Bank liquidity rules need more flex at times of stress – BoE
Bank regulators need to look at rules on liquidity requirements so banks can more freely use their liquid assets at times of stress to avoid cutting lending or hurting market activity, a leading regulator has said.
“There is evidence suggesting that banks may be overly reluctant to use their liquid asset buffers when facing liquidity pressures,” said Victoria Saporta, executive director of prudential policy at the Bank of England. “This could have negative impacts on markets and the real economy, and means that central banks may need to intervene faster and to a greater extent than is desirable.”
Global regulators strengthened bank capital and liquidity rules following the 2008/09 financial crisis, and introduced a liquidity coverage ratio to improve resilience to short-term liquidity runs. That has encouraged banks to hold far more high-quality liquid assets (HQLA) and cut reliance on short-term funding.
But the rules were also designed to allow the use of liquid assets when banks faced pressures, and Saporta said that did not appear to be the case at the start of the pandemic. Indeed, at the end of 2020, LCR levels were above where they were at the start of the year, she said.
“We may have found ourselves in an unintended equilibrium where the idea that a bank should not fall below 100% LCR is hardwired within banks’ internal governance systems and internal risk appetites, meaning that when a shock hits, banks are reluctant to use their liquid assets – they would rather deleverage,” Saporta said in a speech at the Bank of England on Thursday.
“This tendency for banks to collectively hoard liquidity in fear of being the first to use their liquid assets substantially can be collectively damaging,” she said. Actions to preserve liquidity can include cutting lending, holding assets, restricting trading desk activities and slowing the onboarding of new clients.
It also means central banks had to intervene in markets faster and to a greater extent than is desirable, she said. “We might not have got the balance quite right: maybe the system is relying a bit more than is appropriate on central banks to jump in super quickly and in size.”
Saporta said regulators may need to be bolder to encourage banks to use their liquid assets, and one solution could be to clearly allow the release of LCR in times of stress, similar to the way a counter-cyclical buffer is used for bank capital.
“Releasing the liquidity standard in times of stress could communicate authorities’ views on banks’ forward-looking liquidity resilience and appropriate usage of liquidity buffers, supporting financial stability and market confidence,” she said.
Saporta recalled a metaphor used by economic historian Charles Goodhart in 2008 about the conundrum faced with unused liquidity buffers: a weary traveller arrives at a railway station late at night and is delighted to see a taxi there; so he hails the taxi, but the driver says he cannot take him, as local bylaws require there must always be one taxi standing ready at the station.
She said there are several reasons why banks are reluctant to use their liquid assets, including the potential stigma of using HQLA and risk of a negative market reaction.
“Banks do not want to be seen as the first to draw on their liquidity reserves, for fear of being stigmatised as being in trouble,” she said. “This market stigma may then turn out to be self-fulfilling, triggering market reactions that lead to a loss of short-term funding, which may result in a bank’s failure even if it was otherwise solvent.”
Other reasons why banks may not want to use liquid assets are uncertainty over how regulators would respond to LCR levels below 100%; the role of disclosures around liquidity, including potential obligations to notify debt investors if the LCR drops below 100%, or the risk of a credit rating downgrade; and the uncertainty of how long market or economic problems are going to last.
Capital buffer too
Saporta also addressed a problem with bank capital rules, which has been vexing regulators for some time and heightened during the pandemic: the reluctance of banks to use their capital buffers at time of stress.
Regulators in the US and elsewhere have criticised how buffers are formulated and said changes need to be made to help remove the stigma of approaching capital buffers, which cuts lending and hurts economic recovery.
Saporta said there was ample evidence during the pandemic that banks were reluctant to use capital buffers in 2020 because of the stigma of doing so, and regulators should consider making the capital conservation buffer, or CCoB, releasable during tough times.
“We now have clear evidence that fear of breaching regulatory thresholds played a crucial role in affecting banks’ behaviours during the pandemic,” Saporta said. “The importance of market stigma as a factor in banks’ reluctance to use buffers has been confirmed in many conversations I have had with bankers during the peak of the pandemic crisis and thereafter,” she said.