Free Slides from Ed Dolan’s
Econ Blog http://dolanecon.blogspot.com/ More on Financial Reform and Basel III: Regulating Bank Liquidty Post prepared September 12, 2010 Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.

Basel III and Liquidity <ul><li>As
an earlier post explained, bank regulators of individual countries coordinate their work through the Basel Committee on Bank Supervision, an international group that meets in Basel, Switzerland </li></ul><ul><li>The committee is working on a new international agreement that will be called Basel III, replacing an earlier agreement, Basel II, that was found inadequate during the global financial crisis </li></ul><ul><li>The agreement will regulate bank capital, as discussed in the earlier post, and also bank liquidity, as discussed here </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Building of The Bank for International Settlements in Basel, Switzerland, where BCBS meetings are held Photo source: http://commons.wikimedia.org/wiki/File:BIZ_Basel_002.jpg

What is Liquidity? <ul><li>A financial
asset is said to be liquid if it can quickly and easily be converted to money without loss of nominal value </li></ul><ul><li>Coins and paper currency are the most liquid assets of all—they already are money </li></ul><ul><li>Safe, short-term government bonds and bank deposits are also very liquid </li></ul><ul><li>Assets like common stock, real estate, or production equipment are not very liquid </li></ul><ul><ul><li>Their market price (nominal value) is uncertain and changes constantly </li></ul></ul><ul><ul><li>They may take time to sell, and sales may be subject to large fees or commissions </li></ul></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Photo source: Nicole-Koehler, http://commons.wikimedia.org/wiki/File:Faucet.JPG

Why do Banks Need Liquidity?
<ul><li>Banks need liquidity because they cannot always control the timing of their needs for funds. Examples: </li></ul><ul><li>Depositors may decide to withdraw funds from their accounts without advance notice </li></ul><ul><li>Bank creditors may decide not to renew short-term wholesale funding as it matures </li></ul><ul><li>Line of credit agreements give customers the right to take out loans on short notice </li></ul><ul><li>Off-balance-sheet operations like third-party loan guarantees and complex derivative transactions create additional needs for liquid funds </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Headquarters of the bank BNP-Paribas in Paris, France Photo source: Tangopaso, http://commons.wikimedia.org/wiki/File:Siege_BNPP_rue_Taitbout.jpg

Liquidity Crises: Bank Runs <ul><li>Bank
runs are the classic form of liquidity crisis </li></ul><ul><li>If customers fear that a bank may not have enough assets to pay all depositors, the depositors run to the bank and stand in line to withdraw their money before the bank goes bust </li></ul><ul><li>As withdrawals deplete the bank’s liquid assets, the fear of failure can become self-fulfilling </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Bank run in Birmingham, England, September 2007 Photo source: Lee Jorndan, http://commons.wikimedia.org/wiki/File:Birmingham_Northern_Rock_bank_run_2007.jpg

Deposit Insurance as Protection Against
Runs <ul><li>Most advanced countries now use deposit insurance to reduce the risk of bank runs </li></ul><ul><li>If people know their deposits are insured, they do not need to worry about being first in line </li></ul><ul><li>However, insurance only covers deposits of retail customers. It does not protect large depositors or non-deposit liabilities like interbank loans </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ An FDIC deposit insurance sign from the 1930s. The maximum insurance is now $250,000 per depositor Photo source: Mathew Bixsantz, http://commons.wikimedia.org/wiki/File:FDIC_5000_sign_by_Matthew_Bisanz.JPG

Liquidity Crises: Fire Sales <ul><li>During
a liquidity crisis, a bank may deplete its reserves of liquid assets </li></ul><ul><li>The bank may be then forced raise new liquid funds by selling less liquid assets, like long-term securities and loans, at “fire sale prices”—prices below the value they would have if the bank held them to maturity </li></ul><ul><li>The resulting loss of value of assets, in turn, depletes the bank’s capital. When capital falls to zero or less, the bank becomes insolvent </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Photo source: Julia Manzerova, http://commons.wikimedia.org/wiki/File:Fire_Evacuation_Sale_%281186978688%29.jpg

Liquidity Crisis and Insolvency: Example
<ul><li>Suppose depositors unexpectedly withdraw $20,000 from a bank that starts with a healthy balance sheet </li></ul><ul><li>The first $10,000 of withdrawals can be covered from liquid cash reserves </li></ul><ul><li>The next $10,000 must be raised by selling loans, but under “fire sale” conditions, they only bring half of their previously listed book value </li></ul><ul><li>The loss from selling loans previously valued at $20,000 in order to raise just $10,000 in cash reduces capital from $8000 to -$2,000 </li></ul><ul><li>With less than zero capital, the bank is insolvent </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

How a Liquidity Spiral Spreads
the Crisis <ul><li>At the beginning of a crisis, liquidity problems may force a few weak banks to sell assets at fire sale prices </li></ul><ul><li>As market prices of loans, securities, and other assets fall, more banks suffer losses and erosion of capital </li></ul><ul><li>Those banks, in turn, are forced to sell assets in an attempt to safeguard their balance sheets </li></ul><ul><li>The spiral of losses, forced sales, and plunging market prices can create a liquidity crisis that spirals out of control </li></ul><ul><li>In the fall of 2008, a liquidity spiral of this kind helped spread the financial crisis throughout the world from its start in the U.S. subprime mortgage market </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ This dramatic NASA experiment used colored smoke to show how an airplane’s wingtip creates a rapidly spreading spiral vortex. Photo source: NASA, http://commons.wikimedia.org/wiki/File:Airplane_vortex_edit.jpg

What Kind of Regulations can
Reduce Liquidity Risk? <ul><li>Asset-side liquidity regulations </li></ul><ul><li>Excessive holdings of assets whose market value may plunge in a crisis are a source of liquidity risk </li></ul><ul><li>Regulations can require banks to hold minimum amounts of liquid assets </li></ul><ul><ul><li>Official reserves (cash and deposits at central banks) are banks’ first line of defense against liquidity problems </li></ul></ul><ul><ul><li>Additional liquid assets like short-term, high-quality government bonds provide further protection </li></ul></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Liability-side liquidity regulations </li></ul><ul><li>Liability-side liquidity risks arise when banks depend too much on “volatile” sources of funding </li></ul><ul><ul><li>Uninsured deposits </li></ul></ul><ul><ul><li>Short-term wholesale borrowing that may not be renewed in a crisis </li></ul></ul><ul><li>Regulations can require minimum levels of stable funding </li></ul><ul><ul><li>Retail deposits protected by deposit insurance </li></ul></ul><ul><ul><li>Medium and long-term borrowing </li></ul></ul><ul><ul><li>Capital </li></ul></ul>

Basel III: Proposed Liquidity Coverage
Regulation <ul><li>Proposals for the Basel III agreement include a regulation requiring a liquidity coverage ratio sufficient to guarantee that a bank could survive a 30-day stress period, allowing recovery or orderly wind-up </li></ul><ul><li>The liquidity coverage ratio is the ratio of liquid assets to estimated cash outflows under stress conditions </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Estimation of cash outflows is based on a stress test that considers what would happen in a crisis involving events such as: </li></ul><ul><li>Outflows of insured retail deposits </li></ul><ul><li>Downgrade of the bank’s credit rating </li></ul><ul><li>Loss of access to markets for short-term wholesale funding (e.g., interbank loans) </li></ul><ul><li>Collateral calls on derivatives or other off-balance-sheet obligations </li></ul>

Basel III: Proposed on Net
Stable Funding Regulation <ul><li>A further Basel III proposal has been a regulation requiring a net stable funding ratio of 100% or more </li></ul><ul><li>The net stable funding ratio is defined as the ratio of available stable funding to required stable funding </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ <ul><li>Available stable funding is a weighted average of liabilities, in which stable sources of funding, like insured retail deposits and capital, have high weights, and volatile funding, like short-term wholesale borrowing, have low weights </li></ul><ul><li>Required stable funding is a weighted average of assets, in which liquid assets like cash and government bonds have low weights and illiquid assets like loans and risky private securities have high weights </li></ul>

Will Basel III Succeed in
Reducing Liquidity Risk? <ul><li>The Basel III negotiations are to be completed by the end of 2010 </li></ul><ul><li>Final regulations are the object of tough negotiations among national governments and fierce lobbying by banking interests </li></ul><ul><li>A preliminary meeting in July, 2010, already weakened some proposals, for example, postponing the net stable funding regulation to allow several years of preliminary observations </li></ul><ul><li>The outcome of negotiations will be a key factor determining the timing and severity of the next financial crisis </li></ul>Post P100912 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/