Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Basel Liquidity Regulation: Was It Improved with the 2013 Revisions?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Basel Liquidity Regulation: Was It Improved with the 2013 Revisions?

Article excerpt

One of the surprises of the 2007-09 financial crisis was how quickly global funding markets for financial institutions broke down. Negative news stories about the U.S. housing market started to appear in February 2007. In August 2007, funding from the interbank loan and asset-backed commercial paper markets suddenly dried up, soon followed by a breakdown in secured money markets. In reaction, central banks across the world provided liquidity on an unprecedented scale. The global intervention calmed markets, but only until the fall of Lehman Brothers in September 2008. The collapse of Lehman Brothers was followed by a systemic crisis in financial markets and the most severe recession since the Great Depression.

The distress in funding markets was amplified by preceding changes in the liquidity management practices of financial institutions, changes that had accelerated in the decade leading up to the crisis. On the asset side of their balance sheets, financial institutions relied increasing- ly on securities that were liquid in good times but could become illiq- uid under market-wide stress. On the liability side, the largest financial institutions relied increasingly on short-term, wholesale money market funding, such as overnight repurchase agreements, to fund long-term assets. The financial crisis, during which liquidity shocks at individual institutions led to a systemic crisis in financial markets, suggested to global financial regulators the need for greater liquidity regulation to complement simultaneous changes in capital regulation.

In December 2010, the Basel Committee for Banking Supervision, consisting of senior representatives of bank supervisory authorities and central banks, reached the Basel III Accord (following Basel I in 1988 and Basel II in 2004). Basel III introduced several standards designed to reduce the probability of systemic crises caused by liquidity distress at individual financial institutions. The most prominent of these stan- dards was a requirement that financial institutions maintain liquidity buffers: stocks of liquid assets sufficient to cover 30 days of cash out- flow in a "stress event."

The Accord was revised in January 2013, with new provisions regarding the size, composition and availability of liquidity buffers. This article finds that while the revised liquidity provisions of 2013 improved on the original 2010 provisions, there still are important shortcomings. Section I reviews liquidity management practices in the run-up to the recent financial crisis and their potential contribution to the crisis. Section II describes the rationale for liquidity buffers and the differences between the original and revised sets of provisions. Section III considers the importance of liquidity buffers' size, composition, and availability and, along each of these three dimensions, evaluates the 2013 revisions of the Basel III Accord relative to its original provisions.


Liquidity management is an everyday aspect of banking because banks finance long-term loans and other assets with short-term liabili- ties, such as deposits. Because deposits can be withdrawn at any time, banks must manage their liquidity to ensure they can satisfy deposit withdrawals without being forced to liquidate long-term, illiquid loans. To liquidate loans on short notice is usually costly or, in some cases, im- possible. The most traditional liquidity management method applied by commercial banks is the use of interbank loans and highly liquid securities such as U.S. Treasuries to insure against liquidity shocks.1

Starting in the late 1990s and increasingly in the 2000s, liquidity management in commercial banks changed dramatically These chang- es occurred particularly at the largest U.S. bank holding companies and European universal banks (which combine commercial and investment banking) and at the newly emerging "shadow banks" (financial institu- tions that perform bank-like activities but outside the scope of tradi- tional banking regulation and supervision). …

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