In response to the recent financial crisis, the Basel Committee on Banking Supervision has drafted a new regulatory framework (henceforth Basel III) with the aim to achieve a more robust banking system. While it also tightens the existing requirements for capital, the proposal stands out as it is the first to attempt harmonised liquidity regulation across the globe. Specifically, the framework includes the short-term Liquidity Coverage Ratio (Liquidity Coverage Ratio) and the long-term Net Stable Funding Ratio. The Liquidity Coverage Ratio requires financial institutions to hold high-quality liquid assets at least equal to their net cash outflows over a 30-day stress scenario.
The purpose of the Liquidity Coverage Ratio is to incentivise banks to hold larger liquidity buffers and to shift their funding mix towards longer maturities. An increase in the importance of longer-term markets might impact monetary-policy implementation. The Group of Governors and Heads of Supervision also decided that, since deposits with central banks are the most reliable form of liquidity, the interaction between the Liquidity Coverage Ratio and the provision of central bank facilities is critically important, and the Basel Committee on Banking Supervision will therefore continue to work on this issue (Bank for International Settlements 2013). Governor Jeremy C. Stein of the Federal Reserve Board also noted in a recent speech that while liquidity regulation is desirable, the interplay between the Liquidity Coverage Ratio and central bank liquidity provision is perhaps the most fundamental issue, and a natural starting point for further work regarding the Liquidity Coverage Ratio. Contributing to this discussion, this column presents the results of our recent working paper, in which we analyse banks’ behavioural reactions to the introduction of the Dutch quantitative liquidity requirement, and the impact on monetary-policy implementation (Bonner and Eijffinger 2013).
Our analysis is a follow up of an earlier column, in which we argue that a liquidity requirement leads to increased interest rates and reduced lending volumes in the unsecured interbank money market (Bonner and Eijffinger 2012). While we confirm these results, it might only be one part of the story. Re-using the same dataset on the Dutch quantitative liquidity requirement, we specifically distinguish between short-term and long-term loans when analysing the impact of a liquidity requirement on interbank markets.
What is the issue?
In many jurisdictions, the central bank relies on the overnight rate at which financial institutions lend central bank reserves to one another as operating targets for monetary-policy implementation. A bank with a liquidity deficiency has stronger incentives to obtain long-term interbank funding and is more likely to borrow from the central bank's standing facility. Both of these actions help a bank to fulfil its reserve requirement and thus lower the need to access overnight markets. This lower demand for overnight loans may drive down the corresponding interest rate, whereas the increased demand for long-term funding is likely to steepen the short end of the yield curve. Bech and Keister (2013) argue that in such a situation, central banks can no longer follow the standard procedure for monetary-policy implementation, as there is no amount of reserve supply that will yield an overnight rate equaling the target rate.
A primer on the Dutch quantitative liquidity requirement
Similar to the Liquidity Coverage Ratio, the Dutch quantitative liquidity requirement is based on classic liquidity ‘coverage’ considerations used by banks and some national supervisory authorities. Banks are required to hold an amount of unencumbered high-quality liquid assets at least equal to their net cash outflows over a 30-day stress period.
Under both regimes, interbank loans with maturities shorter than 30 days do not help banks to eliminate a regulatory liquidity deficiency. The reason for this is that any loan with a corresponding maturity shorter than 30 days comes due within the 30-day horizon, and therefore not only increases a bank’s available liquidity but also its cash outflows.
By contrast, interbank loans with maturities longer than 30 days can help a bank to reach its regulatory threshold, as the repayment occurs outside the 30-day horizon. In light of this special feature, Bech and Keister (2013) argue that the introduction of such a liquidity requirement makes interbank loans with maturities longer than 30 days relatively more valuable.1
Relative and absolute effects on interest rates
Our analysis is in line with this theory, suggesting that the introduction of a liquidity requirement causes banks to pay and charge higher interest rates for unsecured interbank loans with maturities longer than the requirement’s 30-day horizon. Similarly, banks seem to borrow more and grant fewer long-term loans. However, we do not find evidence of decreasing overnight rates. Rather, our analysis shows an increase in short-term lending rates and no effect on short-term borrowing rates. The increase in short-term lending rates is likely to be caused by the institution’s increased marginal costs of funds due to the introduction of a liquidity requirement, and its intention to at least partially pass on these costs to clients. We attribute the insignificance of the liquidity requirement on short-term borrowing rates to the fact that our sample does not include an aggregate liquidity shortage. Although a liquidity requirement might reduce the relative value of overnight funding, reduced demand by only a few institutions is unlikely to drive down overnight rates.
Conclusions and aggregate shortages
The impact of the Liquidity Coverage Ratio depends crucially on the aggregate regulatory liquidity shortage. While a bank can set its overnight lending rate in response to increased marginal costs of funds individually, it is likely not be able to affect its overnight borrowing rate. Whether the aggregate overnight rate increases or decreases – which would affect monetary policy implementation – therefore depends on the aggregate liquidity gap. In case only a few banks have to eliminate a liquidity deficiency, our analysis suggests that short-term lending rates will increase while short-term borrowing rates will be unaffected. However, once a considerable share of banks falls below the threshold, the aggregate reaction of banks might drive down overnight interest rates.
By clarifying that banks are expected to actually use their liquidity buffers during stress, the Basel Committee on Banking Supervision made the occurrence of aggregate shortages less likely and in a way more predictable. Central banks, on the other hand, are advised to closely monitor banks’ compliance with the Liquidity Coverage Ratio and take into account the interaction with the Liquidity Coverage Ratio when conducting monetary policy operations. Whether or not further measures (such as the recognition of committed central bank facilities in the Liquidity Coverage Ratio) are needed crucially depends on the economic and legal context in which they take their effect. Answering this question, however, is beyond the scope of this column.
Bank for International Settlements (2013), “Group of Governors and Heads of Supervision endorses revised liquidity standard for banks”, Press release, 6 January.
Basel Committee on Banking Supervision (2013), “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools”.
Bech, M and Keister, T (2013), “The Liquidity Coverage Ratio and monetary policy implementation”, BIS Quarterly Review, December: 49–61.
Bonner, C and S C W Eijffinger (2012), “Basel liquidity rules and their impact on the interbank money market”, VoxEU.org, 13 October.
Bonner, C and S C W Eijffinger (2013), “The Impact of the Liquidity Coverage Ratio on Financial Intermediation”, CEPR Discussion Paper 9124.
De Nederlandsche Bank (2003), “Regulation on liquidity under the Wft”.
Stein, J C (2013), “Liquidity Regulation and Central Banking”, Speech at the “Finding the Right Balance” Credit Markets Symposium sponsored by the Federal Reserve Bank of Richmond, Charlotte, NC.
1 It is important to point out that the difference between short-term and long-term loans is only significant in case of the Liquidity Coverage Ratio requirement being at least 100%. As long as the requirement is below 100%, a bank can increase its ratio by attracting short-term funding despite the fact that they are considered to entirely flow out within the 30-day horizon. The reason for this is that if both an institution’s liquid assets and its outflows increase, the Liquidity Coverage Ratio asymptotically approaches 100%. Having said this, individual supervisors might not allow banks to take such steps. This, however, is caused by prudent liquidity supervision rather than the Liquidity Coverage Ratio.