Thursday, December 11, 2014

Tarullo: Liquidity Regulation Today and Tomorrow

Who Will Be Swept Up in the Next Round of Liquidity Rules?


Author: David Schwartz J.D. CPA

The financial crisis of 2007-08 was a crisis of liquidity. Facing deep uncertainty about the condition of counterparties and the value of collateral assets, investors refused to offer new short-term lending or even to roll over existing repos and similar extensions of credit. As a result, many funding markets ground to a halt.  The role liquidity, or rather the sudden lack of liquidity, played in the most recent crisis is unlike crises experienced in the past like the savings and loan crisis or the Latin American debt crisis of the 1980s.  Consequently, regulators and policy-makers have found the regulation of liquidity to be a new frontier, and one that remains the focus of keen interest to the Federal Reserve.  Recently, Fed Board Governor Daniel K. Tarullo

outlined his thoughts on both the importance of liquidity regulation, and the direction he sees it heading.  


Despite the central role liquidity played in the financial crisis, efforts to to put into place prudential liquidity regulations and enforce some levels of mandatory liquidity amongst key financial players has lagged other kinds of reform.  According to Tarullo, there are two reasons for this lag:


"First, prior to the crisis there was very little use of quantitative liquidity regulation and thus little experience on which to draw. While the Basel Committee got to work quickly, senior central bankers and heads of bank supervisory agencies extended the timeline for implementation of liquidity standards to guard against unanticipated, undesirable consequences from these innovative regulatory efforts. A second reason liquidity regulation has followed other reforms is that judicious liquidity regulation both complements, and is dependent upon, other important financial policies--notably capital regulation, resolution procedures, and lender-of-last-resort (LOLR) practice. Work on liquidity regulations has both built on reforms in these other areas and occasioned some consideration of the interaction among these various policies."


Despite the initial delays, recently, there have been two very important steps in building a framework of liquidity regulations:

 

 

 

  1. a final version of a Liquidity Coverage Ratio (LCR) has been agreed internationally and adopted by in the United States; and
  2. the Basel Committee has recently announced final guidelines for the Net Stable Funding Ratio (NSFR). 

 


With those two very new and somewhat novel pieces of liquidity regulation at last in place, what is next?  


Next Steps


In his speech, Mr. Tarullo indicated that the Fed intends to concentrate in the short term on securities finance transactions, the NSFR, risk capital surcharges for G-SIBs, and the LCR:

 

 

 

 

 

 

 

  • In order to mitigate the potential risks that banks with matched book securities finance transactions would preference some counterparties over others in unwinding positions, “the NSFR will require firms to hold some stable funding against short-term loans to financial firms.”
  • “Under the enhancement of the international G-SIB surcharge being developed by the Federal Reserve, the formula used to set risk-based capital surcharge levels for U.S. G-SIBs would incorporate each U.S. G-SIB’s reliance on short-term wholesale funding.”
  • “The Basel LCR does not impose any regulatory charge on a bank’s use of overnight funding to fund assets that mature in less than 30 days. This lacuna leaves open the possibility of a significant maturity mismatch within the 30-day LCR window. The U.S. LCR fills this gap by imposing a regulatory charge on maturity mismatch within the 30-day period.”
  • “Because the Basel LCR and the NSFR each calculate the liquidity position of a firm on a fully consolidated basis, neither adequately addresses the risk that stress could occur in one part of the organization while the liquidity needed to deal with that stress is trapped in another.”

 


Broadening the Scope


"While prudentially regulated dealers will continue to play a central role as intermediaries in short-term funding markets, post-crisis reforms directed at the regulated sector could lead to the disintermediation of regulated entities over time."


Worried that better regulation of the liquidity positions of regulated firms may result in the migration of run risks to the shadow banking system, Mr. Tarullo indicated that regulators may potentially broaden the scope of their liquidity regulation efforts to include any firm that provides any form of liquidity to financial markets.  This means that money market funds, hedge funds, and futures and swaps market basis traders may soon find themselves dealing with new standards and liquidity ratios similar to those of their banking counterparts.  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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