FSA timing on liquidity rules critical

October 6, 2009

The UK’s Financial Services Authority has come up with a sensible set of rules to shore up banks’ liquidity buffers. But the real test will be managing the transition. Banks know they will have to buy tens of billions of pounds of government bonds, but the regulator is being deliberately vague about when. There are substantial risks if the FSA gets its timing wrong.

There is no question that new rules are needed. The financial crisis exposed the banks’ lack of adequate reserves when faced with market turmoil. The FSA’s correct conclusion is that they should have bigger buffers, and that they should be of higher quality. In practice, this means holding more government bonds, as these can be sold even in a panic. Fortunately, there should be no shortage of supply as Western governments finance their deficits in the coming years.

Knee-jerk complaints about threats to Britain’s competitiveness miss the point. All the country’s banks suffered from the run on Northern Rock, which was the weakest link in the chain. They will all benefit from a more robust financial system, as will taxpayers. True, this will not be cheap: the FSA estimates that banks will forgo 2.2 billion pounds in income by holding lower-yielding government bonds rather than other instruments. In its most extreme scenario, the costs could be as high as 9.2 billion pounds.

A bigger challenge, however, is getting from here to there. The FSA’s central case says British banks will have to increase their holdings of government bonds by 110 billion pounds, from about 280 billion pounds today. However, the shift will not start until the regulator has decided the recession is over. Banks will then be given “a number of years” to meet the target.

This is tricky territory. If the FSA moves too quickly, it risks choking off the recovery. If it is too slow, banks may not be ready for the next crisis. At the same time, the regulator is also introducing new capital rules, which make the balancing act even more difficult. And this assumes it can control the process. The danger is that, when the FSA publishes average liquidity targets for the industry early next year, investors will punish any bank that isn’t already meeting them.

The international dimension also matters. The FSA has deliberately rushed ahead with a new framework in the hope that other countries will follow its lead. If they fail to do so, complaints about the lack of a level playing field will only increase. It’s hard to fault the design of the FSA’s new rules. The real challenge, however, is making sure they are implemented.

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