Misdiagnosis of Crisis has led to Botched Liquidity Regulation

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Representatives of Shadow Financial Regulatory Committees (comprising independent academics) from around the world met recently in Japan to discuss financial regulation developments since the Global Financial Crisis and issued the attached statement. In the statement they argue that the Basel liquidity requirements for banks are overly complex and that more emphasis should be placed on disclosure of simpler measures of liquidity and consequent market discipline rather than a regulatory requirement.

The Basel Committee’s response to the 2008-2009 financial crisis is based on a misdiagnosis. The lack of recognition of losses from the original subprime crisis delayed the recovery and economies worldwide are still suffering the consequences. The fundamental cause of this recent crisis was insolvency problems in the U.S. and Europe rather than lack of liquidity.  For example, it was uncertainty about which banks had large exposure to bad assets that led to a collapse in the functioning of the interbank money markets. We also observed a significant widening in the credit risk spreads between bank-issued paper and the government issued alternative.

Banking regulatory agencies have recently put forward quantitative liquidity requirements based on the continued misunderstanding of the role that liquidity problems, relative to solvency problems, played in the recent financial crisis.  Indeed the U.S. regulatory authority just announced the final implementing regulation for the liquidity coverage ratio last Thursday for large US banks.  The Shadow Committees believe that liquidity problems were symptomatic of underlying solvency problems. Hence, what is needed is not a regulation of minimum required liquidity but a clear indicator of the liquidity deficiency of an institution. The Committees instead have an alternative proposal for measurement and disclosure of liquidity that would rely on an indicator that encourages transparency of an institution’s short term funding needs and its ability to meet those needs from its liquid assets without extraordinary reliance on central bank funding.

Imposing binding liquidity requirements as a means of buying time to deal with a troubled institution facing insolvency may increase the problem, which ultimately may spill over to the rest of the banking sector. Central banks still need to fulfill the traditional role of the lender of last resort for all solvent institutions that need temporary liquidity assistance. In the global financial crisis, such temporary facilities became protracted because the underlying solvency problems were not recognized and addressed.


Download the Statement: Misdiagnosis of Crisis has led to Botched Liquidity Regulation


About the Australia-New Zealand Shadow Financial Regulatory Committee

The ANZSFRC meets approximately twice every year in one of the major cities in Australia and New Zealand. The ‘shadow’ function of the Committee is related to its purpose of following and analysing critically the existing and evolving regulatory framework for financial institutions and markets. The Committee is fully independent of the providers, regulators and supervisors of financial services whose behaviour it aims to evaluate.

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