Liquidity, RIP?

Several months ago, I provided theoretical and historical/empirical evidences that new bank rules put in place in most jurisdictions would harm banking by limiting cross-border and intragroup cross-entity flows of liquidity and capital* (see here, here, here and here). A few weeks ago, I pointed out that some of the most recent banking regulations that formed the pillars of the Basel 3 framework were also limiting market liquidity. Since then, the market liquidity issue has been all over the financial press (see Fitch, which published a warning precisely regarding this point, as well as David Riley, a former colleague of mine (though he probably has no idea who I am!) did the same in the FT here). I promised to get back to the topic so here we are.

Let’s sum up the current constraints on market liquidity:

• Market risk capital requirements: market-making requires banks (broker-dealers) to maintain a certain amount of various securities in inventory to face market demand at a certain price and provide… liquidity. The Basel 3 regime has increased the amount of capital banks have to maintain against various assets and activities. As market-makers, banks are faced with market risk capital requirements (market RWAs), which have been strengthened to help banks absorb losses that could emanate from fluctuations in the market value of their portfolio of securities. As banks try to minimise their capital buffer to maximise their RoE, they tend to now favour smaller inventory sizes, avoiding securities that experience too much market price variations.

• Credit risk capital requirements: but let’s not forget that market-makers are also exposed to default risk on their inventory of fixed income and derivative securities. Here again, Basel 3 has pushed RWAs up on a number of assets. Consequently, the more ‘risky’ bonds a bank holds, the higher its capital requirements. Many banks seem to have decided that the marginal decrease in fixed income inventory (and resulting revenues) would be more than offset by a marginal increase in RoE.

• Liquidity requirements: new rules (Liquidity Coverage Ratio) also require banks to hold a sufficient buffer of very liquid assets to face a 30-day outflow of cash (i.e. redemptions by depositors and other creditors). Of course, regulators have defined what they view as ‘safe and highly liquid’ assets: mostly sovereign and some other highly-rated bonds (and central bank reserves). As a result, many banks have to hold more of those assets than they had originally planned, reducing their available supply, with little flexibility to offload them in case of sudden high market demand. Liquidity rules that require broker-dealers to hold liquid assets against withdrawal of cash margin posted by clients have also been reinforced.

• Funding requirements: banks used to fund their inventories using typically short-term funding instruments such as repurchase agreements. Basel 3 has now introduced tighter standards (Net Stable Funding Ratio) that require some types of bonds to be funded through longer-term (and hence less flexible and possibly more expensive) funding sources (customer deposits or long-term debt). In the words of Daniel Tarullo of the Fed:

On its face, a perfectly matched book might seem to pose little risk to the firm, since it could run off assets as it lost funding. In reality, however, a firm may be reluctant to proceed in so symmetrical a fashion. In such a context, “running off assets” may mean denying needed funding to clients with which the firm has a valuable relationship. Moreover, even if the firm does run off assets, a firm with a large matched book will almost surely be creating liquidity squeezes for these other market actors. To partially address these risks, the NSFR will require firms to hold some stable funding against short-term loans to financial firms.

Unfortunately, all those new constraints reinforce each other. As banks have to hold more safe but low-yielding assets, this puts pressure on their net interest income and thus on their revenues (and this is exacerbated by the low interest rate environment). Those assets also have light (but not non-existent) extra capital requirements, and must be funded by longer-term instruments. By itself, this might lead to a lower level of RoE. Meanwhile, banks have also been subject to new minimum capital ratios, forcing many of them to deleverage. The only rational solution is to cut the balance sheet assets that use too much capital and don’t generate enough revenues, within the new liquidity and funding constraints. This means cutting on inventories (and business lending, but that’s another story).

And, as many have already described, cutting inventories imply reducing liquidity to investors, potentially amplifying a market crash.

Add this lack of market liquidity to a lack of cross-border and intragroup liquidity caused by financial balkanization, and you can potentially achieve a disaster of epic proportions.

Let’s consider this (very) hypothetical story: market tensions arise in a particular jurisdiction/region/country, leading to falling stock/bond market prices. As investors try to exit those markets, local banks experience significant pressure on their inventories and aren’t able to adequately provide the liquidity demanded. Prices fell further as a result, this time endangering banks themselves through their holdings of fair valued and AFS securities. There are bank run threats. Several of those banks are members of larger international banking groups, and their parents/subsidiaries are ready to provide them with extra capital and liquidity, but their regulators prevent them from doing so as they would breach local requirements. As the local banks collapse, news spread that members of international banking groups couldn’t be rescued by their group. International contagion is now likely.

Of course, central banks could provide extra short-term liquidity (though the central bank funding stigma would strike at some point), governments could bailout the banks, etc. But those options would have limited effectiveness: beyond the border, confidence in banking groups would be shattered.

Some regulators acknowledge that new regulations might create some problems. Still, they usually dismiss the issue by saying that, nevertheless, our new system will be more resilient. Ironically, we are now living in a bipolar world: one of excess liquidity injected by central banks and that investors are trying to invest, and another one of reduced liquidity levels as banks cannot deal with investors’ demand. How this mismatch is going to end is anyone’s guess.

* I only very recently found out about this excellent year old CATO Policy Analysis report that reaches the exact same conclusions:

We argue that these measures [i.e. UK’s ring-fencing and US’ Foreign Banking Organization proposals] amount to little more than a mandatory, inefficient shuffling of corporate entities and business units that will not help ward off future financial crises. At the macro level, both proposals interfere with the ability of global banks to allocate capital and liquidity in the manner they determine to be most efficient. We find that the proposals, therefore, threaten to increase financial instability and dampen economic growth and signal an unfortunate step in the wrong direction.

A recent Fed staff study also seems to find that intragroup lending plays the role of buffer against liquidity risk. I let you guess what happens when you limit those intragroup flows.