Earlier this week, FedFin sent clients our in-depth analysis of the Basel III liquidity rules. These are often overlooked in favor of the new global capital standards, but the liquidity regime will, we think, have even more profound strategic consequences for global finance. Banks had already gotten a warm-up for Basel III capital standards in Basel II, but the new liquidity-risk requirements are totally unprecedented. We won’t contest their importance – all too many banks failed or came close to it because they repeated the age-old mistake of borrowing short to lend long. In fact, some banks didn’t even bother to borrow, since huge off-balance sheet positions went wholly unfunded. But, to say that the liquidity rules are needed isn’t to say they’re perfect. In fact, they pose several potential perverse results that could in fact heighten global liquidity risk – oops.

If you have the strength for it, please see the in-depth analysis for a thorough strategic assessment of Basel III’s liquidity provisions. Key to them is the creation of two new ratios – a liquidity coverage ratio (LCR) designed to ensure that banks can handle all the liquidity risk that comes their way under stress for thirty days and a net stable funding ratio (NSFR) that is to do the same over a one-year time horizon. Both the LCR and NSFR require banks to match high-quality assets to anticipated funding run-offs and demands from contingent commitments. Both ratios must be 100 percent.

This is all too close to the leverage capital rule – a flat ratio based on best-guess assumptions slapped atop a highly-complex set of forecasts premised on a lot of crossed-fingers hoping for luck. The flat ratios are supposed to ensure that liquidity risk isn’t based on internal model assumptions – these of course proved woefully wrong in the crisis – but they do slap a lot of regulatory guesses into the seemingly transparent new requirement. Just as the leverage rule created big incentives for high-risk assets and off-balance sheet structures, several of the liquidity ratio’s assumptions could actually increase risk.

Case in point: the rules require banks to assume that every liquidity facility put in place for themselves evaporates under stress. This is based on the supervisors’ scenario, in which banks all pull up their drawbridges under stress and, thus, deny contractual commitments to other banks. Supervisors also fear that banks drawing down funding from other banks in a systemic scenario would create contagion risk and, thus, worsen, widespread stress into a potentially unmanageable firestorm.

But, would it? We’ve in fact been to the brink. What banks and other financial firms – think Bear Stearns, AIG and Lehman – did under stress was very different. Few in fact had big lines out to other institutions for more than a day or two because these lines cost too much. Instead, these firms simply failed to fund their on- and off-balance sheet operations. When they put a bit aside for liquidity risk, it was largely in the form of U.S. Treasury and agency securities they hoped they could sell under stress. However, as it turned out, the markets were so spooked that even the highest of all quality assets couldn’t be liquidated at anything close to fair value.

Still, the final rules put all their stock in holdings of sovereign obligations – think Portugal and Greece, not just the U.S. – and wash out the value of any intrabank liquidity facilities. These lines of credit cost banks money – that’s why they didn’t have them before. So, if regulators give banks no LCR or NSFR credit for backstops, most will drop them. Result: in our view, financial-system liquidity risk will rise, not fall because banks will not only reduce their contingent funding lines, but also rely far too much on government assets with, at best, an uncertain value under stress.

The perverse result of higher liquidity risk resulting from the rules comes not just from provisions applicable to bank liquidity facilities, but also to those banks provide to corporate and financial-institution customers. Oddly, the rules anticipate that all of these lines will be fully drawn down during a crisis – clearly an inconsistent assumption in light of the conclusion that banks in fact will have nothing on hand from other banks. It’s also a dubious one in light of experience under stress, when non-financial companies in fact didn’t draw down every dollar they could from all their bank-provided liquidity facilities. Some firms of course pulled down funding, but the 100 percent draw-down assumptions never happened.

So, what does the assumption that all bank-provided liquidity facilities are pulled in their entirety mean in terms of real liquidity risk? It costs banks money to provide lines of credit and other contingent facilities for customers – money both in terms of new capital requirements (long overdue, by the way) and funding costs. But, if these contingent lines need to be dollar-for-dollar funded up-front with Treasuries or similar securities, this cost will rise – a lot.

When funding-line costs rise, lots of customers won’t take them out. When lots of customers don’t take them out, lots of liquidity will wash out of global financial markets. As we said, oops.