Basel III monitoring questionnaire insights

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Basel iii Compliance ProfessionalsAssociation (BiiiCPA)
1200G Street NW Suite800Washington, DC 20005-6705USA Tel:
202-449-9750Web: www.basel-iii-association.com
Dear Member,
I will leadaBaselIII classin Londoninafew
days (March20-22,2013).
Wehaveensuredthat not onlythecourse, but
alsothevenue is great: Four SeasonsHotel, Canary Wharf, London.
Theview and thefood
thereis fantastic.
Yes,this isvery
important too.
I want to spend 3 great
days, not simply lead a
class.
You can call RossFenwick after visiting:
http:/ / www.baseliiitraining.com/book_course.php?InstanceID=174
I lookforwardto meetingsomeof you.
Todaywewill start with themonitoring of theimpact of theBasel
frameworks.Yes,westill have Basel iii monitoring with―Basel i figures‖
Basel iii ComplianceProfessionalsAssociation (BiiiCPA)
www.basel-iii-association.com

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Basel III monitoring
Questionnaire and instructions
TheBasel Committeeon Banking Supervisionis
monitoring the impact of Basel III: Aglobal
regulatory framework for moreresilient banksand
bankingsystems and Basel III: International
frameworkfor liquidityrisk measurement,
standardsand monitoringon a sampleof banks.
Theexercisewill be repeatedsemi-annuallywith
end-December and end-Junereportingdates.
Scope of the exercise
Participationin themonitoring exerciseis voluntary.
TheCommitteeexpectsboth largeinternationallyactivebanks and
smallerinstitutionstoparticipatein the study, asall of them will be
materiallyaffectedbysomeorall oftherevisionsof thevariousstandards.
Whereapplicableand unlessnoted otherwise,datashouldbereported for
consolidatedgroups.
Themonitoring exerciseistargetedat both banksunder the Basel II/ III
frameworksand at thosestill subject to Basel I.
However,asoutlinedin theremainderof theseinstructionssomeparts of
thequestionnaireare only relevant for bankssubject toBasel II or to
banksapplying a particularapproach.
If Basel I figuresareused, they should be calculatedbased on the
national implementation, referred to as―Basel I‖ in this document.
In some countries supervisorsmay have implemented additional rules
beyond the1988Accord ormay havemademodificationstotheAccord in

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their national implementation, and theseshould be consideredin the
calculationof ―BaselI‖ capital requirementsfor thepurposesof this
exercise.
If a bank hasimplemented Basel II at a particular reportingdate, it
should calculate capital requirementsbasedon thenational
implementationoftheBaselII framework, referredtoas―BaselII‖ in this
document.
Unlessstated otherwise,the changestothe risk weightedasset
calculationof the BaselII framework introducedin 2009whichare
collectivelyreferredtoas―Basel2.5‖ (RevisionstotheBasel II market
risk framework(―theRevisions‖) and Enhancementsto theBasel II
framework(―the Enhancements‖)) and through the Basel III framework
should onlybe reflectedif theyarepart of the applicableregulatory
frameworkat thereportingdate.
When providingdata on Basel III, banksshould alsotake intoaccount
thefrequentlyasked questionson capital, counterparty risk and liquidity
publishedbythe Committee.
This data collectionexerciseshould be completed on a best-effortsbasis.
Ideally, banksshould includeall their assetsin thisexercise.
However, due to data limitations, inclusion of some assets (for example
the portfolio of a minor subsidiary) may turn out to be an unsurpassable
hurdle.
In thesecases, banksshould consult their relevant national supervisor
todeterminehow to proceed.

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Financeand EconomicsDiscussion
Series, Divisionsof Research& Statistics
and MonetaryAffairs, Federal Reserve
Board, Washington, D.C.
Lessonsfrom the Historical Useof Reserve Requirements in the
United Statesto Promote Bank Liquidity
MarkA. Carlson
NOTE: Staff workingpapers in the Financeand Economics Discussion
Series (FEDS) are preliminarymaterialscirculatedtostimulate
discussion and critical comment.
The analysis and conclusionsset forth are those of the authors and do not
indicate concurrence by other members of the research staff or the Board
of Governors.
Referencesin publicationsto the Financeand Economics Discussion
Series (other than acknowledgement) should be cleared withthe
author(s) toprotect thetentativecharacter of thesepapers.
***
Shortlyafter the Panic of 1837, statesbegan institutingreserve
requirementswhichmandatedthat bankshadto hold liquidassets
representingat least someminimum fraction of their liabilities.
When Congresspassedthe National Bank Actsin the 1860s,banks
receivingNational Bank chartersalsofaced a minimum reserve
requirement.
Theseruleswerepart of an effort topromote liquidityand soundnessby
ensuringthat eachindividualbank hadapoolofliquidassetsthat it could
draw on during timesof stress.

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Despitetheseefforts, aswell assomeeffortsfrom within the banking
sectortoprovide liquiditysupport, thebankingsystem remained
vulnerable tobankingpanicsand suspensionsof convertibilityin which
bankstemporarilystoppedor restricted withdrawalsof funds(Calomiris
and Gorton 1991,Sprague 1910,Wicker 2000).
Thesepanics werequitedisruptive toeconomicactivityand
demonstratedthat the reserve requirementswerenot sufficient toensure
that the financial system remained liquid during periodsof stress
(Grossman 1993, James,Weiman, and McAndrews2012).
In part toaddresstheseconcerns, CongressestablishedtheFederal
Reservetocreatean ―elastic‖ currencythat could add liquidityto the
bankingsystem and serve asa lender of last resort.
This paper reviewsthe historical experienceof the United Stateswith
reserverequirementsto provide insightsfor policymakers today
regardingeffortsto promote individual bank liquidityand the relationof
thoseeffortswith a lender of last resort.
(Someproposals, such asthe, liquiditycoverage ratio proposed bythe
BaselCommitteeonBankingSupervision, arequite similar tothese
historical reserve requirements.)
Theinsightsdiscussedhere draw importantlyon the activediscussions
amongacademics,policymakers, and bankersduring the 1800sand early
1900sabout thevalueof reserve requirements.
Other lessonsare based on contemporarydiscussionsand some data
analysisregardingthedynamicswithinthebankingsystem during panics
andtheimpact of reserverequirements.
While thispaper reviewsthehistorical experienceof theUnited States
with reserverequirementsstartingin the 1830s,there is a bit more
emphasison material from the National BankingEra (1863-1913).

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Theempirical partsof the paper alsodraw on data from thisperiod.
Thefocuson theNational BankingEra reflectsthe fact that it was
in this period that use of reserve requirementswasmost prominent and
that the experiencesduring this period ultimately resulted in the creation
of the Federal Reserve and a shift awayfrom the useof reserve
requirementsto regulate liquidity.
Onekeylesson that can be drawn from historicalexperienceisthat
central banksare important during panicsfor multiplereasons.
Onedescription of a panic is a situationwhereextraordinarydemand for
liquidassetsexceedsthe availablesupplyof thoseliquid assets(as
evidencedby thesuspensionsof convertibility that occurred during
panics and by the spikes in short-term interest rates).
Acentral bank can help easea panic byrapidlyexpanding thesupplyof
liquidassets.
Relatedly, banks oftendepend on other banksfor liquidity.
During a panic, theabilityof other bankstofurnishthat liquiditysupport
is likelyto become impaired.
Without accessto this usual source of liquidity, and in the absenceof a
lender of last resort, banksmay faceincreased incentivestohoard
liquidityduring stressevents.
This dynamic may exacerbatethe severityof thestressepisode.
Thus, during a crisis, the liquidityof an individual bank isintricately
connected to central bank liquiditypolicyand optimal liquidity
regulation should consider these jointly.
There areother pertinent lessonsaswell.

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Theliquidityreservesmandatedby reserverequirementsaregenerally
intendedto be used whenliquiditydemand spikes.
Nevertheless,banksareoftenreluctant todraw downtheirstoresofliquid
assetsduringpanics.
Historicalexperiencesuggeststhat if therulesregarding the instances
whenthe reserveshould be usedare unclear, the lack of clarity may
exacerbatebanks‘reluctance.
On a relatednote, the regulationsand penaltiesassociated with
monitoringand enforcingthe reserve requirement during normal times
that werein placeduring the late1800sand early1900sdo not appear to
havebeen particularlyeffectivewhichindicatesthe importanceof
consideringtheseaspectsof liquidityrequirementsaswell.
Additionally, historicalexperiencesuggeststhat when certain assetsare
designatedasstoresof liquidity, institutionswill seekto accumulate
thoseassetsduring a crisistodemonstrate their strength;
Uunlessthepool of liquid assetscan be expandedat thosetimes,there is
some riskthat the functioningof the market for thoseassetsexpectedto
provideliquiditycan deteriorate.
This paper isorganizedasfollows.
Section 2 describesthe introduction of reserve requirements,reviewsthe
argumentsfor and against suchrequirementsduring the 19th and early
20th centuries, and providessome stylized factson reservesheld by
banks.
Section 3 reviewsmechanismswithinthesystem designed toaddressthe
stressesassociatedwith banking panics and presentssome evidenceon
howholdingsof reserves changedshortly after a panic.

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Section 4 brieflyrecountseventsfrom thePanic of 1907and discusses
some reasonswhythe reserverequirementsalonewerenot sufficient to
stop banking panics.
This section alsoreportson the subsequent debateabout the need for a
central bank toprovide liquiditysupport tothe banking system.
Section 5 describesreserve requirementsin the presence of a central bank
and the decline in the use of reserve requirements as a tool for regulating
liquidityfollowingtheestablishment of the Federal Reserve.
Ageneral review of the lessonsfrom thehistorical experienceand
concludingthoughtsare provided in Section 6.
Section 2. Reserve requirements prior to the Federal Reserve
This section brieflyreviewsthehistory of the lawsregardingreserve
requirements.
It alsodescribessome of the reasonsgivenbypolicymakers for having
reserverequirements,thedifferencesin requirementsacrossstates,and
theenforcement of the reserve requirements.
Additionally, this section providessome basicempirical information on
thelevelsof reservesheld by individual national banks.
Section 2.1 Introduction of reserve requirements
Thefirst reserve requirementswereintroducedin the United States
shortlyfollowingthePanic of 1837bythe states of Virginia, Georgia, and
New York (Rodkey 1934).
Theserequirementsweregenerallyintendedtoensure that bankshad
ready accessto resourcesthat wouldenablethem tomeet their liability
obligations.

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Theadoption of reserve requirementsbyother statesoccurred slowly;
only10 stateshad such lawsby 1860.
Although after the Panic of 1857there werea number of journal articles
andpamphletsadvocatingin favor of reserve requirements.
When reserve requirementswere first enacted the main bank liability was
bank notes, which were privately issued currency that the bank promised
to redeem for specie (gold or silver coin), and state laws referred to those
liabilitiesasthe basefor determiningtheappropriatereserve.
As the liability baseof banksshiftedtoward deposits,the referencepoint
for the reserve requirementsshiftedaswell.
In 1842, Louisianapassed a law requiringbankstomaintain a reservein
specie equal toone-third of itsliabilitiestothepublic, whichincluded
both notesand deposits(White 1893).
By 1895, 21stateshad reserverequirementsfor commercial banks;at this
time, all such lawsincluded depositsin liabilitybase(Comptroller 1895).
For statesthat enactedreserve requirements,the lawsregarding the ratio
of reservesthat had tobe held relativetothe liabilitybaseranged from
between10 percent and 33 percent.
Statelawsalsodifferedwith respecttowhat could be included in the
reserve.
Somestatesalloweddepositsin other bankstocount aspart of the
reserve.
This feature likely owedtothefact that many banks in smaller
communitiesmaintainedbalancesat banksin larger citiestoclear
payments.

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As many bank notes, and later checks, were redeemed at these clearing
banks, interbank deposits played an important part in a bank‘s liquidity
profile (James1978, White 1983).
Other statesrequired that that theentire reservebe carried asspecie in
thebank‘svault.
Afew statesallowedshort-term loanstocount aspart of the reserve.
There weresome further debatesabout thetype of depositsshould be
includedin the basefor the reserve. Some policymakersargued that
banksought tomaintain a greater reserveagainst more volatiledeposits.
As a result, some statesonly required a reserve againstdemand deposits
(Comptroller 1895,Welldon 1910).
Ahandful of states mandated reservesagainst both demand and time
deposits,but specifiedthat the amount of liquid resourcesthat needed to
beheld against each dollar of timedepositswassmaller than that required
for demand deposits.
Nevertheless, a majority of statesrequired the reservetobe calculated
against all deposits.
When the U.S. Congress passed the National Banking Acts in the early
1860s and provided for National Bank charters, the legislation included
reserverequirementsfor National Banks.
Thesereserve requirementsweretiered dependingon thelocation of the
banks.
For much of theNational BankingEra, bankslocatedoutsidemajor
cities—referredto as―country banks‖—wererequired to hold reserves
equal to 15 percent of deposits, three-fifthsof whichcould beheld as
depositsin banksofreservecitieswhiletherestwasrequiredtobeheldas
vault cash.

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Banks in reserve cities—generallylarger cities—wererequired to hold
reservesequal to 25percent of deposits, half of which
could be carriedasbalancesin central reserve cities.
Banks in central reserve cities—at first justNew York but later also
Chicagoand St. Louis—heldsignificant amountsof interbank deposits.
Thesebankswererequired tomaintain a reserve equal to 25percent of
depositswhichneededto be held in gold or in Treasurynotes.
Onereason that banks in reserve and central reserve citieswereexpected
toholdahigherportion of their assetsasreserveswasthat theyheldmore
interbank deposits; thesedepositswereseen asmore volatileand, in
particular, more likelyto be withdrawnduring bankingpanics(Federal
Reserve1927).
Section 2.2 The purpose of the reserve
As noted above, reserve requirementswerea prudential requirement
meant toensure that banksmaintainedtheresourcesto meet their
obligations.
This goal is quitebroad and hasaspectsof both solvency and liquidity.
Indeedproponentsof reserverequirementsoften blended thetwoor
spokeof the benefitsboth in termsof the safetyof thebanksand the
promptnesswithwhichbankscould meet withdrawals, though there was
perhapsa bit more frequent mention of the liquiditybenefits.
An exampleof argumentsframing thereserve asa tool for supplying
liquiditycomesfrom the1873report of theComptroller of the Currency
(Comptroller)—thechief regulator of theNational Banks—whonoted
that ―thequestionisnot whetherareserveshall beheldwhichshall insure
thepayment, merely, of the note, for that is unnecessary, but what

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amount of reserve shall be held by thebankstoinsurethe prompt
payment of all their liabilities?(p.19)‖
Among the argumentspointingto solvency benefits,Tucker (1858)
suggestedthat bank failures, such asduring the Panic of 1857, werethe
result of ―imprudence‖ asbanks overextendedthemselvesand did not
maintaina reserveof at leastone-third of their liabilities.
Most advocatestendedto blend theseextremes.
Hooper (1860) providedone of themost interestingblends.
He maintained that a bank could reduce its riskiness by adjusting either
itscapital or its reserve and that for a given level of capital, a bank could
extendmore loansif it held greater reserve.
Havingastrongreservemeant that thebank wouldbeabletoavoidbeing
forcedtoaccessemergencyfundsfrom other banksorrapidlycall in their
loans(or presumablybe forced to sell assetsin firesales) and thusbe
stronger overall.
While much of the discussionfocused on themicroprudential benefitsto
the individual banks of requiring a minimum level of reserves,some
commentatorsdid suggest that there were systemic benefitsof ensuring
banksretained sufficient liquid resourceson hand.
Opdyke (1858)arguedthat excessivecredit growthledtoaboomandbust
cycle and that a reserve requirement could be useful in restraining credit
growth.
Moreconcretesystemic benefits weredescribedby Hooper (1860) and
Coe (1873) whosuggestedthat there werecollectiveaction reasonsto
mandateminimum reserves,especiallyfor banks in themain money
center of New York City.

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Hooper noted that thereserveof banksinNewYork wasacommon good
benefittingall thebanks in the cityaswell asthe rest of the country and
that the management of thosebanksmight not internalizethesocial
benefit they provided.
As a consequence, he arguedthat the law needed to require them tohold
a larger reservethan thebankswouldotherwisehavechosen.
It is out of the question for the banks of the city of New York to hold that
relation of the entire confidence through the country, solong asthe action
of each bank, in regard to the amount of itsreserve of specie, isdependent
upon thepeculiar viewsor character of itsboard of managers.
Thelaw must secure theuniform ability of thebanksto meet their
engagementsby making it imperativeupon each one of them tohold the
requisiteamount of specie asa condition of their power to discount
(p.44).
Coe noted that banksin New York City werelinked both through their
generaldependenceon thecall loan market for liquidity(describedin
detail below) and that interior bankstendedtoreact to troublesat one
bank asa signal of troublesat all the banks.
Thus, during a panic thestrong banksneeded tosupport theweakto
contain liquiditydrainsand prevent problemsfrom cascading.
This linkage, Coe argued, wasa reason that all banks neededtohold a
strongreserve and wasa motivation for the New York Clearinghouseto
establisha reserverequirement in 1857.
Section 2.3 Enforcing the reserve requirement
Thedebate about how to ensure that banks met thereserve requirement
startedsoon after therequirementswereintroduced.

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Tucker (1839) advocated enforcingtherequirement using a moderate
penaltyproportional to any deficiency of the reserve.
He maintained that the penalty should be high enough to dissuade banks
from running below the reserve in good times but not so high that banks
wereunwillingto use thereserve during a crisis.
Opdyke (1858) argued for requiring a minimum reserve somewhat below
what was desired as he maintained that banks would hold a buffer stock
abovethe requirement and that thebuffer could then be used:
―A legal minimum of 20per cent will, it is believed, give a practical
minimum of not lessthan 25to30 per cent, for noprudent bank will
voluntarilyoccupya position on the vergeof legal death (p.15-16).‖
In the National Banking Era, the law providedthat in the event the
Comptroller found that a National bank wasdeficient in itsreserve, the
bank could be required toceasemaking loansand stop paying dividends
until the amount of the reserve wasrestored.
TheComptroller (1893) statedthat in theevent that thebank had loaned
out toogreat a portion of its fundsor depositorshad withdrawna
significant amount of funds, the only―safeand prudent course for the
bank topursue is toceasepaying out money in anydirectionexcept to
depositorsuntil either through the collectionof demand or maturing loans
ontheonehand, orthereceipt ofdepositsontheother,therequired
portionhasbeen restored (p.18).‖
If the reserve wasnot restored within 30 days, the Comptroller could, with
the concurrence of the Secretary of the Treasury, appoint a receiver for the
bank.
It waswell noted that both the findingby theComptrollerthat the bank
wasdeficient and thedecisiontoseek areceiverwerediscretionaryonthe
part of theComptroller.

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Moreover,theComptrollerstated that heonlyhad the opportunityto
learnabout the bank‘sbalancesheet from one of thebiannual bank
examinationsor thereport of condition filedfivetimesa year (1893).
Theactual abilitytomonitor wasslightlymore complicated.
In their examinationreports, examinerswereasked tolook through the
bank‘sbooksand calculate and comment on the adequacyof bank‘s
reservefor thepast 30 days(or more if deemed appropriate).
Thusthe examinationreportsallowedtheComptroller more just than a
singleday‘s observation.
Carter Glass(1913) assertedthat this particular penaltyregimewas
reportedlynot very successful.
In the debatesrelated to Federal ReserveAct, he maintainedthat the
penaltiesfor holdinginadequatereservesfor an extended period wereso
severethat theyhad thenever been applied and that in some casesbanks
hadbeen allowedby regulatorstohave deficient reservesfor periodsof
several years.
Lookingat examination reportsfor a sampleof banks indicatesthat the
examinerstook noteof theconditionof the bank‘sreservesand used this
information, along withother aspectsof thebank‘scondition, to make
recommendationsabout whetherthebank should be allowedto pay
dividendsor make other changestoits capital account.
This indicatesthat the conditionof the reserve did matter tothe
examiners.
There werenosuggestionsin thissample of examinationreports that a
bank ought not make new loansdue toa deficit reserve.

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Information from Welldon (1910) suggeststhat, asof 1909, manystates
had similar, though perhapsslightlylesssevere, penaltiesfor banks
fallingshort of their reserve.
Out of the 39 statesthat had reserve requirementsat that time, Welldon
mentionsa penaltyfor failing tomeet that reservefor 25states.
In everycase, that penaltyinvolvedaprohibitionon extendingnewloans.
In 15 cases, there wasalsoa prohibitionon issuingdividends.
For onlyone state, Arizona, doesWelldon mention an explicit provision
that failure torestorethereserve could result in a bank beingdeclared
insolvent.
For one other state, Welldonnotesthat it had removed a previous
provision allowinga bank tobe declaredinsolvent if the bank failed to
restorethereserve.
Section 2.3 Use of interbank deposits in the reserve
Whether or not to allowinterbank depositsto count aspart of the reserve
wasa subject of considerabledebate.
TheNational Bank Act allowedcountry and reservecitybanksto count
interbank deposits for up totwo-fifthsand one-half of their reserve
respectively.
Most statesallowedinterbank deposits tocount aswell;only 3 out of the
21statesthat had reserve requirementsin 1895required that all reserves
beheld at thebank.
Interbank depositswereallowedpartly asrecognitionof thewaybanks
operated.

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As noted earlier, smaller banks had historically maintained deposits at
correspondent banks in larger cities to clear payments or facilitate the
redemption of their bank notes.
As liability holders would seek to redeem the notes in the larger cities, it
made some sense to include part of the balance held there to meet those
obligationsaspart of the bank‘sliquidityreserve.
However,during a panictheseinterbank depositsweregenerallynot an
effectivesource of liquidity.
Noyes(1894) notesthat whendemand during a panicwasfor physical
currency, reservesheld elsewherewerenot particularlyuseful.
Morefundamentally, it wasalsonoted that allowinginterbank depositsto
count asreservescreateda pyramid structure.
Abank could deposit cash in another bank and count that deposit in its
reservewhile thesecond bank countedthe cash in itsreserve.
Thesecond bank could then deposit thecashin a third bank and
compound the process.
Awithdrawal of reserves by thebottom of the pyramid during a panic
could thusresult in a rapid depletion of reserveswithin thebanking
system (Bankers‘Magazine1907, July).
The Comptroller noted in 1900 that reservesheld in other banks had been
ineffective in protecting depositors during the panicsof 1873and 1893and
encouraged Congressto increasethe portion of the reserve that banks had
tocarry asmoney in their vaults(seepages25-27).
Section 2.4 Some empirical observations on reserve holdings
Lookingat thestatusof reservesfor asampleof 208banksin both reserve
cities(82banks)andlargercountrytowns(126banks)usingdatafromthe

P a g e | 18
September 1892Call Report providessome further information about the
level of bank reserves.
Most banks appear to have held reserve in excess of the required reserve;
the average reserve ratio wasaround 29 percent and quite similar for both
country banksand thosein reserve cities.
(Theseratiosare similar tothosefound by the Comptroller in 1887.)
Moreover,theratio of reservestodepositsexceededthelegalrequirement
(15percent for country banks25percent for reservecitybanks) by 10or
more percentagepointsfor three-fifthsof country banksand almost
one-fourth of reserve citybanks.
Banks may havepreferred tohold reserveratiosin excessof what was
requiredsimplybecausetheypreferredbeingmore liquid, asissuggested
bythe Bankers‘Magazine(1908, November), or becausetheyviewedthe
requiredreserve ratioasa minimum theydid not want tobreach and
desiredtomaintaina buffer.
Reservesheld in thebank (asopposed towithreserve agents) accounted
for about half the total reserve.
Relativetodeposits, reservesat thebank averaged about 14percent for
both groups;alsowell above the legal requirementsof 6percent for
country banksand 12.5 percent for reservecity banks.
Thefinding that about half the reserve washeld in cashmatchessimilar
findingsby theComptroller a decade or solater (Comptroller1907). While
manybanks appear tohavepreferredto hold reserve well in excessof
what waslegallyrequired, some bankshaddeficienciesin their reserve
ratios.
Of the banks in thesample, 10percent of the country bankshad a
deficient reserve and 25 percent of reserve citybanks did.

P a g e | 19
That bankshad deficient reservessuggeststhat theydid not see the
reserveratio assomething that had to bemet at all times(perhaps
especiallyastheyhad 30days torestoreit upon notice by the
Comptroller).
Nevertheless, most of thesebanksdid not sink toofar below thelegal
limit—manyof them being within 3percentagepointsof thelimit—
perhapsindicatingtherule did have some influenceon their behavior.
Section 3. Reserve requirements and liquidity during panics
It wasunderstoodthat bankingpanicswerestressful periodsin whichthe
liquidityof the banking system wouldbe tested.
In the absenceof a central bank, there weretwoprimarymechanismsfor
provideliquidityduring the panics:usingthe reserve and issuanceof
Clearinghouseloancertificates.
This section considersthesetwomechanisms.
Section 3.1 Usability of the reserve during a panic
There aretwoaspectsof the debateabout theusabilityof the bank
reserve.
Oneiswhetherthelawallowedbankstousetheirreserve, and theotheris
whetherbanks woulduse their reserve tosupport other institutions.
Theconcern that legallyrequired reservesheld by bankswouldnot be
helpful if thebankshadtomaintain these reserveat all timesand could
not usethem wasstated clearlyearlyon.
In 1848, Kettell argued that ―This keepingof 15per cent. of specieon
hand hasbeen tried in New York, inAlabama, and elsewhere,and its

P a g e | 20
grossabsurdityalwaysmade manifest. Of what useisit that a bank has
thegold and silver, if the law forbidsit to part withit?‖
Thedebate about whetherbankscould legallyuse their reserves
continued during the National BankingEra.
In his annual report for 1894,theSecretaryof the Treasuryarguedagainst
thereserverequirement forNationalBanksasthenwrittensayingthat, as
thelaw wassilent on whenthe National bankscould usetheir
reserves,the law created a situationin whichtheywereunusable:
―Among thesearethe requirements…that a fixed reserve, whichcannot
belawfullydiminished, shall be held on account of deposits.
Theconsequenceofthislastrequirement isthatwhenabank standsmost
in need of all its resourcesit cannot usethem without violatingthe law
(reprintedin Rodkey 1934).‖
Proponentsof reserve requirementsrespondedthat thereserve was
established withtheintent that it be used during stressperiods.
As noted above, thedecision to find a bank deficient in itsreservewas
discretionaryon thepart of theComptroller.
This discretionallowedthe Comptroller to effectively waivethe
requirement duringapanic and allowbankstime torebuild their reserves
subsequently(Comptroller1893).
Othersviewedthevaguenessofthelawregardingtheuseofthereserveto
bea notableimpediment to banks‘willingnessto use the reserve.
TheBankers‘Magazine(1907,August) arguedthat the vaguenessof the
law regardingwhenthe reservecould be drawnmeant that manybankers
felt that the reservecould not beused during a crisis.

P a g e | 21
ThePresident of theAmerican BankersAssociation expressedsimilar
sentimentsin 1908(seeBankers‘Magazine1908, November).
Providingcertaintyabout when thereserve could be used wasseen as
inherentlydifficult.
Coe (1873) arguedthat it isvery challengingto prescribe rulesregarding
thecircumstancesor timing in whichthereserve should beallowedto be
used or rebuilt.
Concernsthat the ruleswere preventingbanksfrom runningdown their
reserveweresufficientlygreat that in at least one instance, Congress
introduced legislationin whichone goal tomake the reservemore clearly
usable.
In 1897, RepresentativeWalker, Chair of the House Committeeon
Bankingand Currency, arguedthat the currencylegislation―forbids,
under severe penalties,thebanks under anycircumstancestousetheir
reservesfor thevery purposefor which thebanksare required to
keepsuch reserves‖ and proposed legislationto allowthe ―bankstouse
their reservesin anylegitimatewayfor thepurpose for whichtheyare
requiredtokeep a reserve (Committeeon Bankingand Currency, 1897p.
28).‖
This claim wasstrenuouslydenied by the Comptroller (Eckels 1897, pp.
320and 324).
Thereserve and itspotential use alsocreated tension betweenbanks
subjecttothereserverequirementsand thosenot subject to them.
TheBankers‘Magazine(1894,April) indicatedthat there wassome
expectationthat theNational Banks wouldusetheir reservestoprovide
liquidityand support to stateand trust companiesnot subject to the
reserverequirements,even if this support wasonlyprovided by the
National Banks to protect themselves.

P a g e | 22
Thearticleindicatedthat thisexpectationwasthesourceof some tension
amongbankersand resultedin some lack of cooperation duringthe
panic.
One might alsospeculate that some state banksor trust companiesmay
haveheld lowerreserves than theywouldhave if they had not expected
theNational Bankstoprovide support.
Hooper (1860) suggested that confidenceabout the reservealsolikely
affected banks‘willingnessto use it.
In particular, he arguedthat banksin New Orleanswererequired by law
tomaintainahigherreservethanthoseinBostonandthatthepopulaceof
NewOrleans,knowingthestrengthofthereserve,hadgreater confidence
in their banksand thusthe New Orleans banksweremore ableto use
their reservetimesof financial trouble.
Section 3.2 Evidence on Use of the Reserve During a Panic
Evidenceon useof thereserveduring panics situationsprovidesa mixed
picture of whetherbankswerewillingtousetheir reserve.
As their reservesweredepleted during bankingpanics, banksin the
central reserve cityof New York wouldsuspend or curtail shipmentsof
currencytoother parts of the country.
Sprague(1913) argued that theNewYork bankstendedtodo sowell
beforetheyhad exhaustedtheir reserve.
In 1907,theWall Street Journal notedthat reserveswerearound21percent
of depositsaround the time of suspension, belowthe legal requirement
but still fairly high.
It wasnoted in the Journal that use of the reserve during thepanic was
appropriate:
[T]hereis a deficit of the bank reserve of $38,838,825. It should be

P a g e | 23
remembered, however,that a reserve is for use.
There is no wisdom in locking up immensesums of moneyin bank vaults
unlessthey can be employed in times of emergency…although the deficit
is very large, yet there is still left in the banks a reserve amounting to over
21percent of deposits(Wall Street Journal, Nov. 4, 1907).
Detailedinformationonbank balancesheetsand reservesareavailableat
a timeshortlyafter thepanic from the October 3, 1893call report.
Comparing reserves in 1893 for banks in the same citiesas in 1892
suggests that reserve rates declined slightly for country banks and
increaseda bit for reserve citybanks.
There alsoappearstobea shift towardholdingthereservesin cash at the
bank rather than asdepositswithreserve agents.
Shiftsin thesizeof thetotal reserveratio appeartoduelargelytoshiftsin
whichbanksare reporting.
When thesampleis restricted to banksreporting in both 1892and
1893,for the medianbank thetotal reserve ratiosis higher in 1893by less
than onepercentagepoint higher.
By contrast, theshift towardcash is evident even whenlookingat the
samebanks.
Again lookingat themedianbank for banks reportingin both 1892 and
1893,the ratio of cash to liabilitiessubject to the reserve requirement rose
byover5percentagepoints,whiletheratioofdepositsatreserveagentsto
liabilitiessubject toreserverequirementsdecreased by over 5 percentage
points.
This shift wasobservableat both countyand reservecity banks.

P a g e | 24
Moreover,thenumber (and share) of banksreportinga reserveratio
below the legal requirement decreased relative to what wasobserved in
1892.
Overall, thesefiguresgive the impression that banksnot under such
pressure tended not usetheir reservestosupport the general liquidityof
thefinancial system.
Given the pyramiding of reservesthat occurredthrough interbank
deposits,the shift towarduseof cash in reserveslikelyhad a detrimental
impact on overall system liquidity.
Looking at how thereservesin 1894compare tothosein 1892provides
some information about longer-term changestoreserve holdings
followinga panic.
Reserveratiosat country bankscontinued to average29percent, but the
averagereserve ratio for reservecitybanks increasedto 33 percent.
Consideringonly banks that reported in both years, reserveratios
increased1percentagepoint for banksin country townsand 2percentage
pointsfor banksin reserve cities.
(Thechangesare stronglystatisticallysignificant for reservecitybanks
andmoderatelysofor country banks.)
These changes took place entirely from increases in cash holdings at the
banks as ratios of reserves held with agents relative to depositswere little
changed.
Thesechangessuggest that some of theincreased preference for cash
evident in 1893persisted for some time.

P a g e | 25
Section 3.3 Private sector mechanisms for promoting liquidity
during banking panics
Commercial banksdid have some mechanismsfor responding to panics
andtrying to expand thesupply of liquid assets.
Banks in New York, and other largecities,formed clearinghousesto
facilitate the settlement of paymentsbetweenmembers.
Theclearinghousesalsoprovided a wayto supplyliquiditytotheir
membersduring a panic.
In particular,theclearinghousesestablishedprocedurestoallowbanksto
deposit securitieswiththe clearinghouseand receiveclearinghouseloan
certificatesthat could beused tomake paymentstoother membersof the
clearinghouse.
Using clearinghousenotesallowedspecieor other forms of cashtobe
used to satisfythe heighteneddemand from others for liquidassets
(Comptroller 1873and 1890, Nash 1908).
Theclearinghousenotesworked for interbank and sometimeslocal
transactions,but not well for interregional payments.
Clearinghousenoteswereissued extensively in thePanic of 1907.
In New York these notes continued to belargedenomination
notes,but in many smallercitiessmall denominationnoteswere
issuedand circulatedwith other currencyin the general public
market.
Banks appear tohave been fairlywillingtouse these loan certificates
whenthe need arose.
Tallman and Moen(2012) report that themajorityof theloan certificates
issuedby theNewYork ClearinghouseAssociation during the Panic of
1907went tothe six largest banks.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)

P a g e | 26
Nevertheless, there appears to have been some concern about the
possibility of a negative reaction to the issuance of clearinghouse
certificates.
Coincident with theissuanceof clearinghouseloan certificates,theNew
York ClearinghouseAssociation halted itsnormal practice of issuinga
weeklystatement that provided information on the balancesheet of each
individual bank and instead reported only aggregate figures for all
clearinghousemembers.
This shift wasreportedlydone in part toprotect members receivingthe
loancertificatesand whosereservesmight otherwiseappear tobe
depleted(Bankers‘Magazine1907, November).
Mediareaction totheissuanceof loancertificateswasalsomixed.
Shortlyafter the issuanceof the loan certificatesin 1907, the Wall Street
Journal noted:
Although the issueof these certificatesis a confession of weakness
neverthelessit isalsoan assuranceof strength, and the situation at the
endoftheweekisall thebetterfortheactiontakenbytheClearingHouse
Association (Oct. 28, 1907, p.1).
Section 3.4 Discussion
Thetwomechanismsdid providesome additional liquidityduring a
bankingpanic.
Nevertheless, asevidenced by the widespreadsuspension of
convertibilityduring themajor bankingpanics that occurredbetween
1865and 1910,thesemechanismswereclearlyinsufficient toprovidethe
necessaryliquidityduring timesof stress.

P a g e | 27
Thereservedoesnot appear tohave been usedtothe degreethat
proponentsmight havehoped, perhapsbecausethe degreeof regulator
discretionand rulesfor its use and restoration wereunclear.
Clearinghousecertificatesalsohelped, but, asthey could not facilitate
distancetransactions,alsoproved insufficient.
Section 4. The Panic of 1907
This section very brieflydescribesthe eventsof the Panic of 1907,which
providesa useful illustration of thedynamicsof bank liquidityduring a
crisis.
Thesection alsodiscussesthe lessonsof the crisisand the resulting
impetusfor a central bank.
Section 4.1 Brief history of the Panic of 1907
Twopiecesof background information are useful for understandingthe
panic.
First, in the years prior tothepanic, therehad been considerablegrowth
in thesize of thetrust companiesof New York City.
Theseinstitutionstook depositsand weresimilar tobanksbut the state
lawsallowedthem tooperatewithsmaller reserverequirementsand
without some other restrictionsfaced bybanks.
Indeed, these institutionsestablishedthemselvesastrust companies
partly toavoid capital and reserve requirements.
Trust companieswerenot membersof the NewYork Clearinghouse
Association, but relied on membersof theassociationasclearing agents
for payment processing.

P a g e | 28
Asecondpieceof backgroundinformationisthat, at bothbanksandtrust
companies, a significant portion of liquid assetsconsisted of call loans.
Both banksand trustsdependedon thecall loanmarket asa secondary
sourceof reserves,and most of the funding for the call loanmarket came
from the banks and trusts.
(Call loanswereshort-term loanstostock brokerstofinancestock
purchasesand werecollateralized by the purchasedstocks.
Theseloanscould becalledby the bank whenfundswereneeded and it
wasassumed the stock brokerswouldbe easilyabletosell the stockto
repay the loan.)
ThePanic of 1907started whenan attempt tocorner the copper market
collapsed.
Anumber of bankswereimplicated, but runson these institutionswere
quelledfollowinga statement of support from the Clearinghouse
Association.
Shortlythereafter, a National Bank announced that it wouldnolonger
provideclearingservicesfor theKnickerbockerTrust company.
When it became clear that the ClearinghouseAssociation wouldnot
support the trust companies,a number of trustsexperienced runs.
Thecall loan market quicklycame under immensepressureand
borrowersin that market that wereunableto find alternativefundingand
faced theprospect of sellingtheir stocksin a firesaleand possibly
defaulting.
Consequently, bankswerenot ableto tap the call loanmarket asa
secondarysource of liquidityastheymight normally do and the
functioningof that market deterioratedsignificantly.

P a g e | 29
Although the bankshad held reservesin excessof what wasrequired by
law prior to thecrisis,such reserveswerenot sufficient to prevent the
New York banks from beingforced to restrict paymentsto outoftown
banks.
Sincetheyheld largequantitiesof interbank deposits, theserestrictions
affected bank liquiditythroughout thecountry.
Theinterbank market for reserves—ona national level and at thecity
level for many regional financial centers—broke down asmany banks
feareddeposit withdrawalsand ―hoarded‖ cash and maintained reserves
well in excessof what wasrequired (Yates1908).
Thepanic endedwhenJ.P. Morganand a consortium of bankers agreed
toserve asa de factolender of last resorttothefinancial sector.
Section 4.2 Impetusfrom the Panic of 1907 for establishing a
central bank
There wereseveral lessonsthat policymakers took from thePanic of 1907
that prompted them toworktowardestablishinga central bank.
One lesson was that when the instrument used as a reserve and primary
source of supply liquidity—in this case the supply of gold and Treasury
notes—was fairly inelastic in the short run, demand for that instrument
wouldexceed the availablesupplyduringa panic.
Thesubsequent scramblefor liquiditywouldcauseshort-term funding
marketsto freeze.
(Goldcould, and did, flowintothe USfrom abroadin responseto rising
interest rates.
Theseinflowsboosted liquidity, but did take some timetoarrive in
quantitiessufficient tomeet demand.)

P a g e | 30
As a result, manypolicy makersconcludedthat an―elastic‖currencythat
could increasein quantitywasrequired (Vanderlip 1908).
The notion that an elastic currency wasneeded was not new; as early as
1868, the Comptroller argued in favor of providing some elasticity to the
currencyfor use during timesof stress.
In particular, theComptroller arguedthat The treasuryof the United
Statescould hold in reservea certain amount of legal tender notesin
excessof the amount of money in regular circulation, tobe advanced to
bankinginstitutionsat a specified rate of interestupon thedeposit of
UnitedStatesbondsascollateral security, a source of relief wouldbe
established whichwouldeffectuallyprevent a monetary pressure
from being carried toany ruinousextent (1868,p.27).
Similar argumentsin favor of making availableadditional currency
backedbybondstoaddelasticitytothecurrencyandrelieveseasonaland
other financial pressureswere madeby the Comptroller in hisAnnual
Report in 1899(pp. 11-17)and 1902(pp. 61-63).
Variousbankersalsoargued for an elastic currency(Seefor instance
Pugsley(1902) and Hamilton (1906).
White(1983) describesvariousother initiatives.)
Nevertheless, followingthe Panic of 1907, legislativeaction seemed
considerably more likely.
Some proposals provided for an emergency currency that could be issued
by a central authority only during a crisis; asa temporary palliative such a
currencywasincludedin theAldrich-VreelandAct of 1908.
Under thisAct theSecretary of the Treasury could, during a
crisis, authorizetheissuanceofcurrencybackedbyanysecuritiesheldby
banksinstead of the usual requirement that thecurrencybe backedby
U.S.government bonds.

P a g e | 31
Ultimately, policymakers choseinsteadtocreatetheFederal Reserveasa
permanent solution wherethe discount window could be used to turn
bank assetsintocentral bank reservesand wouldthusprovidean elastic
currencythatcouldbeusedtorespondtochangingstringenciesin money
marketsmore flexiblyand continuouslythan could the issuanceof
emergencycurrency.
Acloselyrelatedargument made by advocatesof a central bank wasthat
onlycentral bank notesor reservesare certain tobe liquid during a
financial crisis(Sprague1911).
Other assetswerearguedtobeliquidonlytotheextent that theycouldbe
converted intocentral bank reserves:
In countrieswherethesenotesof thecentralbanksaregenerallyaccepted
in settlement of debtsby businessmen and banks, the ‗bankingreserves‘
of the stock banksmay safelyconsist of the central bank currency, or of a
balancekept withthecentral bank, convertibleintosuch currency. These
form the first lineof banking reserves.
Thesecond lineconsistsof thoseassetswhich, withcertaintyand
promptness, may be converted intocredit balanceswith thecentral bank
(Warburg 1916,p. 9).
Central bank reservesalsohave theadvantage of being able tobe
expanded by the central bank during a stressepisode.
Moulton(1918) notesthat the expansion of liquidityis essential during a
crisisasbanks areexpectedtobe thesource of liquidityfor their
non-financial customersduring a crisisand if banksare required to
bolster their own liquiditytosupport their reservebydemanding
repayment of, or even refusingto renew, loansduring a crisisthen
financial strainscan be significantlyexacerbated.

P a g e | 32
(Moulton alsocautionsthat, at least at that time, securities holdingswere
unlikelyto be effectiveasa secondary reserveduring a crisisasbanks
could only sell their securitiestoother banks.
If all bankswereseekingtoselltheirsecuritiesholdingsat thesame
time, thosesecuritieswouldbe not function asa source of liquidity.
This impliesthat tofunction asa source of liquidityduring a crisis, a
security must have readypurchasersfrom outside thebanking
system.)
Another lesson wasthat behavioral dynamicscould be affectedby the
absenceor presenceof a central bank.
During a panic, individual bankswouldpull their fundsout of thebanks
in thereservecitiesandbolstertheir liquid resources(Bankers‘Magazine
1908,November); several observers, such asthe Comptroller (1907) and
Herrick (1908), reportedthat declinesin interbank depositscontributedat
least asmuch tothepanic asthe actionsof individual depositors.
Banks wereargued tohave acted out of self preservation becausethere
wasnoguaranteethat their regular sourceof liquidity, the
reservecitybanks, wouldbe able tofurnishliquidityshould thecrisis
intensity(Roberts 1908, Sprague1913).
Indeed, the banksin New York had suspendedpaymentstoout-oftown
banksduring severalprior banking panics.
As a central bank wouldbe able to provide a guaranteed liquidity
backstop, individual bankswould not need to hoard liquidityat the first
sign of stressbecause theywould know that thebackstop wouldstill
beavailable in a crisis; Warburg (1914) goesa bit further and arguesthat
toprevent hoardingthe backstop and ability toturn supply cashmust
haveabsolutecredibility whichonly a central bank could provide.

P a g e | 33
It wasexpectedthat the existenceof the central bank wouldprompt a
changein behavior during a panic and wouldstop minor stressesfrom
escalatingintofull blowncrises(Warburg 1916).
Athird lessonwasthat the liquidityrequirementsthat tried tostrike a
balancebetweenensuring that the liquidityof the banking system was
maintainedyet not hamperingbanksin providing credit werelikely tobe
overwhelmedduring a panic.
Even critics of central banks sought waysto allowprivatemarket
participantsto expand the supplyof liquid assetsduring a panic.
Oneother aspect of thepanic that wasnot loston policymakers wasthat
institutionsoutsidethe normal banking system, in thiscasetheTrust
companies, could precipitatea run on the banking system.
Therealizationthat theseoutsideinstitutionscould threaten thestability
of the system may haveprompted some largeinfluential Clearinghouse
Association membersto support a central bank (seeWhite 1983, Moen
and Tallman 1999).
Section 5. Reserve requirements after the founding of the
Federal Reserve
With the establishment of the Federal Reserve, required reserves were
reduced asit wasexpected that theliquiditybackstop from thecentral
bank provided individual commercial banks witha ready meansof
meetingextraordinary liquiditydemands.
As noted by Rodkey (1934):
With the advent of the Federal Reserve System in 1914,weenteredupon
an era of central banking...

P a g e | 34
Thecentral bank is thusplaced in position to make advances,either
directlyor indirectly, to the individual member banksasthe
replenishment of their reservesbecomesnecessary...
It is clear that the presence of a central bank, prepared to make advances
on eligible assets, places the individual bank in a less vulnerable position
with respect todemandsof itsdepositors.
It tends tolessenthe need for primaryreserves.
TheFederal ReserveAct recognizedthisfact by reducingmateriallythe
percentageof required reserves(p.64).
Westerfield (1921) notedthat thereductionin reserveswasappropriatefor
severalreasonsincludingthat thereservebecausetheywereconcentrated
(asopposed to dispersedacrossbanksthroughout thesystem), because
thereserveswere―locatedin acentral bank whichfeelsitsresponsibility‖
andbecausetheir ―availabilityisnow unquestioned.‖
Lunt (1922), whoprovided instructionstoinsurerson how to assessthe
qualityof a bank from itsbalancesheet, noted that prior tothefounding
of the Federal Reserve the statement of cashand cashitems ―was
regarded asextremelyimportant, and banks that habituallycarried larger
reservesthan thoserequired by law werethought to be exceptionallysafe
(p.217).‖
However,withtheFederal Reserve, the ―point seemsfar lessimportant
now, sinceanybank that hasa proper loanaccount can replenish its
reserveat will by thesimpleprocessof rediscounting.‖
While reserve requirementscontinuedtobe viewedasa tool topromote
bank liquidityfor some time, there wasa gradual shift awayfrom this
view.
Indeed, by the late 1930s,reserverequirementswereno longer seen as
playing an important role in providingliquidity.

P a g e | 35
Thecommittee [Federal Reserve System Committeeon Bank Reserves]
takesthepositionthat it isnolongerthecasethat theprimaryfunctionof
legal reserve requirementsisto assureor preservetheliquidityof the
individual member bank.
Themaintenanceof liquidityis necessarilytheresponsibilityof bank
management and isachieved by the individual bank whenan adequate
proportion of itsportfolio consistsof assetsthat can be readilyconverted
intocash.
Sincetheestablishment of theFederal ReserveSystem, theliquidityof an
individual bank is more adequately safeguarded by thepresenceof the
Federal Reserve banks, whichwereorganizedfor the purpose, among
others,of increasingtheliquidityof member banksby providingfor the
rediscount of their eligiblepaper, than by thepossession of legal reserves
(FederalReserve 1938).
It is useful tonote that during thisperiod, theFederal Reserve was
important asa lender tothe banking system.
Burgess(1936)notesthat in a typical month during themid-1920sabout
one-third of member banksobtained at least one loanor advancefrom
their Reserve Bank.
As a regular lender tothesystem, it wouldbe fairlyeasyfor the Federal
Reservetoprovideadditional liquiditytoindividual banks.
Thediscount window wasseen by Federal Reserve staff asthe primary
sourceof emergencyliquidityfor the bankingsystem, especiallyafter the
rangeof eligiblecollateral wassignificantlyexpanded in 1932.29
As theyshiftedawayfrom beingseen aspromotingindividual bank
liquidity, reserverequirementswereincreasinglyseenasatool tomanage
credit growthand facilitate theuseof monetary policy.

P a g e | 36
This development occurred asthe Federal Reserve began to useopen
marketoperationstoadjustavailablereservesin thebankingsystem asits
primarymonetary policy tool; it wasseen asimpractical tohavereserves
bothserveasasourceofliquidityandbemanipulatedformonetarypolicy
purposes.
Thetwomain functionsof legal requirementsfor member bank reserves
under our present bankingstructureare, first, to operate in the direction
of sound credit conditionsby exertinganinfluenceon changesin the
volume of bank credit, and secondly, toprovidethe Federal Reserve
bankswith sufficient resources to enablethem topursue an effective
bankingand credit policy (Federal Reserve 1938).
Section 6. Lessonsand concluding remarks
From thelate1830suntil 1913,regulatoryeffortsaimedat promotingbank
liquidityconsisted primarily of reserve requirementsthat mandated that
individual institutionshold liquid assets.
However,thesereserves werenot sufficient toprovideliquidityand
prevent banks from suspendingdeposit withdrawalsduring banking
panics.
Toprovidefor an elastic currencythat could be expandedtomeet the
extraordinaryliquiditydemandsexperiencedduring a crisis, the Federal
Reservewasestablished.
Several lessonsfrom thehistorical reserverequirement experienceare
apparent.
Oneof themost important lessonsisthat individual bank liquidityis
intricatelyconnected to central bank liquiditypolicy.
For instance, in the absenceof a lender-of-last-resort backstop, banks
havemore incentiveto hoard liquiditywhichcould exacerbatestress
episodes.

P a g e | 37
Second, thehistorical debatespoint out that a knownand understood
regulatoryresponsetoshortfallsin the reserveisan important factor for
whetherthe reservewill be used in timesof stress(and for how binding
thereserve requirement will be during ordinary times).
Third, historical experienceindicatesthat whencertain assetsare
designatedasstoresof liquidity, institutionswill seekto accumulate
thoseduring a crisis.
Unlessthe pool of designatedassetsislargeor can be expandedat those
times,there is some risk that thefunctioningof themarket for those
assetscan deteriorate.
Further, if non-regulated institutions also use the designated assets as a
source of liquidity, then problems at those institutions can spill over and
affect theliquidityof the banking sector.
Policymakers todayare consideringvariousliquidityrequirementsfor
banks.
For instance, under the Basel III requirements, bankswill be subject toa
liquiditycoverageratio (LCR).
Under this requirement, bankswill be required tomaintain a stock of
high qualityand liquid assetsasa buffer that issufficient tocover
potential netcumulativecashoutflowsat all timesduringa30-dayperiod.
Toa largedegree, the LCR is similar toa reserve requirement in that it
effectivelyrequiresliquid assetsto be held against certain classesof
liabilities(and linesof credit).
Thehistorical experiencewith reserve requirementsoffersvaluable
lessonsfor policymakers astheyimplement the LCR and other liquidity
regulations.

P a g e | 38
Bank for International Settlements
International financial markets and bank
funding in the euro area: dynamics and
participants
JaimeCaruana, General Manager
Adrian Van Rixtel, Senior Economist
1. Introduction
Financial marketsare undergoing major and at
timesveryrapid changes,mostlyasaresult ofthe
financial crisisthat beganin 2007.
It isstill tooearlytosayfor certainwhichof these
changeswill endure and whichwill disappear –
andtowhat degree– whenanew balanceis
reached.
However,wemust analyse them in order to be
ableto design appropriate policies.
Among the many forcesdrivingthesemarket developments, wewould
like to focuson three whichhave their rootsin the crisis.
First are changesin market participants‘perception and management of
risk.
Counterparty and liquidityrisk, for example, wereundervalued in the
years precedingthecrisisbut are now major concernsfor financial
institutions.
In addition, systemic risk, stemmingfrom the interconnectionsbetween
thefinancial system and the real economy, must be internalised.

P a g e | 39
Second, imbalancesaccumulatedon public and privatebalancesheets
over many years must be corrected.
Theseimbalancesarereflectedonfinancialinstitutions‘balancesheetsin
theform of excessiveleverageand excessivematurityand liquidity
transformation.
While deleveragingispart of the adjustment needed to restorethe
soundnessof the banking sector, at thesametime it burdensfinancial
marketswithasset salesand contractionsin credit, giving riseto vicious
cyclesthat increasesystemic risk.
Policies toreduce riskand provideprotection against contagion are
leadingtoa renationalisationof financial flowsand tomarket
fragmentation.
Cross-border lendinghascontracted more rapidlythan domestic
lending.
In particular, marketsin the euro area have been segmented increasingly
alongnational borders.
As theyattempt toprotect themselvesagainst the effectsof the
crisis, somenational authoritiesare building barriers against cross-
national liquiditymovementsthat threaten further segmentationalong
national lines.
Third are regulatorychanges.
Financial marketsare undergoing regulatory changesaimedat making
them sounder and more stable.
Thesechangesseek to applythe lessonslearned from thecrisis while
preventingcollectivebehaviour from leadingto a watering-downof
regulations.

P a g e | 40
Much emphasisisbeingplacedon consistencyin the adoption of the
regulationsindifferent countriesand onanalysingtheunwantednegative
effectsthesemeasuresmight have.
Thesedriversand their effectson thefinancial system can be clearlyseen
in theunfolding crisisin theeuro area, particularlyin the strainsand
changesin bank financing.
At the most critical points in the crisis, risk aversion and volatility in euro
area financial markets increased sharply, with severe contagion effects to
international financial markets.
Therecent tensionsin some countriesweredrivenby theincreasing
interaction betweenconcerns about the sustainabilityof publicfinances
andthe fragilityof financial systems in an atmosphere of lowgrowth.
Concernsabout government deficitsand debts in variousperipheral
European countries,especiallywhenaccompaniedby external
imbalances,spilled over to euro area banks.
And financial systems‘ fragility generatedcontingent liabilitiesin
public finances,thusmaking the fragilitiesof sovereign debt become
increasinglyintertwinedwith thefinancial crisis,and creatingdifficulties
for bank funding.
In addition to this vicious circle, lower economic growth and the inability
to provide stimulusdue to the lack of fiscal space make deleveraging even
more difficult and weakenbank asset quality.
Bank funding had already seen major changesin theyearsprior to the
euroarea crisis.
During the past few decades, banks loosened the constraints of deposit
growth and raised funds from institutional investors in global financial
markets.

P a g e | 41
Theytappednew sourcesof funding, such assecuritisation.
The business model of investment banks relied on wholesale funding
from institutional investors, especially at short maturities (Merck et al
(2012)).
Financial globalisationallowedbanks totap institutional investors
beyond national borders, whichexpanded traditional international
fundingtointernational interbank markets(CGFS (2010a), McGuireand
von Peter (2009), Fender and McGuire(2010)).
This greater relianceon fundingprovided through financialmarkets
experienced unprecedenteddislocationsduring the 2007–09global
financial crisis.
It set off major adjustmentsin banks‘businessand funding
models,whichinmanycaseswerelaterreinforcedbytheeuroarea
financialcrisis.
In both crises,somebanks‘accesstofundingwaslimited, predominantly
becauseof a deterioration of the qualityof their assets, eg mortgage -
relatedfinancialinstrumentsin thecaseof the global crisisand sovereign
debt in theeurocrisis.
Thisarticleinvestigateshowbank fundingin theeuroareain recent years
reflectedthesemarket developments.
In fact, bank fundingcan be seen asthearea whereimportant issues
relatedtothe crisisand financial marketscome together.
It should be emphasisedthat this analysissimplifies a very complex
reality, with profound differencesamong different financial institutions
and countries.
First, adversefeedback effectsbetweentheweaknessesof sovereignsand
banksdisruptedfundingmarketsseverely.

P a g e | 42
During episodesof severe sovereign strains, accesstoshort- and
longer-term wholesalefundingmarketsbecameproblematic even for
euroareabankswiththe highest credit ratings, forcing them toresort to
alternativefunding sourcesand to shrink the sizeof their balancesheets.
Second, BISdata show that international interbank fundingfor euro area
bankshascollapsedfrom thehigh levelsobserved in 2008.
Thisrenationalisationappliesespeciallytofundingprovidedbyeuroarea
banksto other euro area banks.
As a result, a bank‘scountry of origin largely determinesitsaccessto
variousfundinginstrumentsand their costsinstead of itsfinancial
strength.
Thesedifficultieshave been most pronounced for banksfrom peripheral
countries,which have suffered themost severelyfrom fiscalimbalances.
Third, aparticularclassof internationalinstitutionalinvestors,US money
market mutual funds, has on balanceover thepast year withdrawnlarge
sumsof short-term fundingfrom euro area banks.
For theseinstitutional investors,however, it is not somuch a caseof a
return to home biasasa shift from euro area and UK bankstoother
foreign banks.
Fourth, the crisis hasled to a growingrecourse to fundingsecured by
collateral, such ascovered bonds.
This development addsto the alreadygrowingdemand for assetswith
high liquidityand low credit risk, in theaftermath of the 2007–09global
financial crisis.
Meanwhile, changesin regulation are addingtodemand for such assets
even asthe lossof creditworthinessof sovereignsis reducingthenumber
of suppliers.

P a g e | 43
This hasraised concerns about a potential scarcityof ―safe‖ assetsthat
can be used ascollateral.
In addition, thefact that a larger part of bank assetsis used ascollateral
for covered bonds(BIS(2012)) tends toraisethe riskinessof unsecured
debt, leadinginvestorsall themore todemandthat debt be collateralised.
Finally, the renationalisationof bank fundinghasintensified the
dependenceon ECB liquidity, whichhassubstituted for lostaccessto
euroarea cross-borderinterbank and bond funding.
In what follows, weanalysesome of these market trends:first wesketch
theadverse feedback betweensovereignsand banks.
Thenweconcentrateonthedynamicsof several main sourcesof funding,
namely international interbank markets(mostly for loansbut alsofor
bond holdings), US money market funds, bond marketsand ECB
liquidity.
Thefinal section concludes.
2. Link between sovereignsand banks
Sincethe first quarter of 2010,sovereigndebt tensionsand their spillover
tobanks in general and their funding in particular havedominated, in
variousstagesand todifferent extents, financial and economic
developmentsin theeuro area.
Thesesovereign debt strainscame beforemany Europeanbanks had
reallycleanedtheir balancesheetsof assetsthat wereimpairedduringthe
global financial crisis.
In theevent, government financesand banks‘fundinginteractedstrongly
(Caruana (2011), Caruana andAvdjiev (2012)).
In particular, sovereignrisk affectsbank fundingthrough several
channels(CGFS(2011)).

P a g e | 44
Many bankshold significant amountsof predominantlydomestic
sovereignbondson their balancesheets,whichcan leadtovaluation
lossesand credit risk concernswhensovereign yields rise sharply.
Moreover,sovereign debt servesascollateral for variousfinancial
transactions,includingprivate repos.
Sovereigntensionsresult in lowercollateral values, owingto larger
haircutsor margin requirements,whicheffectively reducethe abilityof
banksto obtain funding.
In addition, sovereign downgradesspill over tobanks, worseningboth
their cost of and accessto funding, whilereducingthe fundingbenefits
theyderivefrom implicit and explicit government guarantees.

P a g e | 45
Signsof the strong link betweensovereignsand banksstarted to become
more pronounced earlyin 2010.
Tensionsin international financial marketsweredriven by growing
concernsabout thesustainabilityof publicfinancesin view of persistent
government deficitsandhighlevelsofpublicdebt inperipheralEuropean
countriesin general and in Greece in particular.
Specifically, this wasthecasewhenthetensionswerecompounded by
countries‘extensiverelianceon foreign fundingand that fundinghadto
competewith therefinancingof high public debt.

P a g e | 46
Theseconcerns spilled over to banksand, in most euro area countriesand
most periods, were reflected in marked increases in bank CDSspreadsin
paralleltothe sovereign ones(Graph 1).
In this context, interbank funding costs, not only for euro borrowingbut
alsofor that in USdollarsand sterling, increasedsharply (Graph 2,
left-handpanel).
Again, euro area banksexperiencedstrainsin US dollar short-term
fundingmarkets(Fender and McGuire(2010)).
International spillovers of the euro area financial crisiswere alsovisible in
the frequent and often sharp declinesin stock pricesof US and UK banks
in parallel tothoseof euro area banks (Graph 2, right-hand panel).
Weak economicgrowthand lossof competitivenesspointedtolower
government revenuesand loan losses,and theanticipation of these
feedback effectspressured banksfurther.

P a g e | 47
Thesignificanceof the strong interconnection betweensovereigns and
banksin the euro area financial crisis is shownby the overall increasing
trend in thepredominantly positive 90-daymoving correlationsbetween
sovereign and bank CDSspreadsfor most countries(Graph 3).
Theco-movement betweenthesespreadsincreasedacrosseuro area
countriesafter thenationalisationofAllied Irish Bank in January2009,
whichsubsequentlycontributedtoa more pronounced transmission of
sovereign risksto banks (Modyand Sandri (2011)).
It wasparticularlyhigh for most euro area countriesduring crisisperiods
involvingvariousperipheral countries,such asGreece, Ireland and
Portugal, joinedlater in the crisisby Spain and Italy.
At the same time, correlationsbetweensovereignand bank CDSspreads
of thesecountries declined sharply after theyreceivedsupranational
support.
[Greece, Ireland and Portugal received support through joint EU-IMF
programmesin May2010/March 2012,November 2010andApril
2011, respectively; the ECB re-activateditsSecurities Markets
Programme (SMP) for Italian and Spanishsovereign debt inAugust
2011;Spain receivedlimitedofficial fundingtosupport the
recapitalisationof its bankingsector in June2012.]

P a g e | 48
Cross-border holdingsof government debt by bankshave played an
important role in the development of theeuro area financial crisis.
Traditionally, domestic banks in keyeuroareacountriesheld a larger
shareof their respectivegovernments‘debt than banksin theUS or
UK (but a smaller one when compared with Japanesebanks).
Theintroductionoftheeuroreducedthishomebiasbyfosteringportfolio
diversification, whichledto a significant increasein cross-border euro
area sovereign bond holdingsamong euroarea countries.
In fact, owing to EMU, euro area investors increased the share of their
investments in debt securities issued by euro area countries more than
investorsfrom all other countries (De Santisand Gérard (2009)).
Still in 2007, the share of sovereign debt held by domestic banksremained
large, particularlyfor theperipheral countries
(Greece, Ireland, Italy, Portugal and Spain).

P a g e | 49
Moreover,there areindicationsthat during more recent crisisperiodsthe
homebiasof banks from peripheral countries increased again (Merlerand
Pisani-Ferry(2012)).
Holdingsby euro area monetary financial institutions(MFIs) of other
euroarea countries‘sovereign debt asa ratioof their total bond holdings
havebeenonadecliningtrendsince2006andhavenowreturnedtolevels
observed in 1998(ECB (2012b)).
All in all, the euro area crisishasdemonstrated that sovereign debt
holdingscan impede banks‘effortstoregain the trustof their peersand
market participantsat large.
The high degree of international integration between government debt
marketsand banking systems in the euro area has played an important
rolein thepropagation of the crisis (Bolton and Jeanne(2011)).
Exposurestosovereignsin theeuroarea‘speripheryspreadbank distress
tocountries with stronger statefinances.
And for many banksheadquarteredin theperiphery countries, exposures
toown governmentsare much higher than common equity.
Theyare alsosizeablein the caseof largenational bankingsectorsin
other euro area countries.
Thus, gettingsovereign financesin order is a necessarycondition for a
healthybankingsystem.
3. International interbank lending
Sincetheonset ofthefinancialcrisisinAugust 2007,euroareabankshave
seen their accesstointernational interbank fundingreduced, in some
casessubstantially.
This hasbeenmainlyconcentratedin intra-euroarea interbank markets:
international lendingby euro area banks to other euroarea bankshas

P a g e | 50
declined sharply, asfundingwithin the euro area hasagain become
segmentedalong national lines.
Overall, between end-2008 and end-2011, international interbank lending
from one euro area bank to another shrank drastically, thereby reversing
an equallydramaticsurgebetween2003and 2008(Graph 4).
This withdrawal of international fundsfrom intra-euroarea interbank
marketswasnot offset by an increasein funding providedbynon-euro
area banks.
Thedecline in international interbank lendingwithin the euroareawas
concentratedinfundsprovidedthroughboth loansand depositsanddebt
securities(Graph 5).
Debt securitiescontracted most in proportional terms, but international
loansand depositsalsofell sharply from thehistoric high recordedat
end-June2008.
Thedynamicsof the movement in international fundsprovidedbetween
banksin theeuro area followedthedevelopment of the euroarea crisis
closely.
For both loansand depositsand debt securities, it fell sharplyduring
episodesof severe market stress, such asthe first half of 2010and the
second half of 2011, whileit recovered during periodsof subdued
tensions,most notablythe first half of 2011.
Therecent measurestaken by the ECB, theexpansion of therangeof
acceptablecollateral and thenew sovereign bond-buying programme
(Outright MonetaryTransactions, OMT) have reduced redenomination
risk, one factor that had increasinglybeen contributingto market
fragmentation.
Sustainingthe improvementsachievedwith regard torisk premia will

P a g e | 51
requireswift progressboth at the country level and through institutional
advancesin the euroarea.

P a g e | 52
4. The role of US money market funds
So-calledprime US money market funds(MMFs) are important
participantsin international financial markets,astheychannel funds
from US householdsand firmsto non-USbanks.
Thesefundsinvest in short-term instrumentsand try to offer more
attractivereturnsto retail and corporate investorsthanbank depositsdo.
Before the crisis,US MMFs became oneof themain fundingsourcesof
theshadowbankingsystem, by purchasingasset-backedcommercial
paper (ABCP) from structuredfinancevehiclesand other short-term debt
issuedby USinvestment banks and non-bank mortgage lenders.
Competition to offer investorshigher yieldshaslongled MMFstohold
short-term debt and certificatesof deposit issued by European and other
banksheadquartered outsidetheUnited States.
US MMFsbecame thelargest singlesupplier of dollar funding tonon-US
banks, providingaround one trillion US dollarsto European banksin
mid-2008(Baba et al (2009)).
In theaftermathof the2007–09globalfinancialcrisis,theyincreasedtheir
exposurestoeuroareabanksfurther,whilethosetoUSbanksfell strongly
(Graph 6, left-handpanel) asUS banksweredowngraded, and changed
their fundingmodels.
Sinceearly2010,followingthe intensificationof the euro area financial
crisis, however,US MMFshave sharply reducedtheir exposurestoeuro
area banks in general and to peripheral countries‘banks in particular
(Graph 6, right-hand panel).
This hasbeendriven not only by heightedassessment of underlying
risk,but alsoby managersof MMFsseekingtoreassure uninsured
investors.
After therun by institutional investorson prime MMFsin September–

P a g e | 53
October 2008and amid ongoing discussion of whetherthesystemic
threat of suchrunshad been removed bysubsequent Securitiesand
ExchangeCommission reforms,such fundsappear tohave been
particularlyquick toreduceexposurestoeuro areabanks.
With the intensification of the crisisin thesummer of 2011, thejoint
exposuresof USMMFstothefive peripheral euro area countries, which
werenever large, becamenegligible.
Strikingly, theyalsoreduced their short-term investmentsin core euro
area banks, which werelarge.
This reduction wasthe most pronounced for French banks, driven by
concernsabout their exposurestoperipheralsovereign debt, but also
affected German, Dutch and Belgian banks (Graph 6, right-hand panel).
In the firsthalf of 2012,euro area exposuresof US MMFs stabilisedbut
remainedat very lowlevels.
Rather than retreatingfrom international exposures,thesefunds
increasedtheir investment in debt instrumentsissuedby Canadian,
Japaneseand Swissbanks, aswell asScandinavian banks (not shownin
Graph 6).

P a g e | 54
5. Bond markets: preference for secured funding can lead to
scarcity of Collateral
Institutional investorsin bank bondshave reducedholdingsof euro area
bank bondsaswell.
Theeuro area financial crisishasimpaired accesstothesemarkets, most
notablyduring episodesof rapidlyincreasingmarket tensionsand for
banksfrom peripheral countries.
Banks from Greece, Ireland and Portugal have been virtuallyshut out of
primarybond markets,while thosefrom Italyand Spainhaveenjoyed
onlyintermittent and unreliableaccesstothem (Graph 7).
At thesametime, fundingstressfrequentlyaffectedcore countries‘banks
aswell.
Banks from Germany, France and the Netherlandsissued very modest
amountsof bondsin monthsof severemarket turmoil linkedtotheeuro
area crisis.

P a g e | 55
Moreover,during theseepisodes, market strainsspilledover tobanks
outsidethe euro area, suchasUK banks(Graph 7).
Overall, grossbond issuanceby euro area bankshasdeclined withthe
worseningof thecrisis, by 15% in 2011from 2010and by 22% in the first
half of 2012from thesameperiod one year earlier.

P a g e | 56
Thecrisishasled to major changesin thecomposition of grossbond
issuanceby instrument, especiallyfor banksfrom peripheral countries.
Theeuro area financial crisishasreinforcedthetrend towardsgreater
recourseto secured longer-term funding, such ascovered bonds(Romo
González and Van Rixtel (2011), ECB (2012a)).
Theshare of covered bondsin total grossbond issuancebyeuro area
bankshasincreasedfrom 26% in the first half of 2007to 40% and 45% in
thefirst half of 2010and 2012,respectively.
For many banks from peripheral countries,most notablyfrom Spain and
Italy, thisinstrument hasbecome themain sourceof long-termwholesale

P a g e | 57
funding, astheir accessto unsecured marketshasbeen partiallyor fully
closed (Graph 7).
Covered bond issuancehasbeen spurred aswell by more structural
factors,such asfavourable regulatorytreatment, for exampleunder Basel
III and SolvencyII and in various―bail-in‖ proposals, and legislative
initiativesin several countries.
Growingissuanceof covered bondshasaddedtotheconcernsabout the
scarcityofcollateral, ormorepreciselyof―safe‖assetsthat canbeusedas
collateral.
Covered bond issuanceby banks resultsin a balancesheet in whicha
substantial proportion of their assetsis encumbered, ie pledgedwith
priorityto investorsin covered bonds.
Theintensificationof the crisishasled banksto overcollateraliseto a
larger degree, whichhas reduced even more the unencumberedassets
availableto serve ascollateral for new covered bonds.
Asset encumbrancealsoreducesaccesstounsecured senior debt
issuance,becauseasthepool of encumberedassetsunderlying covered
bondsgrows,holdersof unsecured bank debt have a claim on fewer
assetsin the event of thebank‘sinsolvency.
This substantiallyreducestheir attractivenessasinvestments
(Oliver-Wyman (2011), BIS (2012), ECBC (2012), ECB (2012a)).
Concernsabout collateral scarcityseem tobe an important driver of the
increasingtrend of so-called―retained issuance‖ by peripheral countries‘
banks.
As the accessof many of these banks toprimary bond marketshas
become impaired, theyhave started to retain larger partsof their gross
bond issuanceinstead.

P a g e | 58
Thesebanksmainlyusethispaper ascollateral in ECB liquidity
operations.
In the first half of 2012,significantlylarger sharesof grossbond
―issuance‖ by Italian, Portugueseand Spanish bankswereretained
(Graph 7).
In contrast, issuanceby German, Frenchand Dutch bankshasremained
targeted to primary public marketsand therebyto outsideinvestors.
This differencein bond issuancepatternsbetweenperipheral and core
countriesagain underscoresthe renationalisationof fundingmarkets.
Strained accesstobond financinghasled to a revival of the issuanceof
government guaranteedbonds.
Theintensificationof the crisisin the second half of 2011propelledthe
re-activationor prolongationof programmesin all peripheralcountries,
aswell asin Germany.
Government guaranteed issuancehad become a very important source of
longerterm bank fundingin 2008and 2009at the height of theglobal
financial crisis,and generallyhasbeen assessed positively, although not
asbeing without some costs(CGFS(2011), Mulleret al (2011)).
Thereactivationof the programmesin Italyand Spain allowedsolid
positionshad not reducedthe valueof these explicit guarantees
substantially.
6. The provision of ECB liquidity
With thedevelopment ofthecrisis, someeuroareabankshaveresortedto
central bank fundingon a massivescale.
TheECB hasconducted a widerangeof open market operations,
amounting toanunprecedented €1.1trillion at theend of June2012.

P a g e | 59
This liquiditywasabsorbed predominantlyby banks from countrieseither
under joint EU-IMF programmesor experiencingseveresovereign
tensions,showingthedistinct segmentationofbank fundingaccordingto
bank nationality.
It wasaugmented by Emergency LiquidityAssistance(ELA) especially
in Greece and Ireland, wherenational central bankstook on the risk of
fundinglocal banksthrough their ―lender of last resort‖ function.
All in all, the worseningeuro area financial crisishassubstantially
increasedthe dependenceof several national banking systemson central
bank liquidity, asa result of the increasingrenationalisationof
market-basedbank funding.
Thistrend hasbeentheclearest for Greece, withalmost 30% of total bank
assetsfinancedby ECB liquidity, while for Ireland and Portugal the
proportion hasreachedabout 10% (Graph 8, left-handpanel).
Thesharp deterioration of the crisisfrom March2012onwardsthat was
concentratedonSpain andspilledovertoItalyledtosignificant increases
in thedependenceof their bankingsystems on ECB liquidityaswell
(Graph 8, right-hand panel).

P a g e | 60
7. Policy implications
Thesevere fundingdislocationsthat wereobserved during the most
intenseepisodesof the euro area crisis led to unprecedentedchallenges
forpolicymakersandforcedthemtotakeexceptionalmeasuresonalarge
scale.
Although the dynamics of thecrisis are still evolving, wewouldlike to
emphasiseseveral implicationsfor policy.
First, recent experiencehasagain demonstrated how quicklyand
profoundlybank fundingcan dry up whenthereis a lackof confidencein
themarkets.
Fundingstructuresthat seem stablein normal timescan turn highly
unstableduring episodesof financial market stress.
Financingobtained from foreign sourcestends tobe particularly
unstable,andmaybeespeciallysensitivetoshocksin recipient countries.
Acaseinpoint isthesharpreductionininternationalinterbank exposures
withinthe euro areain recent years.
This hasdemonstrated again the benefitsof stablefunding
structures,whichfacilitatethe lengtheningof maturities,and of
considerablediversification betweendomesticand foreign sources
basedmainlyon depositsand equityand lesson short-term wholesale
funding.
TheBasel III Frameworkpromotes thelatter shift.
It ensuresthat banksrely on their own capacitytobuild liquiditybuffers
and raisestablefunding, therebyreducingfunding liquidityrisk.
Banks withstrong capital and liquiditybuffersaremuch better equipped
towithstanddisruptionsin funding.

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Second, the strong link betweensovereignsand bankshasunderscored
theimportanceof fiscalprudenceand, intheEuropean case,theneed for
greater financial integration in the euro area.
This is particularlytrue for thosedependent for funding on foreign
capital, whichcan suddenlyleave, shifting the burden to domestic banks
and investors.
It is easiertobuild up fiscal buffersin good timesthan torestore
confidencein a crisis.
Financial cycles arelonger and more difficult toassessthan normal
businesscycles, and more room for manoeuvre is required todeal with
them.
Third, becauserecourse tosecured fundingencumbersa larger part of a
bank‘sassets,in theevent thebank fails fewer assetsare availableto
holdersof thebank‘sunsecured debt, whichreducesitsattractivenessto
investors.
Thus, heavier asset encumbrancemay increaseconcernsof collateral
scarcityand potentiallymay impair both theaccessto and cost of
unsecured funding.
Scarcityof collateral is worsenedif formerly―safe‖assetsthat could be
used ascollateralbecome seen asriskyassets.
Quiteapart from theusual macroeconomic reasonsfor appropriatefiscal
policy, financial marketsrequire sovereignsthat are considered
practicallyrisk-free.
For thisreason, in financial systems that tend to operateon the basisof
collateral, confidencein thesustainabilityof public debt hasan added
value.

P a g e | 62
Its absenceleadstodifficultiesand higher fundingcostsfor theeconomy
asa whole.
Finally, theincreasedfragmentation of financial markets, especiallyin
theeuro area, and thereliance of peripheral banking systemsin theeuro
area on ECB liquidityrequire action on several fronts.
Withineach country, public debt must be made more sustainable,
structuralreformsmustfacilitategrowthandthefinancialsystem must be
repaired.
For theeuro area asa whole, institutional improvementsmust continue,
andthere must be greater financial and fiscal integration, mainlywith
regard to thethree aspectsof thebankingunion: common supervision,
system-widedeposit insuranceand a singleresolution system.
Therecent ECB measuresprovidemore time for thesereformsto be
implemented, but theyare not a substitutefor the reforms, soswift
progressisstill needed.

P a g e | 63
Countercyclical loans for the
management of exogenousshocks in
small vulnerable economies (SVEs)
and non traditional sourcesof
development finance
Openingremarksby Mr JwalaRambarran,
Governorof the Central Bank of Trinidad
and Tobago, at the Joint Commonwealth
Secretariat and UnitedNationsDevelopment Program workshopon
―Countercyclical loansfor themanagement of exogenousshocksin small
vulnerableeconomies(SVEs)and non-traditionalsourcesofdevelopment
finance‖,Port of Spain
Ladies and Gentlemen,
I thank the CommonwealthSecretariat and the United Nations
Development Program (UNDP) for theinvitationto deliver opening
remarks at this joint workshopon what I consider tobe one of the more
critical issuesfacingsmall vulnerable economies, but whichten years
after theMonterreyConsensuson Financingfor Development hasbeen
largelyignored by theinternational policycommunity.
While developing countries have made much progressin meetingthe8
Millennium Development Goals(MDGs) tofree humanity from extreme
poverty, hunger, illiteracyand diseaseby2015,substantial challengesstill
remain, especiallyin reachingthe most vulnerable.
Multiplefinancial, food, energy and economic crises, whichoften respect
noborders, further aggravatematters.
As the deadlineapproaches, wehavethe opportunityto design a
post-2015frameworkthat builds on successes,learnfrom past
shortcomings,and addressesthe gapsin thecurrent MDGs.

P a g e | 64
JeffreySachs, Professorof SustainableDevelopment at Columbia
University, warnsusin hisJanuary 24th 2013article entitled―Writingthe
Future‖ that humanity facesno greater challengethan to ensure a world
of prosperityrather than a worldof ruins.
ProfessorSachsstrikesaprescient notewhenhestates―Like anovel with
twopossibleendings,oursis a story yet tobe writtenin thisnew century.
There is nothing inevitableabout thespread – or the collapse– of
prosperity.
Morethan weknow (or perhapscaretoadmit), thefuture is a
matter of human choice, not mere prediction.‖
I thereforecommend the CommonwealthSecretariat and theUNDP for
mounting this first of three workshopshere in the Caribbean, withthe
other twoto be held in theAfrican and Pacific regions.
Perhapsthiswill be the first chapter on the post-2015development story
of new financingarrangementsfor small vulnerable Caribbean
economies,whosefuture might be partlybased on the choicesyou make
at this workshop.
I certainlylook forwardto the outcomesof all three workshops,and hope
that the shared positionswill help toinfluenceAfrican, Caribbean and
Pacific governmentsin their advocacyfor innovativesourcesof
development financeto bea front-burner issueon the international
economicagenda.
Ladies and Gentlemen, it is no secret that small vulnerable economies in
the Caribbean have grappled with external shocks of varying magnitudes
andduration over the past twodecades.
Theseshocks includea compression of aid flows, dismantlingof
preferential trade arrangementsfor sugar and bananas,interventions

P a g e | 65
relatedtoanti-moneylaunderingand combating thefinancingof
terrorism.
Morerecently, the Caribbeanhasbeen graduallyrecoveringfrom the
shockof the global financial crisis, whichoriginated in the UnitedStates
and spread to Europe, the region‘stwoclosest tradingand investment
partners.
The untold story, however, is that the combined influence of these
multiple shocks hasled to a dramatic and fundamental shift in the
composition of external financing flowstothe Caribbean.
In my respectful view,themost significant changein theregional pattern
of external resource flowsstemmed from thesharp compression in
Official Development Assistance (ODA).
Flowsof ODAtomany Caribbean countries beganfallingin the 1990s,as
donorsredirectedtheir aid prioritiestothe newlyemerging
Commonwealthof Independent Statesand the Least Developed
Countries.
This is certainlyironic becausethe eighthMDG recognizesthat
developing countriesrequire more generousdevelopment aid to have the
best chancesof reducingpoverty and acceleratingdevelopment within the
stipulated15 year timeframe.
Faced with decliningaid resources, many Caribbean governments
resortedtomoreexpensivecommercialborrowingtobridge their funding
gaps.
This, combined withthe growinginabilityof regional governmentsto
generatehigh enough primary fiscal surplusesfor debt servicing,
contributedtoa largepublic debt overhang.

P a g e | 66
Grosspublic debt in theCaribbean climbed rapidlyfrom 65percent of
GDPin 1998toapeak of almost 100percent of GDPin2002,beforefalling
toa still elevated 80percent of GDP in 2012.
Theaccumulationof publicdebt waseven faster in the Eastern
Caribbean, moving from just over 60 percent of GDP in 1998toa high of
almost 120percent of GDP in 2004, beforefallingto 95 percent of GDP in
2012.
Generally, a public debt ratio of over 90 percent of GDP is considered
exceptionallyhigh.
By thismeasure, four countriesin the Caribbean are projected to hold
exceptionallyhigh public debt in 2013:Jamaica(140percent), St. Kitts&
Nevis (139percent), Grenada(109percent), andAntigua & Barbuda (93
percent).
Another six countriesare projectedto haveheighteneddebt
vulnerabilities,averagingin therangeof 50to90percent of GDP, in 2013.
ThesearetheBahamas, Belize, Dominica, Guyana, St. Lucia and St.
Vincent and theGrenadines.
Ladies and Gentlemen, the magnitudeof the fiscal adjustment required to
stabilizeand eventuallyreducetheCaribbean‘spublic debt overhangis
neither sociallynor politicallyfeasible.
Onlytwosmall island developing statesin the Caribbean – Guyana and
Haiti – have been ableto accesscomprehensivedebt relief under the
enhancedHeavily IndebtedPoor Country (H IPC) Initiativeand under
theMultilateralDebt Relief Initiative(MDRI).
Other small vulnerableCaribbean economiesare considered not poor
enough and/ or not severelyindebted enough to benefit from similar
international debt relief measures.

P a g e | 67
In the meantime, a few Caribbean small islanddeveloping stateshave
engagedin debt restructuringoperations, sometimesmorethanonce,but
debt problemspersist.
Thesombre picture, Ladies and Gentlemen, is one of wideexternal
current account deficits,heavypublic debt and slowingcapital flows
whichareplacingundue pressure on theregion‘s international reserves
andpredominantlyfixed exchangerateregimes (inclusiveof a currency
boardarrangement in theEastern Caribbean).
Caribbeancountriesare unwillingto devaluetheir currenciestosupport
their weaker external positions.
Barbados, in particular, remainsvehementlyopposed to
devaluation, whichit considersill-conceivedand unsuccessfulat
correctingthelowgrowth, high debt dilemma facingsmall, vulnerable
Caribbeaneconomies.
An appropriatebalanceisyet tobe struck betweenadjustment and
financing.
SinceSeptember 2008, ninesmall islanddeveloping statesin the
Caribbeanhave turned to the IMF for increasedfinancial support under
variouslendingfacilities.
TheseareAntigua and
Barbuda, Belize, Dominica, Grenada, Haiti, Jamaica, St.
Kitts/ Nevis, St. Lucia and St.Vincent and theGrenadines.
Yet, it isarguablewhetherthe current lendingfacilitiesof theIMF, the
World Bank and other international financial institutionsaresufficient
enough tohelp mitigate theimpact of large, unforeseen external shocks
on Caribbean and other small vulnerableeconomies.
Over thepast decade, the international communityhaschampioned
several initiativesto help mobilize more resourcesfor development or to
make them more effective.

P a g e | 68
Well known examplesincludethe International FinanceFacilityfor
Immunization, debt conversions, emissionstrading, a financial
transactionstax and useof theIMF‘sSpecial DrawingRights(SDRs).
Thejury is still out on whetherthese major schemeshave created
additional financial flowsfor development.
For many Caribbeancountries, remittanceshave become an important
andpromising sourceof non-traditionalexternal financing.
In fact, the Caribbean is among the larger recipient of remittancesin
proportion to itsGDP.
For countriessuchasHaiti, JamaicaandGuyana, remittancesrepresenta
lifeline,contributingto smoothing household consumption, easing
balanceof paymentspressures,and financingdomesticinvestments.
In effect, the Caribbean has created its very own large, highly educated
diaspora pool that represents a potential alternative source of long-term
funding.
Thestockof theCaribbeandiasporaisestimatedtobearound3.5million
peopleor more than one-fifth of the region‘spopulation.
Preliminaryestimatesplacetheannual savingsof theCaribbeandiaspora
at over 15percent of the region‘sGDP.
Despitethis impressivepotential market,regional governmentsare yet to
adopt innovativefinancingsolutionssuch asdiaspora bondstotap into
thewealthof its diaspora.
Ladies and Gentlemen, I have noted thewidescope of this workshop
agenda, whichrangesfrom exploringthe feasibility of countercyclical
loaninstrumentsfrom theIMF and World Bank toidentifying new
sourcesof revenuesincludingnew regional financingmechanismsfor
small vulnerable economies.

P a g e | 69
I am alsomost impressed withthe caliber of the presenters.
I haveno doubt that you havethe right ingredientsfor stimulatingand
fruitful discussionsover thenext twodays.
But wemust be realistic.
There is nosilver-bulletsolutiontothedeep-rooted, financingchallenges
facingsmall vulnerableeconomies.
Stabilizingthe Caribbean‘sdebt overhangasa priority is onlya start.
Putting in place the policiesand institutionsto allow pro-poor growth and
achievement of the MDGs in the Caribbean will require persistent action
from governmentsacrossthe region.
In this regard, I seeboth theCommonwealth Secretariat and UNDP
continuing to playan activerole.
Conclusion
In closing, LadiesandGentlemen, I mustremindour foreignparticipants
that even asyou devote attentiontothe rigorsof theworkshop, you have
cometoTrinidadand Tobagoduring theCarnival season, a most
opportunetime to witnessthecreativity, energyand passion of our people.
Sodo take timeif onlyto experienceSuper Blue‘s―Fantastic Friday‖.
Let me assure you all of the continuedsupport and collaboration of the
Central Bank of Trinidadand Tobagoin helpingto move development
financeissuesfacingsmall vulnerableeconomiesontothe international
agenda.
I thank you.

P a g e | 70
FSB publishes peer review on risk
governance
TheFinancial StabilityBoard (FSB) published today a thematic peer
review on risk governance.
Thereport takesstock of risk governancepracticesat both national
authoritiesand firms, notesprogressmade sincethefinancial
crisis,identifiessound practicesand offersrecommendationsto support
further improvements.
Therecent global financial crisisexposed a number of risk governance
weaknessesin major financial institutions, relatingto the rolesand
responsibilitiesof corporate boardsof directors(the―board‖), the
firm-wideriskmanagement function, and the independent assessment of
risk governance.
Without the appropriatechecksand balancesprovidedby theboard and
thesefunctions,a culture of excessiverisk-takingand leveragewas
allowedto permeatein many of thesefirms.
Thepeer review found that, sincethecrisis, national authorities have
takenseveralmeasurestoimproveregulatoryandsupervisoryoversight of
risk governanceat financial institutions.
Thesemeasuresincludedeveloping or strengtheningexistingregulation
or guidance, raisingsupervisory expectationsfor the risk management
function, engagingmore frequentlywiththeboard andmanagement, and
assessingthe accuracyand usefulnessof the information provided to the
boardtoenableeffectivedischarge of their responsibilities.
Nonetheless,more workis necessary.

Basel III monitoring questionnaire insights

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