more on basel iii regulating bank liquidity
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A set of slides discussing proposed Basel III agreements on the regulation of bank liquidityTRANSCRIPT
Economics for your Classroom fromEd Dolan’s Econ Blog
More on Financial Reform and Basel III: Regulating Bank
LiquidityRevised March 2013
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
Basel III and Liquidity
As a previous slideshow explained, bank regulators of individual countries coordinate their work through the Basel Committee on Bank Supervision, an international group that meets in Basel, Switzerland
The committee is now finalizing a new international agreement that will be called Basel III, replacing an earlier agreement, Basel II, that was found inadequate during the global financial crisis
The agreement will regulate bank capital, as discussed in the previous slideshow, and also bank liquidity, as discussed here Building of The Bank for International
Settlements in Basel, Switzerland, where BCBS meetings are held Photo source: http://commons.wikimedia.org/wiki/File:BIZ_Basel_002.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
What is Liquidity?
A financial asset is said to be liquid if it can quickly and easily be converted to money without loss of nominal value
Coins and paper currency are the most liquid assets of all—they already are money
Safe, short-term government bonds and bank deposits are also very liquid
Assets like common stock, real estate, or production equipment are not very liquid Their market price (nominal value) is
uncertain and changes constantly They may take time to sell, and sales may
be subject to large fees or commissions Photo source: Nicole-Koehler, http://commons.wikimedia.org/wiki/File:Faucet.JPG
Revised version March 2013 Ed Dolan’s Econ Blog
Why do Banks Need Liquidity?
Banks need liquidity because they cannot always control the timing of their needs for funds. Examples:
Depositors may decide to withdraw funds from their accounts without advance notice
Bank creditors may decide not to renew short-term wholesale funding as it matures
Line of credit agreements give customers the right to take out loans on short notice
Off-balance-sheet operations like third-party loan guarantees and complex derivative transactions create additional needs for liquid funds Headquarters of the bank BNP-
Paribas in Paris, FrancePhoto source: Tangopaso, http://commons.wikimedia.org/wiki/File:Siege_BNPP_rue_Taitbout.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
Liquidity Crises: Bank Runs
Bank runs are the classic form of liquidity crisis
If customers fear that a bank may not have enough assets to pay all depositors, the depositors run to the bank and stand in line to withdraw their money before the bank goes bust
As withdrawals deplete the bank’s liquid assets, the fear of failure can become self-fulfilling Bank run in Birmingham,
England, September 2007Photo source: Lee Jorndan, http://commons.wikimedia.org/wiki/File:Birmingham_Northern_Rock_bank_run_2007.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
Deposit Insurance as Protection Against Runs
Most advanced countries now use deposit insurance to reduce the risk of bank runs
If people know their deposits are insured, they do not need to worry about being first in line
However, insurance only covers deposits of retail customers. It does not protect large depositors or non-deposit liabilities like interbank loans
An FDIC deposit insurance sign from the 1930s. The maximum insurance is now $250,000 per depositorPhoto source: Mathew Bixsantz, http://commons.wikimedia.org/wiki/File:FDIC_5000_sign_by_Matthew_Bisanz.JPG
Revised version March 2013 Ed Dolan’s Econ Blog
Liquidity Crises: Fire Sales
During a liquidity crisis, a bank may deplete its reserves of liquid assets
The bank may be then forced raise new liquid funds by selling less liquid assets, like long-term securities and loans, at “fire sale prices”—prices below the value they would have if the bank held them to maturity
The resulting loss of value of assets, in turn, depletes the bank’s capital. When capital falls to zero or less, the bank becomes insolvent Photo source: Julia Manzerova,
http://commons.wikimedia.org/wiki/File:Fire_Evacuation_Sale_%281186978688%29.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
Liquidity Crisis and Insolvency: Example
Suppose depositors unexpectedly withdraw $20,000 from a bank that starts with a healthy balance sheet
The first $10,000 of withdrawals can be covered from liquid cash reserves
Suppose the next $10,000 must be raised by selling loans, but under “fire sale” conditions, they only bring half of their previously listed book value
The loss from selling loans previously valued at $20,000 in order to raise just $10,000 in cash reduces capital from $8000 to -$2,000
With less than zero capital, the bank is insolvent
Revised version March 2013 Ed Dolan’s Econ Blog
How a Liquidity Spiral Spreads the Crisis
At the beginning of a crisis, liquidity problems may force a few weak banks to sell assets at fire sale prices
As market prices of loans, securities, and other assets fall, more banks suffer losses and erosion of capital
Those banks, in turn, are forced to sell assets in an attempt to safeguard their balance sheets
The spiral of losses, forced sales, and plunging market prices can create a liquidity crisis that spirals out of control
In the fall of 2008, a liquidity spiral of this kind helped spread the financial crisis throughout the world from its start in the U.S. subprime mortgage market
This dramatic NASA experiment used colored smoke to show how an airplane’s wingtip creates a rapidly spreading spiral vortex. Photo source: NASA, http://commons.wikimedia.org/wiki/File:Airplane_vortex_edit.jpg
Revised version March 2013 Ed Dolan’s Econ Blog
What Kind of Regulations can Reduce Liquidity Risk?
Asset-side liquidity regulations Excessive holdings of assets whose
market value may plunge in a crisis are a source of liquidity risk
Regulations can require banks to hold minimum amounts of liquid assets Official reserves (cash and deposits
at central banks) are banks’ first line of defense against liquidity problems
Additional liquid assets like short-term, high-quality government bonds provide further protection
Liability-side liquidity regulations Liability-side liquidity risks arise
when banks depend too much on “volatile” sources of funding Uninsured deposits Short-term wholesale borrowing
that may not be renewed in a crisis Regulations can require minimum
levels of stable funding Retail deposits protected by
deposit insurance Medium and long-term borrowing Capital
Revised version March 2013 Ed Dolan’s Econ Blog
Basel III: Proposed Liquidity Coverage Regulation
Proposals for the Basel III agreement include a regulation requiring a liquidity coverage ratio sufficient to guarantee that a bank could survive a 30-day stress period, allowing recovery or orderly wind-up
The liquidity coverage ratio is the ratio of liquid assets to estimated cash outflows under stress conditions
Estimation of cash outflows is based on a stress test that considers what would happen in a crisis involving events such as:
Outflows of insured retail deposits Downgrade of the bank’s credit
rating Loss of access to markets for short-
term wholesale funding (e.g., interbank loans)
Collateral calls on derivatives or other off-balance-sheet obligations
Revised version March 2013 Ed Dolan’s Econ Blog
Basel III: Proposed Net Stable Funding Regulation
A further Basel III proposal has been a regulation requiring a net stable funding ratio of 100% or more
The net stable funding ratio is defined as the ratio of available stable funding to required stable funding
Available stable funding is a weighted average of liabilities, in which stable sources of funding, like insured retail deposits and capital, have high weights, and volatile funding, like short-term wholesale borrowing, have low weights
Required stable funding is a weighted average of assets, in which liquid assets like cash and government bonds have low weights and illiquid assets like loans and risky private securities have high weights
Revised version March 2013 Ed Dolan’s Econ Blog
Will Basel III Succeed in Reducing Liquidity Risk?
The broad outlines of Basel III were agreed upon at the end of 2010
Final regulations are the object of tough negotiations among national governments and fierce lobbying by banking interests
Banks have won a delay in introduction of the liquidity coverage ratio which will be phased in from 2015 to 2019
The net stable funding ratio will be phased in starting in 2018 subject to further study
Revised version March 2013 Ed Dolan’s Econ Blog
Related Slideshow: What is Basel III and Why Should we Regulate Bank Capital?
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