Setting rules for capital and liquidity

March 29, 2010
Kevin Drum and I had a thrilling discussion about liquidity risk and capital ratios over lunch on Friday. He sums up:

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Kevin Drum and I had a thrilling discussion about liquidity risk and capital ratios over lunch on Friday. He sums up:

Getting Congress and the Fed to impose higher and more rigid capital requirements on big financial institutions is important, but what’s even more important is getting an international agreement in place to make sure everyone else does it too. However, there’s really no one who does a good job of reporting on this. Largely this is because the discussions are all held behind closed doors, so we only hear about the status of negotiations when someone like Larry Summers or Mervyn King drops hints in a speech. It’s like reporting on the intelligence community, except worse.

And no sooner do we ask for good reporting on this front than along comes Bloomberg’s Yalman Onaran, with a 1,600-word story on the national and international rules and guidelines governing liquidity risk management. In typical Bloomberg style, however, it’s sometimes hard to see the wood for the trees, so it’s worth backing up a bit here and looking at the three different places that rules governing these things can come from.

Firstly, there’s legislation — and it’s pretty clear that Congress isn’t touching these issues in its financial-reform legislation. It would be nice if it did: simple legislative bounds on how much leverage financial institutions are allowed, and how much liquidity they need to have, can be useful in preventing regulators from loosening things up too much during boom times. But it’s not going to happen.

Part of the reason, I think, is that the executive branch in general, and Treasury in particular, doesn’t want it to happen. They just released their own Interagency Policy Statement on Funding and Liquidity Risk Management, which is about as hard-hitting as you’d expect, but still useful at the margin. If all financial institutions had followed these guidelines to the letter in the run-up to the credit boom, we’d be in a better place than we are now — but the problem of course is finding regulators with both the ability and the inclination to force such behavior. After all, the utterly ineffectual Office of the Comptroller of the Currency has its name at the top of the new guidelines, and there’s no chance of John Dugan baring any teeth to ensure they’re enforced.

On this front, at least, the financial legislation wending its way through Congress might well help, by consolidating regulators and abolishing the OCC: if there’s one regulator who cares about enforcing extant guidelines and who has authority over all systemically-important financial institutions, that’s a clear improvement on what we’ve got right now.

But the real progress on this front, if it happens at all, isn’t going to happen in Congress, and isn’t even going to happen within Treasury. Instead, it’s going to happen in Basel. Onaran explains:

Looming over discussions about liquidity are rules proposed in December by the Basel Committee on Banking Supervision, a 35- year-old panel that sets international capital guidelines. The new framework would require banks worldwide to hold enough unencumbered assets to meet all of their liabilities coming due within 30 days. That amount, called the liquidity coverage ratio, could be used to offset cash outflows during a panic.

Banks would also have to maintain a “net stable funding ratio” of 100 percent, meaning they would need an amount of longer-term loans or deposits equal to their financing needs for 12 months, including off-balance-sheet commitments and anticipated securitizations.

The Basel committee, which is collecting comments on the proposed rules through April 16, would establish clear definitions of liquid assets and funding needs, rather than leave those determinations to the banks. It would also set new capital requirements. The committee expects to complete its work by the end of the year and implement the regulations by the end of 2012.

These are the rules which we should really be caring about, and they’re the ones I was talking about with Kevin: they’re hammered out slowly, behind closed doors, by mid-level central bankers you’ve almost certainly never heard of. They’re people like Nigel Jenkinson and Marc Saidenberg, the co-chairs of the Working Group on Liquidity, or Hirotaka Hideshima and Richard Thorpe, the co-chairs of the Definition of Capital Subgroup.

The Basel rules are important, and they take a long time to coalesce into something acceptable to all the main players — especially the US, whose abundance of small banks makes it wary of rules which are generally designed for much bigger institutions. It’s entirely foreseeable that the Basel committee’s self-imposed 2012 deadline is going to come and go. But if and when the rules go into effect, they’re going to have much more force than anything coming out of Congress or Treasury. So keep an eye on them: if they get diluted significantly from their present form, that’s a bad sign.


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