A new liquidity rule to be imposed on banks by global regulators will not fundamentally impair central banks’ ability to conduct monetary policy but may alter the way they carry out their operations, the Bank for International Settlements (BIS) said.
The liquidity Coverage Ratio (LCR), which requires banks to hold enough liquid assets to survive 30 days of customer withdrawals and a credit squeeze, forms a critical part of the new Basel III banking regulations and is set to be introduced in 2015.
But the new requirement, which has been agreed by global political leaders but recently run into headwinds from Europe, fundamentally affects monetary policy because central bank reserves form a major portion of banks’ liquid assets.
Many central banks, for example the Federal Reserve, carry out monetary policy by setting a target for the interest rate at which banks lend to each other, typically reserves held in their accounts at the central bank, on an overnight and an unsecured basis.
As these reserves are part of a bank’s portfolio of highly liquid assets, along with public and highly rated non-financial corporate bonds, the liquidity rule will potentially change the demand for those reserves and thus the relationship between market conditions and the resulting interest rate, BIS said.
“The key takeaway from our analysis is that, while the LCR will not impair central banks’ ability to implement monetary policy, the process whereby this is done may need to adjust,” BIS said in a special feature in its December quarterly review.
“In certain circumstances, central banks may choose to adjust their operational frameworks to better fit the new environment. At a minimum, they will need to monitor developments that materially affect the LCR of the banking system – just as they have traditionally monitored other factors that affect reserve markets,” it added.
Reserves borrowed by banks from the central bank’s lending facility often perform a double duty: they are part of the banks’ required high-quality liquid assets (HQLA) and can also be applied towards the bank’s reserve requirements.
This creates a direct link between the liquidity rule and the implementation of monetary policy. Banks that meet the liquidity rule without using central bank reserves are not affected while banks that rely on their reserve holdings to satisfy the LCR could be in trouble if there was a sudden payment outflow late in the day.
The Basel Committee on Banking Supervision, the body of global supervisors that proposed the liquidity rule in 2010, is currently reviewing the rule’s impact on bank lending following criticism that it could harm Europe’s struggling economy.
While some of the rule’s calculations may be tweaked, the main thrust of the rule looks to remain intact. Last month Basel Committee Chairman Stefan Ingves said several countries, including Sweden, were already applying the rule and there were no signs that monetary policy or the interbank market had been affected.
The liquidity rule is part of a major reform of global financial regulations that aim to improve the banking sector’s ability to absorb financial shocks and reduce the impact on the real economy.
The critical role of liquidity surfaced during the global financial crises that began in 2007 when many banks encountered a shortage of cash despite adequate capital levels.
It became clear that sudden stress in financial markets could quickly lead to an evaporation of liquidity, requiring the central banks and authorities to support markets and institutions.
In addition to the liquidity rule, the Basel Committee has also developed the Net Stable Funding Ratio (NSFR), which has a time horizon of one year and aims to ensure that banks fund their activities with stable sources.