Jean-Paul Redouin: Liquidity and transformation
Speech by Mr Jean-Paul Redouin, Deputy Governor of the Bank of France, at the General
Meeting of the French Association of Bank Treasurers (AFTB), Paris, 30 May 2011.
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Ladies and gentlemen,
It is a great pleasure for me to speak at this General Meeting of the AFTB. I would like to
take this opportunity to welcome the successful cooperation that has been established
between your association and the Banque de France. It is extremely beneficial for us and I
believe that you and your institutions also find it valuable.
In many respects, bank and market liquidity is a fascinating area because few phenomena
have been perceived in such different ways over such a short period of time. Indeed, market
liquidity became abundant and cheap in the 1980s: financial markets deepened and
transaction costs fell. In the 1990s, the growth of derivatives products facilitated the
management and transfer of risk. In the following decade and up to 2006, many studies had
already focused on excess liquidity. Then, during the financial crisis of 2007-2008, sources
of bank funding suddenly dried up. I would like to highlight some conclusions that can be
drawn from this crisis:
- First, the crisis reminded us that not only does liquidity have a price and that this
price could fluctuate greatly, but above all that liquidity cannot be taken for granted,
irrespective of the price that some market participants are willing to pay;
- Second, central banks rapidly and efficiently adjusted their operational frameworks
to provide liquidity to the financial system, re-establish the normal functioning of the
money market and restore confidence. But such measures must naturally remain
exceptional, and central banks must be vigilant about the signals and incentives
they give to the financial system.
- Third, due to its magnitude, the crisis has highlighted the risks associated with
excessive maturity transformation when long-term assets are funded by short-term
liabilities, or even funded overnight. This raises questions regarding both interest
rate risk management and liquidity risk management. While these are distinct areas,
they have close linkages. It is important not to have a short memory and relegate all
this to ancient history. Indeed, at present, in an environment of ongoing extremely
low interest rates, it is still possible to fund long-term assets at very low cost, with
the risk of creating further asset price bubbles. In this respect, the example of the
real estate sector seems telling. Housing loans have become highly important
commercial product and could prompt certain institutions to slash their profit margins
in order to win customer loyalty. Yet, such practices contribute to rapidly pushing up
property prices.
Thus, having observed that liquidity can disappear very rapidly, that central bank intervention
must remain exceptional and that excessive maturity transformation increases systemic risk,
a preventive approach is called for. Such an approach should take into account two aspects:
- I will start by discussing Basel III liquidity regulation, while stressing the fundamental
goal: reducing liquidity risk and limiting maturity transformation.
- Nevertheless, whatever changes are made to the regulatory framework, this
necessary but one-size-fits-all approach will still be inadequate if it is not
accompanied, or even preceded, by new policies to manage maturity transformation
by banks.
I. An overview of Basel III liquidity regulation
1. A fundamental goal: preventing excessive maturity transformation risks
Since banks are in the best position to reduce information asymmetries in credit markets,
select and monitor loans and diversify their asset portfolios, they are at the heart of maturity
transformation activities.
In traditional financial intermediation, banks collect savings and provide liquidity to the whole
economy through transactions on their balance sheets. To do this, they transform liquid
short-term liabilities into medium- to long-term assets with poor liquidity. This activity
generates well-known risks, in particular in terms of interest rates and liquidity. Maturity
transformation is therefore subject to prudential regulation to ensure that basic security rules
are followed.
At the Seoul Summit in November 2010, the G20 leaders endorsed the Basel III framework
that overhauls the current prudential regulatory regime. In particular, this is the role of the two
new liquidity ratios:
- The one-month liquidity ratio or Liquidity Coverage Ratio (LCR) has the two-fold
objective of preventing short-term liquidity shocks and requiring institutions to
selfinsure against liquidity shortages in order to limit refinancing exclusively via the
central bank. Institutions should in no way consider that they have a guarantee of
permanent access to such refinancing. In this respect, the use of foreign currency
funding is not always justified by the need to fund assets denominated in these
currencies in the absence of a sufficiently broad customer base in the countries
concerned. Such strategies are also used for arbitrage purposes. They contribute to
overall market liquidity but they must remain of a magnitude that allows institutions
to unwind positions in stressed market conditions. However, during complete
liquidity dry-ups some institutions became largely dependent on swap lines between
central banks, as was the case from the end of 2007 to the start of 2010. It is also
clear that the use of swap lines between central banks cannot be considered a
natural market adjustment. In this respect, it is advisable for banking supervisors to
have indicators that enable them to measure possible foreign currency mismatches,
without necessarily imposing a specific currency matching requirement.
- The one-year liquidity ratio or Net Stable Funding Ratio (NSFR), for its part, aims
to limit the risk of excessive maturity transformation such as illustrated by the failure
of Northern Rock. In practice, it is defined as the "available amount of stable
funding" over one year divided by the "required amount of stable funding" for one
year. The standard requires that the ratio be no lower than 100%.
2. A observation period necessary to calibrate these ratios
While the implementation of quantitative and harmonised rules at the international level
represents a major step forward, the calibration of these proposed ratios is not without
shortcomings.
As regards the one-month ratio, the composition of its numerator must be reviewed, that is to
say defining the high-quality liquid assets that are largely composed of government
securities. The sovereign debt crisis has shown us that caution is required when assessing
the degree of actual liquidity of certain debt instruments. Conversely, equities, which remain
liquid even under stressed market conditions, are not eligible for the numerator. Furthermore,
it is somewhat paradoxical that collateral eligible in normal times for central bank refinancing
operations - i.e. excluding non-standard measures - is not considered to come within the
Basel definition of liquid assets and is not fully eligible for the numerator of the ratio.
The one-year ratio raises many questions, including in terms of principles, in that it places
major constraints on certain maturity transformation activities. Also, can a one-size-fits-all
approach be applied to institutions worldwide even though their business models vary from
universal banking to specialised banking models (investment banks, custodians, etc.)? The
greatest attention will be therefore required when assessing the impact of this standard on
the financing of the economy.
To back up this somewhat critical observation, I would like to stress three points:
First, I wish to recall that central banks and supervisors are aware of the demands
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made on banks to implement the new regulations and we are regularly assessing
with them the technical details of these standards.
Second, a distinction must be made between the different measures set out in
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Basel III:
- those that are absolutely necessary, such as the increase of capital
charges for market activities, securitisation and counterparty credit risk
exposures, and,
- those, such as liquidity ratios, whose impact on the real economy must be
assessed ex ante. As regards the latter, a real observation period has been
scheduled to allow for any necessary changes. The current arrangements
should not be regarded as set in stone.
Third, while the proposed rules may appear harsh, we will ensure that a level
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playing field is achieved for their implementation. However, French institutions are
well-equipped to comply with them. The major French banks have no difficulties
raising funds in capital markets: to date, thanks to their size, ratings and reputation
they have maintained their funding capacity.
II. What are the avenues for improving the management of maturity
transformation risk?
The progress made in the reform of the prudential regulation of banks needs to be
accompanied by further reflection about the functioning of the financial system as a whole
and the different ways of improving the management of liquidity risks. That is why, as a
complement to the regulatory responses, banks need to take immediate action straightaway
regarding their internal risk management policies, which play a crucial role both in terms of
liabilities and assets. I would like to say a few words about this.
1. On the liabilities side
• First of all, it seems to me important to not wait for the final calibration of the new
rules to gradually increase the duration of bank liabilities. The management of
maturity gaps, which is the primary responsibility of treasurers and ALM managers,
cannot only be dictated by regulation; it also needs to be adapted to the risk profile
of each institution. In the current context, we can only encourage banks to increase
the proportion of medium- and long-term liabilities issued on the markets, so as to
be less dependent on more volatile sources of funding. They should also reduce as
far as possible their short-term vulnerability vis-à-vis unsecured market funding,
notably in foreign currencies.
Second, the treatment given to customer deposits in the one-month liquidity ratio
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could justify a form of reintermediation of money market funds and increased
competition in banks' deposit-taking. We are monitoring these developments very
closely. The asset management industry is indeed a sector where there is robust
activity that should not be destabilised. Moreover, the reintermediation of the
deposits of institutional clients and companies cannot be justified on the basis of
regulatory ratios (in view of the strict treatment of these deposits in the draft
regulations/reforms). Furthermore, the broadening of the deposit base of banks
should not happen at any price: we are monitoring developments in the
remuneration of deposits very closely.
Lastly, securing maturity transformation activities can be achieved by encouraging
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the use of stable sources of financing. I have just talked about deposit-taking, but I
should also mention the role played by the issuance of covered bonds. Backed by a
dedicated portfolio of underlying assets, these securities proved to be resilient
during the crisis and have since played an important role in the funding of European
banks.
2. On the assets side
The rebalancing of banks' liabilities structure is not sufficient on its own. In a general way,
banks would also benefit from systematically making sure that their maturity transformation
activities are profitable, by ensuring that the return provided by assets is proportional to the
risks incurred. I would like to stress here that the greatest vigilance is required when the
loans extended do not generate sufficient margins. This is the worrying trend that we are
seeing at the moment with respect to housing loans: margins on housing loans - veritable
loss leaders - are being compressed in order to attract customers who become captive due
to their borrowing. In these circumstances, the level of margins may not be sufficient to cover
the cost of the risk, or even the cost of the funding.
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I would like, finally, to underline the need for accurate traceability of funding flows. From this
perspective, improving the management of liquidity risk linked to OTC-traded derivatives
requires stronger supervision of markets and market participants. That is why the Banque de
France supports all of the initiatives taken to this end:
- the clearing through central counterparties (CCP) of all products deemed sufficiently
standardised. The management of margin calls and collateral is more robust here
than in OTC-trades;
- the recording of trades by dedicated infrastructures (trade repositories) in order to
identify all of the systemic players;
- extending the scope of regulation to include players that are part of the unregulated
or "shadow banking" sector.
Several reforms are already well under way as they correspond to G20 guidelines. The
United States adopted the Dodd-Frank Act in July 2010. At the European level, the draft
EMIR regulation should be adopted in summer 2011.
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By way of conclusion, I would like to stress the persistence of a number of warning signals
that are still present. For instance, leverage levels in the financial sector remain very high.
The current low interest rate environment is encouraging risky high-yield strategies; activity
on these high-yield markets is sustained; innovations on the ETF market are raising
questions and the commodity market is being financialised. The active management of these
new complex instruments is thus likely to reach its limits, as happened with CDOs.
The current challenge for central banks is two-fold: we need to improve our ability to monitor
risks at a system-wide level; we also need to re-establish the moral hazard that the
management of the crisis suspended. On their side, banks and market participants need to
ensure that they improve their risk management autonomously in order to reduce this
hazard, in the interests of their shareholders and depositors, but also of economic
development as a whole.
Thank you for your attention.