 100 percent, and therefore constitute a violation of the regulation.  This is the problem of “HQLA usability.”

Consider as an analogy a requirement that a commercial building have a fire extinguisher every 75 feet.  The expectation is that if there were, say, a fire in a trashcan, the company could dip below that ratio and use one of the fire extinguishers to put it out.  But what if doing so would trigger a regulatory penalty and a public notice (“fire in progress at XYZ Company”)?  Presumably, the company would be incentivized to use less effective means to deal with the problem, defeating the purpose of having the fire extinguishers in the first place.

There is a fairly broad consensus that usability is desirable.  If banks, and bank counterparties, are comfortable with the prospect of banks tapping their HQLA when necessary, then relatively small shocks to the liquidity of money markets will be less likely to lead banks to hoard liquidity and withdraw from term lending, resulting in a liquidity crisis.  Such a dynamic was an important early driver of the financial crisis.  Moreover, if banks are fearful of violating the LCR requirement, they will hold a buffer of HQLA above the required level.  Bankers tell us that they maintain LCRs of about 110 percent to reduce the risk that they will fall below the requirement of 100 percent.  There are material social costs associated with banks holding excessive HQLA.  Not only would economic activity be higher if banks were lending to businesses and households rather than holding HQLA, but HQLA has valuable alternative uses as collateral and as an investment for those needing safety and liquidity.

The Basel LCR standard as well as the preamble to the U.S. rule both emphasize the importance of allowing banks to use their HQLA under stress.   For example, the preamble to the U.S. rule states “…the agencies affirmed the principle that a covered company’s HQLA amount is expected to be available for use to address liquidity needs in time of stress.” (p. 61517).  However, the rule imposes consequences for a temporary LCR shortfall that are not compatible with the objective of banks being able to use their HQLA.  Specifically, a covered bank must notify its supervisors on any business day when its LCR falls below 100 by any amount (p. 61537).  And it must present its supervisors a remediation plan if its LCR falls below 100 by any amount for 3 consecutive business days.  By contrast, the rule (as opposed to the preamble) says nothing about the circumstances under which a bank should be expected to use its HQLA.  The intent of this blog post is to encourage the supervisory agencies to modify the LCR rule to enhance HQLA usability while still safeguarding the rule’s commendable objective of ensuring banks maintain robust liquidity; the post also suggests some types of modifications that might be successful.

We recognize that solving the usability problem is difficult.  Carlson, Duygan-Bump, and Nelson (2015) show that during the financial crisis, before there was a LCR, when liquidity strains increased, banks actually improved their liquidity situation, no doubt because the risk that counterparties would make payments on time, and the cost of delaying a payment to others, both rose.  That experience illustrates that it would be challenging to get banks to reduce their liquidity reserves at such times even without the incentives established by the LCR.  Moreover, now that the LCR is established as the standard measure of liquidity condition, credit rating agencies and short-term creditors may penalize a bank that does not meet the LCR even if doing so were to be encouraged by supervisors.  And finally, the usability problem is akin to the stigma problem associated with the discount window, as both are caused by the potentially negative signal associated with using a backup source of liquidity, and that problem has proven to be intractable for more than a century (see the New York Fed note “The History of Discount Window Stigma”).

There are some other, more structural problems associated with increasing HQLA usability, some of which are discussed in, Carlson, Duygan-Bump, and Nelson, cited above.  For one, an objective of the LCR is to bolster counterparty confidence in each other’s ability to meet obligations so that liquidity strains don’t become a liquidity crisis, and that objective may be undercut if it is not certain that banks have the required HQLA.  In addition, another objective of the LCR is to ensure that a bank and, if necessary its supervisors, have time to work out any liquidity problems that arise at the bank and that the central bank has time to assess a situation before deciding if lender of last resort lending is safe and appropriate.  If the bank encounters difficulties right when it has run down its LCR, there will not necessarily be 30 days before the bank risks default.

What are some changes that might improve usability?  Leveraging the resemblance between the usability problem and the discount window stigma problem, it might be helpful to review some steps the Fed has taken to try to reduce stigma.  First, the Fed has always kept borrowing secret, although, as required by the Dodd-Frank Act, they now identify borrowers with a two-year lag.  Second, in 2003, the Fed overhauled the discount window extensively, largely to reduce stigma (see Madigan and Nelson (2002)).  For the forty years prior to that period, the discount rate was below market rates and the Fed controlled use by requiring each bank to borrow only when it had exhausted its other options.  In 2003, the Fed moved to an above-market discount rate, established financial soundness criteria for access to the discount window, and adopted a no-questions-asked lending policy.  After implementation, the Fed also issued supervisory guidance that encouraged banks to incorporate the discount window into their liquidity plans.  The Bundesbank avoided stigma becoming associated with its lending facility in large part by making borrowing regular and unexceptional (see Nelson (2002)).  And the initial response of the Fed to an episode of severe financial stress is often to issue a press release reminding banks that the discount window is available to assist with any funding needs (see, for example, this press release from the Federal Reserve in August 2007.)

These actions to reduce discount window stigma can all be mapped into corresponding actions to increase HQLA usability.  Just as the Fed has kept borrowing secret, banks could no longer be required to report publicly their LCR (except to any extent required by the securities laws).  Just as the Fed now extends discount window loans on a no-questions-asked basis, banks could no longer be required to provide an immediate explanation for a small and transitory LCR breach.  Just as the Fed established financial soundness criteria for the discount window, supervisors could allow greater HQLA usability for better capitalized banks.  Going further, just as the Fed did for the discount window, supervisors could be instructed to encourage banks to use their HQLA occasionally and to incorporate such use in their liquidity plans.  We have concerns that the use of buffers is ineffective in the capital context, as they simply become higher minimum requirements.  However, in the liquidity context, a buffer seems more feasible, as use of the buffer would not appear to require disclosure.  In general, like the Bundesbank’s discount window, usability could probably best be achieved if it became a regular and unexceptional occurrence that a bank would temporarily use its HQLA to meet an obligation.

In times of stress, just as the Fed often issues a “discount window is open” press release, the supervisory agencies could publically announce that banks have robust liquidity reserves that they are encouraged to use to meet transitory funding needs.  Mervyn King, then Governor of the Bank of England, made such an announcement that linked the availability of central bank funding to HQLA usability in a speech delivered in June 2012 during the European financial crisis:

Next January, the Basel rules for the Liquidity Coverage Ratio will be agreed by central bank governors and heads of supervision. Much work still needs to be done to ensure that those rules are properly integrated with the regime of liquidity provision by central banks. In current exceptional conditions, where central banks stand ready to provide extraordinary amounts of liquidity, against a wide range of collateral, the need for banks to hold large liquid asset buffers is much diminished, and I hope regulators around the world will take note. (p. 4)

In a recent TCH working paper, I took the link between the LCR and the discount window even further and described how the Fed could and should create a lending and matched deposit facility to essentially provide banks, for a fee, a line of credit that would count as HQLA.  One of the advantages of such an approach is that it would encourage usability in two ways.  First, if a bank is paying for the “line,” it and its counterparties may see it as unremarkable if it drew on the line.  But more importantly, since a bank would have to pay a penalty interest rate if it drew on the line (essentially using its HQLA), the bank would have a strong financial incentive to repay the draw quickly and any additional rules and administration by supervisors for the bank to get its LCR back up to 100 percent would be unnecessary.  In a similar way, the above-market discount rate adopted in 2003 allowed the Fed to lend discount window credit on a no-questions-asked basis.

While there has been no official evaluation of the costs and benefits of the LCR, the BIS original analysis of the costs of the Basel III package of reforms did include an assessment of the costs and benefits of the net stable funding ratio requirement (NSFR).  The NSFR is another liquidity requirement that is similar to the LCR, but its objective is to ensure a bank can meet it liquidity needs over a one year horizon. The study found that while the NSFR reduced the probability of a financial crisis, it also made bank credit more expensive and reduced economic output.  A recent TCH note points out that the BIS analysis concludes that, at the banking system’s current level of capitalization, the costs of the NSFR exceed its benefits by nearly $1 trillion, suggesting that the costs to society of banks holding more HQLA than required by the LCR are considerable.  As a result, the potential value to society of adjusting the LCR requirement in ways that make usability possible is also considerable.

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership.