Bank regulation battle focuses on liquidity

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When UK regulators pressed ahead last year with requirements for banks to hold a buffer of easy-to-sell assets against a potential market crisis, bankers in London made no bones about their unhappiness.

They complained that the UK Financial Services Authority was making them uncompetitive by forcing them to hold low-yielding assets such as gilts and warned that the damage to their revenue would force them to reduce lending.

The UK, they said, should ease off and follow the lead of global regulators who agreed to give banks until 2015 to comply with liquidity rules.

Fast forward 12 months and many UK bankers now say privately they are relieved that the FSA was so insistent. While eurozone banks struggle to find funding in the money markets, UK banks have large stocks of safe assets that they can sell or use as collateral for overnight loans.

“Basel regulators should have pushed liquidity regulation right away,” says Enrico Perotti, a senior fellow at the Bank of England. “We wasted precious time. Now it is not even possible for some banks. The FSA did push, and UK banks are better off as a result.”

One UK banker admits ruefully: “It turned out not to be such a bad idea.”

UK regulators have also proved more flexible than the industry had feared – rather than insisting that each bank maintain its buffer at all times, the FSA has allowed banks to dip into their stocks to cover temporary funding squeezes, as long as the management has a credible plan to rebuild the base.

The Financial Policy Committee, the UK’s new stability regulator, has said that it wants “buffers [to] be usable. It would make no sense for banks to constrain lending . . . because they believed they could not run down their buffers even temporarily to cushion the shock.”

The UK’s practical experience with liquidity regulation has also proved valuable now that the Basel Committee on Banking Supervision is finalising the global rules. The Basel group met this month and a more senior committee will meet again in January to discuss how the global rules should work.

Essentially, the UK requires banks to hold enough gilts and cash to cover expected outflows during both a short sharp market shutdown and a less severe 90-day stress scenario. The global version uses a 30-day scenario and allows banks to include some high-quality corporate and covered bonds in their buffers.

But the industry has been lobbying hard to water down the requirements and broaden the definition of what counts towards the buffer.

“Liquidity is where we are going to see the biggest gap and the biggest effort in the next few months. Liquidity is just starting. That is going to be a much bigger issue in the weeks and months to come,” says Gerold Grasshoff, a partner at Boston Consulting Group, who works on regulatory issues.

Bankers argue that the current scenario is too harsh because it envisages bigger outflows than occurred during the 2008 crisis and that it unfairly penalises basic banking activities, such as corporate credit lines, that are crucial to economic recovery. They also want to be able to include a wider variety of assets in their liquidity buffers, such as equities.

Part of their concern is about profits. “It is a very straightforward P&L hit. You used to put your capital to work making loans at 15 per cent. Now you’ve got to get 0.48 per cent holding government bonds,” says Benedict James, partner at Linklaters.

But there are also practical concerns that some regulators share.

As the credit rating agencies downgrade more corporates and sovereigns, there is a growing shortage of “safe” assets. The eurozone woes have also highlighted the danger of forcing banks to stock up on local sovereign bonds – the downgrading of Greek and other peripheral eurozone bonds has undermined confidence in those countries’ banking systems and forced shaky institutions to seek new capital.

The 2008 crisis has also made some bankers enthusiastic about shares in big corporates. “When the market had to liquidate a lot of collateral, the easiest stuff to move, outside of G5 government bonds, was equities,” says Harry Samuel, chief executive of RBC Capital Markets.

Politicians are starting to weigh in on the side of the banks.

“Serious people are telling us that the regulators should address the liquidity squeeze by allowing banks to use more corporate debt and possibly equities and securitisations,” says Andrew Tyrie, chairman of the Treasury select committee, who has written to the FSA expressing his concern that the liquidity rules constrain lending.

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