In 2010 the Basel Committee on Banking Supervision introduced new rules for banks aimed at avoiding another full scale financial crisis similar to the one that took place in 2008. In particular, they included a new regulatory requirement whereby banks would be required to hold a portfolio composed of officially approved "High Quality Liquid Assets" equal to the amount of liquidity outflows they might experience under stressed conditions over thirty days. The aim was to ensure that banks have enough assets to support a month's worth of liabilities if one or more banks lose access to the credit market and depositors start to flee.
The original set of liquidity rules proposed in by the Committee in 2010 were criticised by banks for a number of reasons. They argued that they were too stringent, over-estimated the amount of deposits likely to flee in a time of stress, defined 'high quality liquid assets' too narrowly, and imposed too tight a timetable for compliance.
The Committee responded on 6 January 2013 by announcing that the banks would receive relief on each of these three grounds. The banks were given four more years (full enforcement now occurs in 2019, not 2015) plus greater flexibility to improve their funding positions. This addressed fears that an earlier plan for new liquidity rules would have made them yet more reluctant to lend, particularly in Europe where credit conditions are already tough. The regulators also decided to lower the outflow forecasts and expand the definition of high quality assets.
The banks now have a longer timeline in which to buy a smaller portfolio of an expanded class of high-quality liquid assets. Definitely good news for the banks - but is this also good news for everyone else?
Expanding the definition of high quality liquid assets is likely to result in a high-level of demand for whatever types of assets have the highest haircut adjusted returns. It could lead to higher demand for highly rated mortgage-backed securities and lowest rated corporate bonds and the market is likely to respond by creating more of these assets.
The underlying problem with the liquidity coverage ratio is that the system’s safety hinges on the presumption that the assessment of the stability and liquidity of these assets by the banks and the regulators is accurate. If the high quality liquid assets that have been defined by the banks and the Committee are not in fact as safe and liquid as assumed, then creating more of them in the market - far from helping to prevent another crisis - may actually lead to another financial collapse.
What are your thoughts?
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