Liquidity, not capital, is what regulators should be focusing on warned Mr Mark Sheppard, Principal of Hydrargyros and former MD Client Solutions and Advisory at National Australia Bank at an Australian Centre for Financial Studies Boardroom Briefing on Thursday.
While the Murray Inquiry’s Interim Report identifies further increases in capital requirements for systemically important financial institutions as a potential option to improve financial system stability, Sheppard suggests a better solution would be designing funding instruments that assist banks to better match the duration of assets and liabilities.
Sheppard proposes a seemingly simple solution to the stability problem faced by banks – remove maturity transformation all together. He notes that this could be achieved by having bank customers exchange their currency for long-dated market rate certificate of deposits (mCDs) rather than on call deposits. The mCDs could be traded in a secondary market with other participants and ideally, could one day, also be traded for goods and services like a currency. “To remove complexity in the product the mCD would always trade at par value however the rate of return paid on the mCD would be determined by the market and fluctuate with the credit quality of the underlying bank.”
In a compelling presentation, Mr Sheppard explored the history of banking crises, beginning with Gran Tavola Siena in 1298. He noted that “while solvency concerns may be one of a number of triggers of a crisis, invariably the underlying problem has always been liquidity.” This results from what has been considered a primary role of banks, ‘Maturity Transformation’, or borrowing short and lending long.
Sheppard questions the acceptance of maturity transformation as a key function of banks noting the correlation between maturity transformation and banking crises has been widely recognised since Walter Badgehot’s seminal work, ‘Lombard Street: A Description of the Money Market’ published in 1873. A view shared by Professor John Cochrane of the University of Chicago who famously stated “of course, risk and maturity ‘transformation’ are fallacies. Maturity and credit risk can be sliced and diced, pooled and tranched, but they cannot be removed.”
The primary mechanism that has been brought in post-Lombard Street to address the liquidity risk of banks has been the lender of last resort function of Central Banks. Sheppard observes that despite this measure “there has been, on average, a run somewhere in the world every seven years since 1900.”
While Basel III addresses liquidity risk in banks through the new ‘liquidity coverage ratio’, requiring banks to hold the equivalent of 30 days liquidity needs in high quality liquid assets. Sheppard suggests this measure is doomed to fail because unlike other risks which may follow something resembling a bell curve, liquidity is either there or it is not. Similarly, he notes the effectiveness of the Net Stable Funding ratio depends on the perhaps dubious assumption that retail deposits are stable.
Changing the nature of bank deposits, Sheppard argues, would absolve banks of liquidity risk, remove the need for maturity transformation, and let banks focus on their core competencies: credit, interest rate and FX risk.
A webcast of the Boardroom Briefing is available via the links below