Before the financial crisis in 2008, asset markets were liquid and funding was easily available at low cost. However, the emergence of the crisis showed how rapidly market conditions can change, leading to a situation that several institutions – regardless of appropriate capital levels – experienced severe liquidity issues, forcing either an intervention by the responsible central bank or a shutdown of the institution.
As response to this crisis, the Basel Committee for Banking Supervision drafted a new regulatory framework (henceforth Basel 3) with the purpose to achieve a more stable and less vulnerable banking system. Besides new rules for capital and leverage, the framework also specifies a short- and a long-term liquidity requirement as key concepts to reinforce the resilience of banks to liquidity risks.
The Liquidity Coverage Ratio (LCR) is a short-term ratio, which requires financial institutions to hold an amount of highly liquid assets1 at least equal to their net cash outflows2 over a 30-day stress period. The introduction of an internationally harmonised quantitative liquidity requirement is a unique supervisory step and apart from a few exceptions, there is wide consensus about the rationale and merits of the LCR.
But what are the potential unintended side effects of a quantitative liquidity requirement? Given the high run-off assumptions of interbank loans3 and the implied requirement to hold large amounts of liquid assets to balance these outflows, some observers4 are concerned that the LCR makes interbank loans relatively less attractive and thus hampers the effectiveness of monetary policy. Other observers argue that there would be no direct effect of the LCR on interbank loans with maturities shorter than 30 days, which make the largest part of the unsecured interbank money market. The reason for this is that any outflow (inflow) would be compensated by the respective inflow (outflow) within the LCR's 30-day horizon. For loans with maturities longer than 30 days, no repayments would occur within the horizon of the LCR and therefore these loans would have a direct effect. This column presents the results of our recent working paper (Bonner and Eijffinger 2012) in which we show the effects of the Dutch quantitative liquidity requirement on the unsecured interbank money market.
The role of the interbank money market
Before assessing the effects of a quantitative liquidity rule on the interbank market, it is useful to understand the role of the interbank money market in general, and especially its role for monetary policy implementation.
The unsecured interbank money market plays an important role in the allocation and distribution of liquidity among financial institutions. According to Allen and Carletti (2008), the interbank money market allows liquidity to be easily transferred from banks with a surplus to banks with a deficit. Apart from this general function for the entire financial market, the ECB, the Federal Reserve and the Bank of England rely on the interbank money market interest rate as operating targets in monetary policy implementation.5
Hence, some observers argue that a decrease of volumes or an increase of the interest rates in the unsecured interbank money market would negatively affect the liquidity distribution and therefore the liquidity risk exposure of banks, as well as the effectiveness of monetary policy.
However, because the interbank market was a critical source of contingent liquidity risk during the recent crisis, some of these implications on the interbank money market are intended and it is very likely that the positive effects of reducing banks' dependence on the short-term interbank market outweigh its potential negative implications on monetary policy.
The LCR and the unsecured interbank money market
As proxy of the LCR, we examined banks' liquidity holdings using monthly data of the prudential Dutch quantitative liquidity rule DLCR (See DNB (2003)). While there are a few minor differences, the treatment of interbank loans is equal under the LCR and the DLCR. We combine the DLCR data with confidential data on interbank borrowing and lending in the Dutch interbank money market in order to analyse whether banks which are just below/above (henceforth close) their quantitative liquidity requirement behave differently than their peers further away from the threshold (henceforth far).
Our analysis reveals that close banks charge significantly higher interest rates for loans in the unsecured interbank money market. We also find that this effect is even bigger for longer maturities and during the most severe stress from mid-2008 until early 2009 (See Figure 1 top).
With respect to lending volumes it becomes evident that during normal times there is no clear pattern, while with the start of the first turmoil in 2007 and especially after the failure of Lehman Brothers, close banks reduce lending more drastically than their peers and remain until today clearly below banks further away from the threshold (Figure 1 bottom). For lending volumes, maturities are less important.
Generally speaking our results suggest that the current design of the LCR is likely to increase interest rates and reduce volumes in the interbank money market, which potentially hampers the implementation of monetary policy. However, the LCR is designed to reduce banks’ dependence on the volatile interbank money market and therefore some of these implications are intended.
Figure 1. Different behaviour of close and far banks with respect to interest rates (top) and lending volumes (bottom)
Note: The figure shows the behavioral difference between banks which are just above/below (close) their quantitative liquidity requirement and their peers further away from the threshold (far). The red lines refer to close banks while the dark green lines refer to far banks. The upper figure shows volume weighted monthly interest rates while the lower figure reflects the percentage of total lending in relation to total assets.
Implications for the LCR
The purpose of the LCR is to increase banks’ liquidity risk bearing capacity under short-term liquidity shocks. The past crisis has shown that this is necessary. A quantitative liquidity rule will lead to the emergence of a more stable and resilient banking system, including a lower probability of banking and financial crises.
In particular, the current proposals regarding the European Banking Union show that harmonised regulation is necessary. This is not just true due to fact that a European Banking Union will lead to European supervision but also that the LCR is likely to reduce taxpayers’ costs of banking crises and bailouts of large institutions.
In order to tackle the unintended consequences, regulators should clarify the usage of the LCR's liquidity buffer alongside with establishing an extended buffer definition during stress.
Allowing banks to use their liquid asset buffer (and therefore to fall temporarily below their liquidity requirement) during stress would dampen the negative effects of a quantitative liquidity requirement on the interbank money market. The reason for this is that if banks can use their liquid assets to cover outflows (as actually intended by the LCR), the liquidity requirement would be less binding with banks facing fewer incentives to increase interest rates and cut lending. A similar effect can be expected when extending the definition of liquid assets during stress. A potential extension would make it easier for banks to comply with their liquidity requirement, again making the rule less binding and thereby reducing its negative effects during stress on the interbank money market and, more importantly, on the effectiveness of monetary policy.
Allen, F and E Carletti (2008), “Interbank Market Liquidity and Central Bank Intervention”, prepared for the Carnegie-Rochester Series on Public Policy Conference in November 2008.
Bonner, C and SCW Eijffinger (2012), “The Impact of the LCR on the Interbank Money Market”, CEPR Discussion Paper No. 9124.
Cœuré, B (2012), “The importance of money markets”, speech at the Morgan Stanley 16th Annual Global Investment seminar, Tourrettes, Provence, 16 June.
King, M (2012), “Speech at the Lord Major’s Banquet for Bankers and Merchants of the City of London at the Mansion House”, 14 June.
Schmitz, SW (2011), “The Impact of the Basel III Liquidity Standards on the Implementation of Monetary Policy”.
DNB (2003), “Regulation on liquidity under the Wft”.
1 For example (not exhaustive) cash, central bank reserves or highly rated government bonds.
2 Net cash outflows are calculated as difference between assumed outflows and contractual inflows under a 30-day stress scenario.
3 For comparison, interbank loans with maturities of less than 30 days are assumed to run-off with 100% while retail deposits receive a run-off rate between 5% and 10%. In order to comply with the LCR, banks are therefore required to hold an amount of liquid assets equal.
4 See for instance King (2012) or Cœuré (2012).
5 See for example Schmitz (2011).