Liquidity squeeze : Lynn Strongin Dodds

UpDown_500x400Just when you think the well has run dry in the regulator’s pool, a new piece of legislation is finalised that tightens the noose around the banks even more. This is certainly the case in the US where institutions are coming to terms with the Federal Reserve’s freshly minted set of stringent liquidity rules. The aim is to make the world a safer place but it may also mean that banks become even more constrained in their lending activity, which not only puts a damper on their performance but also the broader economy.

The liquidity rule is the first in a new series of restrictions targeting how banks fund loans and other daily operations. The US is taking a much harder line than the Basel III global agreement by forcing banks to hold enough safe assets to cover 100% of their net cash outflows to survive the worst day of a 30-day crisis. Under Basel they need enough liquidity to survive the last day of a crisis-ridden month.

There are different categories. The behemoths with over $250bn in assets will have to go the 30 day distance while smaller banks — those with over $50 bn but less than $250 bn — have a shorter time frame and will only have to keep enough to cover 21 days. Banks with less than $50 bn and nonbank financial firms deemed by regulators as posing a potential threat to the system will not be subject to the requirements.

The impact will of course be different. The Federal Reserve estimated that the systemically important banks would need to hold $2.5 trn in highly liquid assets by 2017, and that they would have a gap of about $100 bn if that threshold applied today. While the coffers of the behemoths such as Bank of America Merrill Lynch and their contemporaries are plentiful, the shortfall will largely affect super-regional banks and some asset custodians.

No one disagrees with the drivers. They are the same that have dictated much of the post financial crisis regulation – to ensure that the financial system is well protected and to prevent firms buckling like Lehman and Bear Stearns. The problem is with the inevitable unintended consequences. It is good to have a buffer but the stockpiling of ultra-safe assets could act as a drag on bank earnings due to the low returns generated. It may also trigger a loss of appetite to lend as the economy strengthens because banks would not want to divert any money away from their buffer.

The result would be weak market liquidity and significantly higher borrowing costs for local governments, businesses and consumers. It’s a fine balancing act between protection and growth but sometimes the pendulum can swing too far.

Lynn Strongin Dodds