Janet Yellen, the chairwoman of the Federal Reserve, announced the Fed's plan to reinforce the regulation addressing the major financial vulnerabilities highlighted by the 2008 financial crisis; increasing reliance on short-term borrowing and high leverage.
Banks and financial institutions have borrowed billions of dollars a day in the short-term-debt markets and relied on those short-term borrowings to create profits through the practice of maturity transformation. Banks take short-term sources of finance such as deposits, and lend long-term source of finance such as mortgages. Banks will create profit by offering to pay less on a deposit than they charge for mortgages. During the financial crisis, short-term creditors withdrew their deposits, rendering numerous financial institutions including Northern Rock, Bear Stearns, and Lehman Brothers bankrupt.
The New Basel Liquidity Standards (Basel III: Liquidity) are an addition to the initial response of the Basel Committee on banking supervision to strengthen the bank capital requirements through the adoption of the Basel III capital accord. The bank capital requirement is currently constructed based on credit and market risks from the asset side of the balance sheet and from off-balance-sheet transactions. It does not directly address the liquidity risk, which has to do with liabilities and shareholder's equity side of the balance sheet.
The new liquidity standards involve the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR is the leverage ratio designed to improve bank's ability to withstand short-term liquidity stress events. It will function as a threshold thatmeasure the amount of capital that a bank holds against its assets. Under the new standards, LCR will increase from roughly 3 percent to 5 percent. The NSFR will promote resilience over a one-year horizon by requiring banks that hold less liquid assets to fund their activities with more stable sources of funding.
The effort to restrain the use of short-term borrowing, thus increasing leverage stability, will ultimately require institutions to hold more capital, making them less vulnerable to bankruptcy in the face of financial risks.
The liquidity standards developed are important steps forwards in addressing the financial stability concerns associated with short-term wholesale funding in the following manners.
First, the new standards insulate banks from liquidity shocks. In the case of the LCR, requiring firms to hold a buffer of highly liquid assets will help to ensure that they have a means of generating liquidity in the event of creditor runs. In the case of the NSFR, requiring firms to use higher levels of stable funding for less liquid assets reduces the vulnerabilities of a firm to structural maturity mismatches. Banking firms that self-insure against liquidity risk in these ways are less likely to need government liquidity support in times of stress.
Second, the new standards provide an incentive for firms to move to more stable funding structures. Under the LCR and NSFR, firms that engage in unstable forms of maturity transformation will be required to maintain buffers of highly liquid assets and use stable funding, both of which will impose costs for the firms. Reducing the amount of maturity transformation they engage in will help firms minimize these costs.