Jeremy C Stein: Liquidity regulation and central banking
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the "Finding the right balance" 2013 Credit Markets Symposium, sponsored by
the Federal Reserve Bank of Richmond, Charlotte, North Carolina, 19 April 2013.
* * *
I'd like to talk today about one important element of the international regulatory reform
agenda - namely, liquidity regulation.1 Liquidity regulation is a relatively new, post-crisis
addition to the financial stability toolkit. Key elements include the Liquidity Coverage Ratio
(LCR), which was recently finalized by the Basel Committee on Banking Supervision, and the
Net Stable Funding Ratio, which is still a work in progress. In what follows, I will focus on the
LCR.
The stated goal of the LCR is straightforward, even if some aspects of its design are less so.
In the words of the Basel Committee, "The objective of the LCR is to promote the short-term
resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an
adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted
easily and immediately in private markets into cash to meet their liquidity needs for a
30 calendar day liquidity stress scenario."2 In other words, each bank is required to model its
total outflows over 30 days in a liquidity stress event and then to hold HQLA sufficient to
accommodate those outflows. This requirement is implemented with a ratio test, where
modeled outflows go in the denominator and the stock of HQLA goes in the numerator; when
the ratio equals or exceeds 100 percent, the requirement is satisfied.
The Basel Committee issued the first version of the LCR in December 2010. In January of
this year, the committee issued a revised final version of the LCR, following an endorsement
by its governing body, the Group of Governors and Heads of Supervision (GHOS). The
revision expands the range of assets that can count as HQLA and also adjusts some of the
assumptions that govern the modeling of net outflows in a stress scenario. In addition, the
committee agreed in January to a gradual phase-in of the LCR, so that it only becomes fully
effective on an international basis in January 2019. On the domestic front, the Federal
Reserve expects that the U.S. banking agencies will issue a proposal later this year to
implement the LCR for large U.S. banking firms.
While this progress is welcome, a number of questions remain. First, to what extent should
access to liquidity from a central bank be allowed to count toward satisfying the LCR? In
January, the GHOS noted that the interaction between the LCR and the provision of central
bank facilities is critically important. And the group instructed the Basel Committee to
continue working on this issue in 2013.
Second, what steps should be taken to enhance the usability of the LCR buffer - that is, to
encourage banks to actually draw down their HQLA buffers, as opposed to fire-selling other
less liquid assets? The GHOS has also made clear its view that, during periods of stress, it
would be appropriate for banks to use their HQLA, thereby falling below the minimum.
However, creating a regime in which banks voluntarily choose to do so is not an easy task. A
number of observers have expressed the concern that if a bank is held to an LCR standard
of 100 percent in normal times, it may be reluctant to allow its ratio to drop below 100 percent
when facing large outflows, even if regulators were to permit this temporary deviation, for
fear that a decline in the ratio could be interpreted as a sign of weakness.
My aim here is to sketch a framework for thinking about these and related issues. Among
them, the interplay between the LCR and central bank liquidity provision is perhaps the most
fundamental and a natural starting point for discussion. By way of motivation, note that
before the financial crisis, we had a highly developed regime of capital regulation for banks
- albeit one that looks inadequate in retrospect - but we did not have formal regulatory
standards for their liquidity.3 The introduction of liquidity regulation after the crisis can be
thought of as reflecting a desire to reduce dependence on the central bank as a lender of last
resort (LOLR), based on the lessons learned over the previous several years. However, to
the extent that some role for the LOLR still remains, one now faces the question of how it
should coexist with a regime of liquidity regulation.
To address this question, it is useful to take a step back and ask another one: What
underlying market failure is liquidity regulation intended to address, and why can't this market
failure be handled entirely by an LOLR? I will turn to this question first. Next, I will consider
different mechanisms that could potentially achieve the goals of liquidity regulation, and how
these mechanisms relate to various features of the LCR. In so doing, I hope to illustrate why,
even though liquidity regulation is a close cousin of capital regulation, it nevertheless
presents a number of novel challenges for policymakers and why, as a result, we are going
to have to be open to learning and adapting as we go.
The case for liquidity regulation
One of the primary economic functions of banks and other financial intermediaries, such as
broker-dealers, is to provide liquidity - that is, cash on demand - in various forms to their
customers. Some of this liquidity provision happens on the liability side of the balance sheet,
with bank demand deposits being a leading example. But, importantly, banks also provide
liquidity via committed lines of credit. Indeed, it is probably not a coincidence that these two
products - demand deposits and credit lines - are offered under the roof of the same
institution; the underlying commonality is that both require an ability to accommodate
unpredictable requests for cash on short notice.4
A number of other financial intermediary
services, such as prime brokerage, also embody a significant element of liquidity provision.
Without question, these liquidity-provision services are socially valuable. On the liability side,
demand deposits and other short-term bank liabilities are safe, easy-to-value claims that are
well suited for transaction purposes and hence create a flow of money-like benefits for their
holders.5 And loan commitments are more efficient than an arrangement in which each
operating firm hedges its future uncertain needs by "pre-borrowing" and hoarding the
proceeds on its own balance sheet; this latter approach does a poor job of economizing on
the scarce aggregate supply of liquid assets.6
3
Although bank liquidity was not regulated prior to the crisis, it played an important part in the supervisory
process. For example, in the CAMELS ratings used by supervisors, the "L" stands for "liquidity."
4
For an elaboration of this argument, see Anil K. Kashyap, Raghuram Rajan, and Jeremy C. Stein (2002),
"Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit-Taking," Journal of
Finance, vol. 57 (February), pp. 33-73.
5
See Gary Gorton and George Pennacchi (1990), "Financial Intermediaries and Liquidity Creation," Journal of
Finance, vol. 45 (March), pp. 49-71. Demand deposits may also represent a form of insurance against
liquidity shocks, as argued in Douglas W. Diamond and Philip H. Dybvig (1983), "Bank Runs, Deposit
Insurance, and Liquidity," Journal of Political Economy, vol. 91 (June), pp. 401-19.
6
See Bengt Holmström and Jean Tirole (1998), "Private and Public Supply of Liquidity," Journal of Political
Economy, vol. 106 (February), pp. 1-40.
At the same time, as the financial crisis made painfully clear, the business of liquidity
provision inevitably exposes financial intermediaries to various forms of run risk. That is, in
response to adverse events, their fragile funding structures, together with the binding liquidity
commitments they have made, can result in rapid outflows that, absent central bank
intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether.
And fire sales and bank failures - and the accompanying contractions in credit availability -
can have spillover effects to other financial institutions and to the economy as a whole. Thus,
while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows,
they may not hold enough because, although they bear all the costs of this buffer stocking,
they do not capture all of the social benefits, in terms of enhanced financial stability and
lower costs to taxpayers in the event of failure. It is this externality that creates a role for
policy.
There are two broad types of policy tools available to deal with this sort of liquidity-based
market failure. The first is after-the-fact intervention, either by a deposit insurer guaranteeing
some of the bank's liabilities or by a central bank acting as an LOLR; the second type is
liquidity regulation. As an example of the former, when the economy is in a bad state,
assuming that a particular bank is not insolvent, the central bank can lend against illiquid
assets that would otherwise be fire-sold, thereby damping or eliminating the run dynamics
and helping reduce the incidence of bank failure.
In much of the literature on banking, such interventions are seen as the primary method for
dealing with run-like liquidity problems. A classic statement of the central bank's role as an
LOLR is Walter Bagehot's 1873 book Lombard Street. More recently, the seminal theoretical
treatment of this issue is by Douglas Diamond and Philip Dybvig, who show that under
certain circumstances, the use of deposit insurance or an LOLR can eliminate run risk
altogether, thereby increasing social welfare at zero cost.7 To be clear, this work assumes
that the bank in question is fundamentally solvent, meaning that while its assets may not be
liquid on short notice, the long-run value of these assets is known with certainty to exceed
the value of the bank's liabilities.8 One way to interpret the message of this research is that
capital regulation is important to ensure solvency, but once a reliable regime of capital
regulation is in place, liquidity problems can be dealt with after the fact, via some
combination of deposit insurance and use of the LOLR.
It follows that if one is going to make an argument in favor of adding preventative liquidity
regulation such as the LCR on top of capital regulation, a central premise must be that the
use of LOLR capacity in a crisis scenario is socially costly, so that it is an explicit objective of
policy to economize on its use in such circumstances. I think this premise is a sensible one.9
A key point in this regard - and one that has been reinforced by the experience of the past
several years - is that the line between illiquidity and insolvency is far blurrier in real life than
it is sometimes assumed to be in theory. Indeed, one might argue that a bank or
brokerdealer that experiences a liquidity crunch must have some probability of having solvency
problems as well; otherwise, it is hard to see why it could not attract short-term funding from
the private market.
This reasoning implies that when the central bank acts as an LOLR in a crisis, it necessarily
takes on some amount of credit risk. And if it experiences losses, these losses ultimately fall
on the shoulders of taxpayers. Moreover, the use of an LOLR to support banks when they
get into trouble can lead to moral hazard problems, in the sense that banks may be less
prudent ex ante. If it were not for these costs of using LOLR capacity, the problem would be
trivial, and there would be no need for liquidity regulation: Assuming a well-functioning
capital-regulation regime, the central bank could always avert all fire sales and bank failures
ex post, simply by acting as an LOLR.
This observation carries an immediate implication: It makes no sense to allow unpriced
access to the central bank's LOLR capacity to count toward an LCR requirement. Again, the
whole point of liquidity regulation must be either to conserve on the use of the LOLR or in the
limit, to address situations where the LOLR is not available at all - as, for example, in the
case of broker-dealers in the United States.10
At the same time, it is important to draw a distinction between priced and unpriced access to
the LOLR. For example, take the case of Australia, where prudent fiscal policy has led to a
relatively small stock of government debt outstanding and hence to a potential shortage of
HQLA. The Basel Committee has agreed to the use by Australia of a Committed Liquidity
Facility (CLF), whereby an Australian bank can pay the Reserve Bank of Australia an
upfront fee for what is effectively a loan commitment, and this loan commitment can then be
counted toward its HQLA. In contrast to free access to the LOLR, this approach is not at
odds with the goals of liquidity regulation because the up-front fee is effectively a tax that
serves to deter reliance on the LOLR - which, again, is precisely the ultimate goal. I will
return to the idea of a CLF shortly.
The design of regulation
Once it has been decided that liquidity regulation is desirable, the next question is how best
to implement it. In this context, note that the LCR has two logically distinct aspects as a
regulatory tool: It is a mitigator, in the sense that holding liquid assets leads to a better
outcome if there is a bad shock; it is also an implicit tax on liquidity provision by banks, to the
extent that holding liquid assets is costly. Of course, one can say something broadly similar
about capital requirements. But the implicit tax associated with the LCR is subtler and less
well understood, so I will go into some detail here.
An analogy may help to explain. Suppose we have a power plant that produces energy and,
as a byproduct, some pollution. Suppose further that regulators want to reduce the pollution
and have two tools at their disposal: They can mandate the use of a pollution-mitigating
technology, like scrubbers, or they can levy a tax on the amount of pollution generated by the
plant. In an ideal world, regulation would accomplish two objectives. First, it would lead to an
optimal level of mitigation - that is, it would induce the plant to install scrubbers up to the
point where the cost of an additional scrubber is equal to the marginal social benefit, in terms
of reduced pollution. And, second, it would also promote conservation: Given that the
scrubbers don't get rid of pollution entirely, one also wants to reduce overall energy
consumption by making it more expensive.
A simple case is one in which the costs of installing scrubbers, as well as the social benefits
of reduced pollution, are known in advance by the regulator and the manager of the power
plant. In this case, the regulator can figure out what the right number of scrubbers is and
require that the plant install these scrubbers. The mandate can therefore precisely target the
optimal amount of mitigation per unit of energy produced. And, to the extent that the
scrubbers are costly, the mandate will also lead to higher energy prices, which will
encourage some conservation, though perhaps not the socially optimal level.11 This latter
effect is the implicit tax aspect of the mandate.
A more complicated case is when the regulator does not know ahead of time what the costs
of building and installing scrubbers will be. Here, mandating the use of a fixed number of
scrubbers is potentially problematic: If the scrubbers turn out to be very expensive, the
regulation will end up being more aggressive than socially desirable, leading to
overinvestment in scrubbers and large cost increases for consumers; however, if the
scrubbers turn out to be cheaper than expected, the regulation will have been too soft. In
other words, when the cost of the mitigation technology is significantly uncertain, a regulatory
approach that fixes the quantity of mitigation is equivalent to one where the implicit tax rate
bounces around a lot.
By contrast, a regulatory approach that fixes the price of pollution instead of the quantity
- say, by imposing a predetermined proportional tax rate directly on the amount of pollution
emitted by the plant - is more forgiving in the face of this kind of uncertainty. This approach
leaves the scrubber-installation decision to the manager of the plant, who can figure out what
the scrubbers cost before deciding how to proceed. For example, if the scrubbers turn out to
be unexpectedly expensive, the plant manager can install fewer of them. This flexibility
translates into less variability in the effective regulatory burden and hence less variability in
the price of energy to consumers.12
Scrubbers and high-quality liquid assets
What does all this imply for the design of the LCR? Let's work through the analogy in detail.
The analog to the power plant's energy output is the gross amount of liquidity services
created by a bank - via its deposits, the credit lines it provides to its customers, the prime
brokerage services it offers, and so forth. The analog to the mitigation technology - the
scrubbers - is the stock of HQLA that the bank holds. And the analog to pollution is the net
liquidity risk associated with the difference between these two quantities, something akin to
the LCR shortfall. That is, when the bank offers a lot of liquidity on demand to its customers
but fails to hold an adequate buffer of HQLA, this is when it imposes spillover costs on the
rest of the financial system.
In the case of the power plant, I argued that a regulation that calls for a fixed quantity of
mitigation - that is, for a fixed number of scrubbers - is more attractive when there is little
uncertainty about the cost of these scrubbers. In the context of the LCR, the cost of
mitigation is the premium that the bank must pay - in the form of reduced interest income -
for its stock of HQLA. And, crucially, this HQLA premium is determined in market equilibrium
and depends on the total supply of safe assets in the system, relative to the demand for
those assets. On the one hand, if safe HQLA-eligible assets are in ample supply, the
premium is likely to be low and stable. On the other hand, if HQLA-eligible assets are scarce,
the premium will be both higher and more volatile over time.
This latter situation is the one facing countries like Australia, where, as I noted earlier, the
stock of outstanding government securities is relatively small. And it explains why, for such
countries, having a price-based mechanism as part of their implementation of the LCR can
be more appealing than pure reliance on a quantity mandate. When one sets an up-front fee
for a CLF, one effectively caps the implicit tax associated with liquidity regulation at the level
of the commitment fee and tamps down the undesirable volatility that would otherwise arise
from an entirely quantity-based regime.
Moreover, it bears reemphasizing that having a CLF with an up-front fee is very different from
simply allowing banks to count central-bank-eligible collateral as HQLA at no charge. Rather,
the CLF is like the pollution tax. For every dollar of pre-CLF shortfall - that is, for every dollar
of required liquidity that a bank can't obtain on the private market - the bank has to pay the
commitment fee. So even if there is not as much mitigation, there is still an incentive for
conservation, in the sense that banks are encouraged to do less liquidity provision, all else
being equal. This would not be the case if the CLF were available at a zero price.
What about the situation in countries where safe assets are more plentiful? The analysis
here has a number of moving parts because in addition to the implementation of the LCR,
substantial increases in demand for safe assets will arise from new margin requirements for
both cleared and noncleared derivatives. Nevertheless, given the large and growing global
supply of sovereign debt securities, as well as other HQLA-eligible assets, most estimates
suggest that the scarcity problem should be manageable, at least for the foreseeable future.
In particular, quantitative impact studies released by the Basel Committee estimate that the
worldwide incremental demand for HQLA coming from both the implementation of the LCR
and swap margin requirements might be on the order of $3 trillion.13 This is a large number,
but it compares with a global supply of HQLA-eligible assets of more than $40 trillion.14
Moreover, the eligible collateral for swap margin is proposed to be broader than the LCR's
definition of HQLA - including, for example, certain equities and corporate bonds without any
cap. If one focuses just on U.S. institutions, the incremental demand number is on the order
of $1 trillion, while the sum of Treasury, agency, and agency mortgage-backed securities is
more than $19 trillion.15
While this sort of analysis is superficially reassuring, the fact remains that the HQLA premium
will depend on market-equilibrium considerations that are hard to fully fathom in advance,
and that are likely to vary over time. This uncertainty needs to be understood, and respected.
Indeed, the market-equilibrium aspect of the problem represents a crucial distinction between
capital regulation and liquidity regulation, and it is one reason why the latter is particularly
13
To be more precise, global incremental demand coming from swap margin requirements is estimated at
$1.24 trillion; see Basel Committee on Banking Supervision and Board of the International Organization of
Securities Commissions (2013), Margin Requirements for Non-Centrally Cleared Derivatives: Second
Consultative Document (Basel: Bank for International Settlements and IOSCO, February). Of this $1.24 trillion,
$810 billion reflects margin (net of collateral already collected) on uncleared swaps, and $420 billion reflects
margin on swaps that will migrate to central clearing. In addition, global incremental demand coming from the
LCR is estimated at $2.39 trillion; see Basel Committee on Banking Supervision (2012), Results of the
Basel III Monitoring Exercise as of 30 June 2011 (Basel: Bank for International Settlements, April). However
this latter number is based on the December 2010 version of the LCR; the recalibration of the LCR in the
January 2013 final version will reduce this value for U.S. banks by roughly one-third. Extrapolating this result
to the global level suggests that incremental demand resulting from the LCR will fall by roughly $800 billion to
$1.6 trillion.
14
Committee on the Global Financial System (forthcoming), Asset Encumbrance, Financial Reform and the
Demand for Collateral Assets (Basel: Bank for International Settlements).
15
According to Federal Reserve Board flow of funds data, as of December 31, 2012 the total stock of U.S.
Treasury securities stood at $11.6 trillion, and the total stock of agency debt and mortgage-backed securities
stood at $7.5 trillion. A caveat here is that agency mortgage-backed securities are considered Level 2 assets,
so they can count for at most 40 percent of any bank's total holdings of HQLA.
challenging to implement. Although capital regulation also imposes a tax on banks - to the
extent that equity is a more expensive form of finance than debt - this tax wedge is, to a first
approximation, a fixed constant for a given bank, independent of the scale of overall financial
intermediation activity. If Bank A decides to issue more equity so it can expand its lending
business, this need not make it more expensive for Bank B to satisfy its capital requirement.
In other words, there is no scarcity problem with respect to bank equity - both A and B can
always make more. By contrast, the total supply of HQLA is closer to being fixed at any point
in time.16
Policy implications
What does all of this imply for policy design? First, at a broad philosophical level, the
recognition that liquidity regulation involves more uncertainty about costs than capital
regulation suggests that even a policymaker with a very strict attitude toward capital might
find it sensible to be somewhat more moderate and flexible with respect to liquidity. This
point is reinforced by the observation that when an institution is short of capital and can't get
more on the private market, there is really no backup plan, short of resolution. By contrast, as
I mentioned earlier, when an institution is short of liquidity, policymakers do have a backup
plan in the form of the LOLR facility. One does not want to rely too much on that backup
plan, but its presence should nevertheless factor into the design of liquidity regulation.
Second, in the spirit of flexibility, while a price-based mechanism such as the CLF may not
be immediately necessary in countries outside of Australia and a few others, it is worth
keeping an open mind about the more widespread use of CLF-like mechanisms. If a scarcity
of HQLA-eligible assets turns out to be more of a problem than we expect, something along
those lines has the potential to be a useful safety valve, as it puts a cap on the cost of
liquidity regulation. Such a safety valve would have a direct economic benefit, in the sense of
preventing the burden of regulation from getting unduly heavy in any one country.
Perhaps just as important, a safety valve might also help to protect the integrity of the
regulation itself, by harmonizing costs across countries and thereby reducing the temptation
of those most hard-hit by the rules to try to chip away at them. Without such a safety valve, it
is possible that some countries - those with relatively small supplies of domestic HQLA - will
find the regulation considerably more costly than others. If so, it would be natural for them to
lobby to dilute the rules - for example, by arguing for an expansion in the type of assets that
can count as HQLA. Taken too far, this sort of dilution would undermine the efficacy of the
regulation as both a mitigator and a tax. In this scenario, holding the line with what amounts
to a proportional tax on liquidity provision would be a better outcome.17
One situation where liquid assets can become unusually scarce is during a financial crisis.
Consequently, even if CLFs were not counted toward the LCR in normal times, it might be
appropriate to count them during a crisis. Indeed, while the LCR requires banks to hold
sufficient liquid assets in good times to meet their outflows in a given stress scenario, it
implicitly recognizes that if things turn out even worse than that scenario, central bank
liquidity support will be needed. Allowing CLFs to count toward the LCR in such
circumstances would acknowledge the importance of access to the central bank, and this
access could be priced accordingly.
Finally, a price-based mechanism might also help promote a willingness of banks to draw
down their supply of HQLA in a stress scenario. As I noted at the outset, one important
concern about a pure quantity-based system of regulation is that if a bank is held to an LCR
standard of 100 percent in normal times, it may be reluctant to allow its ratio to fall below
100 percent when facing large outflows for fear that doing so might be seen by market
participants as a sign of weakness.
By contrast, in a system with something like a CLF, a bank might in normal times meet
95 percent of its requirement by holding private-market HQLA and the remaining 5 percent
with committed credit lines from the central bank, so it would have an LCR of exactly
100 percent. Then, when hit with large outflows, it could maintain its LCR at 100 percent, but
do so by increasing its use of central bank credit lines to 25 percent and selling 20 percent of
its other liquid assets.18
This scenario would be the sort of liquid-asset drawdown that one
would ideally like to see in a stress situation. Moreover, the central bank could encourage
this drawdown by varying the pricing of its credit lines - specifically, by reducing the price of
the lines in the midst of a liquidity crisis. Such an approach would amount to taxing liquidity
provision more in good times than in bad, which has a stabilizing macroprudential effect.
This example also suggests a design that may have appeal in jurisdictions where there is a
relatively abundant supply of HQLA-eligible assets. One can imagine calibrating the pricing
of the CLF so as to ensure that lines provided by central banks make up only a minimal
fraction of banks' required HQLA in normal times - apart, perhaps, from the occasional
adjustment period after an individual bank is hit with an idiosyncratic liquidity shortfall. At the
same time, in a stress scenario, when liquidity is scarce and there is upward pressure on the
HQLA premium, the pricing of the CLF could be adjusted so as to relieve this pressure and
promote usability of the HQLA buffer. Such an approach would respect the policy objective of
reducing expected reliance on the LOLR while at the same time allowing for a safety valve in
a period of stress. The limit case of this approach is one where the CLF counts toward the
LCR only in a crisis.
Conclusion
By way of conclusion, let me just restate that liquidity regulation has a key role to play in
improving financial stability. However, we should avoid thinking about it in isolation; rather,
we can best understand it as part of a larger toolkit that also includes capital regulation and,
importantly, the central bank's LOLR function. Therefore, proper design and implementation
of liquidity regulations such as the LCR should take account of these interdependencies. In
particular, policymakers should aim to strike a balance between reducing reliance on the
LOLR on the one hand and moderating the costs created by liquidity shortages on the other
hand - especially those shortages that crop up in times of severe market strain. And, as
always, we should be prepared to learn from experience as we go.