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.
Download ReportTranscript 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 look at my textbook, Introduction to Economics, from BVT Publishers. 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/