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Transcript Free Slides from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ More on Financial Reform and Basel III: Regulating Bank Liquidty Post prepared September 12, 2010 Terms of Use: These.
Free Slides from
Ed Dolan’s Econ Blog
http://dolanecon.blogspot.com/
More on Financial Reform
and Basel III: Regulating
Bank Liquidty
Post prepared September 12, 2010
Terms of Use: These slides are made available 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
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Basel III and Liquidity
As an earlier post 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 working on 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 earlier post, 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
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 shortterm 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 BNPParibas in Paris, France
Photo source: Tangopaso,
http://commons.wikimedia.org/wiki/File:Siege_BNPP_rue_Taitbout.jpg
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 2007
Photo source: Lee Jorndan,
http://commons.wikimedia.org/wiki/File:Birmingham_Northern_Rock_bank_
run_2007.jpg
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 depositor
Photo source: Mathew Bixsantz,
http://commons.wikimedia.org/wiki/File:FDIC_5000_sign_by_Matthew_Bisanz.JPG
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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_%28118697
8688%29.jpg
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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
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
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 shortterm, 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
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
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 shortterm wholesale funding (e.g.,
interbank loans)
Collateral calls on derivatives or
other off-balance-sheet obligations
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Basel III: Proposed on 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
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Will Basel III Succeed in Reducing Liquidity Risk?
The Basel III negotiations are to be
completed by the end of 2010
Final regulations are the object of
tough negotiations among national
governments and fierce lobbying by
banking interests
A preliminary meeting in July, 2010,
already weakened some proposals, for
example, postponing the net stable
funding regulation to allow several
years of preliminary observations
The outcome of negotiations will be a
key factor determining the timing and
severity of the next financial crisis
Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/