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Basel regulations

Liquidity ratios may be Basel next error

Financial markets

MADRID | By Raimundo Poveda, former director general of banking regulation at Bank of Spain | Liquidity ratios may be Basel next error: a compulsory ratio of liquidity that shall enter into force in 2015.

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The current banking regulation was born in the Basel Committee. As we see today, it has not been able to protect banks from insolvency yet. This is without a doubt, firstly due to the bankers’ mistakes. But the Committee is also guilty. Let’s take a look at some of their past errors.

Basel I, 1988. The great mistake of that remarkable milestone in global banking regulation was to include as capital things that are not (as a courtesy of the Committee towards the Anglo Saxon banks and supervisors). Solvency coefficients were filled with hybrid instruments designed ex professo, that customers didn’t understand (with consequences well known in Spain). Basel took a quarter of century to rectify. This happened when the markets began to move from a little significant ratio to another one more focused in the real capital. And when a brutal banking crisis showed the little use of some of those instruments.

Treatment of market risk, 1996. Financial techniques had come a long way since 1988, and the Committee decided to use the widespread VAR (value at risk) to cover this risk. VAR can be calculated in many ways, so Basel imposed conditions, and also forced not to cover the VAR, but its triple, or quadruple. Even so, a big calibration mistake was made. In the 2008 crisis many big Western banks fell precisely due to market risk. Basel had to add a few reinforcements at least to multiply the VAR by six, as well as other additional reinforcements to cover the credit risk of trading portfolio. Is a calculation basis that needs so many safety measures, and yet is not enough, a good basis?

Basel II, 2004-2005. Alan Greenspan, at the peak of his prestige, wanted the most sophisticated banks to follow their internal methods in the definition of their capital needs. But in credit risk those methods were newcomers, less proven and little used. To resolve this dilemma, the Committee decided to invent something. Everyone “helped” in this task: Governments to lend a hand to SMEs, the mortgages system and themselves; banks, to encourage the securitization). The result was a cryptic and undemanding regulation, with arbitrary correction factors and the requirement of a no less arbitrary cover for operational risk (a strange mixture of accidents of all kinds that Basel, as incredible as it may look, sees as a single measurable risk that can be solved with more capital). Basel had no luck either in assigning risk to operations: it uses ratings from the rating agencies, whose failures are well-known, or internal assessments prepared by the banks themselves, which are still in a worse position than the agencies to generate reliable ratings.

With its error of calibration, Basel II reduced capital needs in the final phase of big bubbles of the first decade, a foolish pro-cyclical movement. Besides, during the key years of 2005 and 2006, supervisors and banks devoted their energies to solve the complications of the implementation of that very complex scheme, and forgot the real problems.

Basel III, 2009-2010. The crisis came and caused a big panic. Basel II schemes were kept (including the reviled rating agencies, still without a substitute), but securitizations, negotiation portfolios, or interbank positions were repriced upwards. The definition of capital was cut from almost all the adhesions of 1988. The coefficient level rose, incorporating countercyclical nature buffer systems. Mistrust in the measurements of risk led to dust off the simple solvency ratios, as an extra safety net. And although the big banks have less overall risk thanks to their diversification, they were demanded higher coefficients, shamelessly recognizing the reality of the too big to fail.

Those reforms entailed a strong hardening of the solvency ratio. The Committee was cautious. They wanted to prevent a pro-cyclical grip in the middle of a generalized depression, and therefore designed a very dilated timetables, relaxed enforcement of countercyclical buffer mechanisms, and postponed the enforcement of the simple ratio. But both markets and supervisors, terrified by what had happened and what could happen, forgot about timetables and flexibilities and demanded the banks to immediately fulfil the toughest version of the coefficient. Even with extra charges. The result is that banking policy, which had just made the oath of anti-cyclic functioning, is being more cyclical than ever. Another error, not made by the Committee, but by those who apply its recommendations.

Let’s talk now about liquidity ratio. It may be Basel next error. Until 2009 the Committee had only produced guidelines of good practices for managing this classic risk. Its best tool were internal stress tests. But in December 2009 it tried a stronger medicine: a compulsory ratio of liquidity (RCL). The proposal became a “final” recommendation a year later. It was not that final, since it was amended in January 2013, we will see why later. It shall enter into force in 2015. The supervisory authorities are already collecting data to see how RCL performs in the tests.

The ratio is original and unprecedented in regulatory practice. It is built on the model of a stress test. The test scenario is a strong idiosyncratic and systemic crisis, and the objective is to maintain a stock of sufficient liquidity to deal with a month of cash outflows. The idea, another invention of the Committee not previously tested such as Basel II, is elegant but controversial in its foundations and its calibration.

A single stress test is a flexible exercise (well done, it should cover several scenarios with varying degrees of pessimism, from the more likely up to the most extreme), which conforms to the experience of each entity and the markets in which it operates. And, very important, it requires a cautious managerial response, although not mechanical. Instead, compulsory ratio only provides a very hard scenario, similar to the situation in 2007-2008, it applies parameters in principle equal for all types of banks around the globe and the obligation to maintain that “required” minimum of liquidity in the extreme scenario during long periods of normality, until the day that a crisis really takes place. At that moment it is allowed to use liquidity buffers to solve the problem at a pace to discuss with the supervisor. This means a step forward on the regulation of solvency, where capital is sterile, since it can only be used to satisfy the legal obligation.

One size fits all was a great critique to Basel I. Here the Committee designed a one-size-fits-all, but allowing local adaptations upwards on certain issues. Will the European Banking Authority and the European supervisor keep that national leeway, increasingly less welcome in Europe?

The ratio requires defining what cash outflows are expected in a crisis scenario and what are liquid assets. The two issues are complicated and have no good solution.

To calculate cash outflows, the Committee built a very detailed theory of conjectures about the gross outputs and the inputs which occur in each type of banking operations within a month. Its main basis seems to be the intuition of designers, as in the extreme circumstances of the model statistical expertise is scarce and erratic. These guesses tend to pessimism, as expected. Therefore they contend with forced outflows and restricting entries for similar operations. Also, only cash inflows up to 75% of the planned outputs–an arbitrary rule designed to force banks to always have some liquidity and not fully depend on planned capital input.

The big question in this type of exercise is how deposits will perform during a crisis. The Committee does not hesitate with those of large companies and other professional management firms: it considers them massive, if not total losses, as soon as deadlines expire. But in the most important case of retailers, more awkward, dismisses absolute pessimism. Withdrawals in that case are relatively modest and they have been reduced twice. This reflects a conflict of difficult solution. In a bankrun (Northern Rock type), forecast outflows will probably not be enough. But major outflows would produce unsustainable permanent liquidity requirements, as the Committee was warned of during consultations.

A calibration error? Rather a misconception one. In an extreme scenario, liquidity management is not something that banks can work out on their own. It is a matter of the exclusive competence of the central bank. Supervisors have tried to help lawmakers, but they can’t. Their calibration will be excessive in normal times, and insufficient in times of crisis.

As for RCL, the liquid assets, there is no doubt that they are the cash of the currency area where the bank is, and deposits at the central bank, if they aren’t blocked by very strict reserve ratios. The rest are marketable securities that a) have a reliable and deep market, the kind of market in which every day billions of dollars go through, or b) are accepted as a guarantee by the central bank (this proposal does not specify it, although it is implicit), or c) are on the list provided by the regulator, and in those of national supervisors.

The proposal outlines a rigorous and correct picture of objective criteria to apply when a transferable security can be considered liquidity. Excellent idea but with a small defect: in most countries the only assets that meet these criteria are public funds. Some countries with chaotic finances would even exclude own public funds; and at the opposite pole, there are countries whose public debt emissions are insufficient for the future needs of the banks. (This may seem anecdotal to the reader, but the Committee devotes four pages to alternative proposals full of conditions and exceptions). So it seems at first reading the liquidity coefficient looks more like a coefficient of public funds, and in atypical cases, a coefficient of public funds… in public American or German funds! This is unacceptable.

The Committee tries to solve the problem with a solution that reminds its “Basel I” error. It produces a list of the types of securities that are officially considered liquidity, which includes public and similar funds, debt of non-bank private companies, and covered bonds (to be clear, mortgages) of non-own banking group bank issuers. This list accepts less liquid assets, assets that probably would not meet all the objective criteria if they were observed thoroughly. To mitigate the possible mess, they are subject to what in the jargon of the regulators is known as “haircuts”. The justification of haircuts is that in a massive sale, also in a time of crisis, their price would plummet; but the real question is not what would happen with the price, but if that sale would be possible. The justification of the quantitative limits is that the regulator is aware that it is not doing well. The same as with the definition of capital.

There are, therefore, level 1 liquid assets, subject to no limit and no haircut, and level 2A assets, with a limit of 40% of total assets, and 15% haircuts. And within that section, and at the discretion of national supervisors, level 2B assets, with haircuts of 25% or 50%, depending on the case. In addition there are some options ad hoc for countries without enough public debt (sorry, I mean national values of high liquidity) to provide for their banks. In addition there are other options for the Islamic countries where, complying with the shariah, do not accept interests.

The allocation of assets to the three lists is made based on a combination of merits in which creditworthiness is as important as liquidity. It may look confusing, but it is not. In many cases, what ultimately matters of an asset, what makes it liquid, is that the central bank accepts it as a guarantee because this is what we are talking about in the event of a crisis. And central banks do not renounce to protect their patrimony. So another secret function of RCL is to reduce the risk of the central bank when it’s forced to act as a last resort lender.

2B assets were not in the texts of 2009 and 2010. 2A haircuts were softened in 2010. Some objective criteria were softened in 2013. Also, here the Committee has been responsive to the demands of its respectable audience. Sooner or later it will have to clean its lists of allegedly liquid assets.

The introduction of this coefficient will force a restructuring of many bank balance sheets in favour of liquid assets and to the detriment of others, like credit to the private sector. In a phase of low economic situation, this measure needs to be categorized as pro-cyclical. It would have been so, and to a great extent, in its initial versions. And it must still be so in the final version, despite its adulterations. The Committee is fearing there’s margin for a new mistake, and the proof is that it asked for the measure being implemented during a four year calendar that was not mentioned in previous versions.

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One Response to “Liquidity ratios may be Basel next error”

  1. BDP says:

    Liquidty measure is not ORIGINAL but made applicable in India by the Reserve Bank for many decades

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