What Binds? Interactions between Bank Capital and Liquidity Regulations

We present a simplified framework in which the risk-weighted capital ratio, the leverage ratio, the liquidity coverage ratio, and the net stable funding ratio are all related to a small set of fundamental bank balance sheet characteristics. Using this framework, we then examine the interactions among the requirements to help understand which are likely to bind and how they affect banks’ business models. Our analysis allows us to conclude that the two liquidity requirements almost surely will never bind at the same time and helps us to understand how stress tests can change which capital requirement binds. Introduction The regulatory framework embodied in Basel III constrains the composition of banks’ balance sheets. It has four parts. Two are related to capital and two to liquidity. The capital regulations include a riskweighted requirement that forces banks that have riskier assets to hold more capital, as well as an unweighted leverage requirement that ties the level of capital to the overall size of the bank (including off-balance sheet items). These rules, which are designed to ensure sufficient buffers should banks face losses, are the outgrowth of decades of experience dating back to the original agreements in 1975. In describing the early days of the Basel Committee, Charles Goodhart (2011) notes that the original intent was to have a liquidity requirement to complement the capital requirement. But international agreement proved elusive until the completion of Basel III in 2010. Current standards include two liquidity regulations, the liquidity coverage ratio and the net stable funding ratio. These rules are intended to ensure that banks can withstand funding reductions such as deposit withdrawals or liquidity demands arising from off-balance sheet activities. The development and calibration of the four capital and liquidity regulations has largely proceeded independently. While the officials understand the interactions – for example, that higher capital levels reduce liquidity needs – there has been little attempt to study the full interactions among all four. The purpose of this short paper is to provide a stylized framework for examining the overall impact of the regulatory system. The main contribution is to describe how the requirements interact so that we can * Cecchetti is Professor of International Economics at the Brandeis International Business School, Research Associate at the National Bureau of Economic Research, and Research Fellow at the Centre for Economic Policy Research. Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago Booth School of Business; an external member of the Financial Policy Committee of the Bank of England, and Research Associate at the National Bureau of Economic Research. Prepared for inclusion in “The Changing Fortunes of Central Banking” which consists of essays inspired by the work of Charles Goodhart. We thank Charles for the many lessons he has taught us about central banking and financial regulation. We also acknowledge comments from the editors and valuable feedback from several senior private sector bankers who prefer not to have their names or firms identified. The views here are purely our own and should not be associated with any institutions with which we are affiliated. Any mistakes are entirely our responsibility. 1 See Basel Committee on Banking Supervision (2011). 2 See Basel Committee on Banking Supervision (2013, 2014). Cecchetti & Kashyap What Binds? November 2016 2/8 study why and when which of them is likely to bind. These observations can be helpful understanding how both how bank business models may evolve and how different types of banks will perform in different stress scenarios. Before getting to the details of our stylized model, it is useful to review the rationale for the structure of the rules. To understand this, we need to think about the fundamental functions of a bank. Following Pozsar, Adrian, Ashcroft and Boesky (2012), these are credit transformation, liquidity transformation, maturity transformation, and access to the payments system. Each transformation function generates returns by divorcing the characteristics of the assets from those of the liabilities: credit transformation produces assets that are riskier than liabilities; liquidity transformation, creates liabilities that are more liquid than the assets; and maturity transformation, generates assets that are longer term than liabilities. And access to the payments system comes from providing liabilities that are accepted as payment. A traditional bank performs all of these intermediation functions— funding long-term, illiquid, risky assets with short-term, liquid, safe liabilities. A combination of limited liability and the government safety net (in the form of deposit insurance and other implicit guarantees), can mean that a bank’s owners and managers reap the benefits of their success but may not bear the full costs of their failures, so this creates incentives to engage in too much credit transformation, too much liquidity transformation, and too much maturity transformation; too much relative to what society ideally needs. Conversely, if information problems hamper the ability of a bank to issue equity, then the scale of intermediation could be lower than society would prefer. Mandating higher capital ratios in this situation could allow them to issue equity that would be free of adverse selection and increase the amount of intermediation. So regardless of whether decentralized allocations lead to too little or too much intermediation, one can imagine a role for regulation. The liquidity requirements attend to concerns with the levels of liquidity and maturity transformation, with the liquidity coverage ratio (LCR) aimed at the former and the net stable funding ratio (NSFR) at the latter. The capital requirements simply say that equity must be greater than a fraction of the sum of assets, weighted or unweighted by their riskiness. The liquidity requirements are different. The LCR says that a weighted sum of assets must be greater than a weighted sum of liabilities. And NSFR reverses this, stating that a weighted sum of liabilities must be greater than a weighted sum of assets. As we will see, the fact that the LCR and NSFR effectively reverse the inequality between assets and liabilities creates some complications. A stylized bank balance sheet To start, consider a bank that has a variety of assets on and off the balance sheet, some liabilities, and capital. It is useful at the outset to divide the assets into to three types: relatively safe, high-quality liquid assets; on-balance-sheet risky assets; and off-balance sheet assets. Since the safe assets include reserves, we label them as R. We take there to be n risky assets, which we label Ai. And the q offbalance sheet assets (converted to the same units as those on the balance sheet) are labelled OBSAj. We assume there are three types of liabilities: deposits Ds, bonds Bk and equity E. The division of liabilities between deposits and bonds is a short-hand. Deposits are those liabilities that are runnable, so they that are subject to the liquidity coverage ratio (LCR). And bonds are long-term liabilities that are the primary source of available stable funding in the computation of the net stable funding ratio (NSFR) – so Cecchetti & Kashyap What Binds? November 2016 3/8 “core deposits” would be bonds in our nomenclature. Using this notation, a bank’s balance sheet looks like this: Table 1: A General Bank Balance Sheet Assets Liabilities R