Although U.S. regulators remain determined to enact each rule as if it relates to no other, researchers have increasingly found that rules have cumulative and often conflicting purposes – see, for example, the sum total of bank rules which empowered nonbank financial intermediaries operating with impunity until they needed trillions in taxpayer backstops in 2020. Following a seminal Federal Reserve Bank of New York paper on the cumulative consequences – none good – of considering capital and liquidity rules in isolation, a new BIS paper considers the internal contradictions of consequential liquidity regulation and central-bank backstops. Now, if only bank regulators at home and abroad did the same.
The BIS paper looks at the push-pull evident in liquidity rules founded on expectations that banks should not use central-bank liquidity even though central banking is founded on the concept of providing liquidity to banks under stress. As all too evident in the 2023 crisis, liquidity compliance cannot ensure banks stand firm in a run, even as the Fed’s discount window opened with all the alacrity of an centuries-old casement. Solutions posed ever since have suggested stiffening the liquidity standards and ensuring discount-window operability, but each thread of this debate ignores the other. The BIS paper happily proposes a framework in which the two pillars of bank resilience under liquidity stress are considered together to craft a sensible benign-scenario liquidity rule along with an effective, disciplined backstop that minimizes moral hazard.
The BIS paper rightly is to avoid so stringent a build-up of liquidity that it drains capital resources and bank lending dries up. The fundamental idea behind global and U.S. liquidity regulation is that banks must hold “high-quality liquid assets” (HQLAs) that can be readily liquidated under even acute stress to give banks the cash needed to handle a run or fire sale. But, the more central-bank deposits, Treasury obligations, and agency bonds banks hold as the most favored form of HQLA, the higher the leverage-capital bill. Some of this is warranted, but all of it makes banks less able to allocate capital for financial intermediation – see above for the migration of finance to NBFIs.
Also, as seen in 2020 and again in April of this year, spooked markets increasingly dash for cash, not for Treasury obligations. All the HQLAs in the world will not ensure liquidity if no one wants them.
It is thus clear that lots more HQLAs will only stymie still more lending even though all these HQLAs will likely have little benefit for actual liquidity in acute stress. The discount window thus becomes an essential escape route, but – as the BIS paper reiterates – one that must be designed to afford as little moral hazard as possible without stigmatizing discount-window draws.
The way to make everyday liquidity sync with emergency backstops is, the paper rightly posits, to require banks to preposition assets at the central bank that will seamlessly collateralize window draws. Importantly, these assets should not be those counted as HQLAs unless a bank has the capital capacity to do so. Instead, prepositioned collateral should include loans and other assets that promote economic growth and bank market capitalization (another critical safety gauge). Haircuts could adjust for added central-bank risk, with the amount of requisite buffer-HQLAs calibrated by risk factors such as a bank’s reliance on uninsured deposits.
The paper does not go on to say so, but changing the supplementary leverage ratio to exempt short-term Treasuries and central-bank deposits would make the entire body of capital and liquidity rules make even more sense. Exempting short-term Treasuries and central-bank deposits means that holding more HQLAs would not necessarily cost banks in terms of credit capacity – a profound problem as both liquidity and capital rules are currently crafted. In short, added liquidity won’t cost nearly as much in terms of diminished credit capacity, a goal bank regulators should readily support in concept with enhancing supervision to guard against interest-rate risk.
This brief description of a harmonized liquidity framework necessarily leaves out critical details. It shows, though, that the liquidity rules can be made to make sense not only in concert with competing policy demands within the liquidity construct, but also with still more important capital standards. The banking agencies will turn to a liquidity rewrite when they release the proposed end-game standards and SLR proposal over the next month or so. The agencies won’t ensure that these capital proposals comport with pending changes to liquidity standards, nor are proposed liquidity rules likely to consider capital ramifications. But, comments can and should press this point. It’s past time to bring key findings in financial-policy research into financial policy-setting. We know all too well the unintended and even disastrous consequences that have attended long years of blinkered decisions. Now would be a good time at long last to heed sound research and ensure that rules reflect the indisputable fact that banks must comply with the sum total of standards required of them, not with each rule as if it were the only one that mattered.