What Regulators Should Consider When Rethinking Liquidity Rules Post-SVB

Unknown Jul 05, 2023

In recent years, bank liquidity rules have taken a back seat to other parts of the regulatory framework, such as capital. The most re cent major overhauls to the post-Global Financial Crisis liquidity framework were finalized at the Basel level in 2014 and were subsequently implemented around the world. That framework consists of the net stable funding ratio, the liquidity coverage ratio, and in the U.S. also includes internal liquidity stress test ing requirements. Following implementation of the framework, policymakers’ attention has focused mostly on other elements of regulation; remarks in Septe mber 2022 by Federal Reserve Vice Chair for Supervision Michael Barr describe those priorities: a holistic review of the capital framework, implementation of t he Basel finalization package, and several other priorities such as resolution, bank merger policy review, stablecoins, financial risks from climate change, in novation, access, and consumer protection and the Community Reinvestment Act.

Liquidity, however, has taken on new urgency among regulators a nd other stakeholders after liquidity risk contributed to recent bank failures. Potential changes to the liquidity framework have emerged in Congressional test imony, regulators’ speeches and oversight reports. Below is a sampling of these suggestions:

• “The Federal Reserve gene rally does not require additional [capital or] liquidity beyond regulatory requirements for a firm with inadequate capital planning, liquidity risk management, or governance and controls. We need to change that in appropriate cases.
• “We should re-evaluate the stability of uninsured deposits and the treatment of held-to-maturity securities in our standardized liquidity rules and in a firm’s internal liquidity stress tests.”
&l t;li>“We should also consider applying standardized liquidity requirements to a broader set of firms.”
• “The standard l iquidity risk metrics in the RBO portfolio were likely not appropriate for a bank like SVB.”
• “Stronger resiliency requirements for large banks with regard to capital and liquidity would have reduced the probability of their failures.”
• “Legal documents an d collateral arrangements for the discount window should be in place well before any funding need arises.

Liquidity regulation is important because it comes with high benefits and high costs, and complex because there are no easy tradeoffs.  A fully liquid bank makes no loans an d does not engage in the core function of banking – borrowing short-term and making long-term loans; a bank that holds no liquid assets and relies solely on government support in the face of a run creates significant moral hazard.

The wide range of liquidity changes under consideration, the hi gh stakes involved, and the complexity of the task present a perfect case for the agencies to invite public input through an advance notice of proposed rulemak ing or a request for information. ANPRs or RFIs are sometimes used at earlier stages of the rulemaking process as a necessary step to gather more information b efore determining an appropriate regulatory response. While they are two separate tools available to the agencies, the distinction between them is largely one of form over function, and using either to obtain public input would be a welcome alternative to reconsidering the liquidity framework behind closed doors and moving straight to a proposed rule to change it. A “holistic” review of the liquidity framework would serve the public well, so long as it reflects public input.

Broad Stakeholder Engagement is Particularly Valuable in the Context of Liquidity PolicyAny changes to the liquidity framework must appropriately weigh the costs that any requirements will impose on both banks and their customers.&nb sp; One of the fundamental roles banks play in the economy is liquidity transformation:  banks fund themselves with demandable deposits and invest in illiquid assets, like small business loans and mortgages, which fuel the American economy and help Americans build wealth.  Reducing banks’ liqu idity risks through more stringent liquidity regulations would reduce banks’ ability to perform this crucial role if such changes include expanding requi rements to hold high amounts of high-quality liquid assets.  The Bank for International Settlements estimates that compliance with the NSFR alone has reduced GDP permanently by 8 basis points, and that at current levels of capital, the social cost of the NSFR outweighs the social benefit. A BIS review of the literature reported findings that compliance with the LCR reduces the supply of bank credit by 3 to 6 percent. These findings do not mean that liquidity frame work changes should be out of the question, but they provide a note of caution that such changes should be carefully crafted to avoid harming banks’ abil ity to support the economy. Policymakers should strike a delicate balance between promoting financial stability and preserving banks’ role as crucial int ermediaries.

Regulators are understandably more focused on the financial stability side of this balancing act.  As we’ve seen with recent bank failures, regulators receive blame when the risks that are inherent in banking lead some banks to fail.  The public is never going to criticize bank regulators because their policies have caused U.S. GDP to grow by 1 percent rather than 1.08 percent in any given year.  Thus, regulat ors are understandably biased toward ever more resilient banks.  That is exactly why the perspectives of a diverse range of stakeholders – banks , academics, legislators, other market participants, and critically, bank customers – should be part of the discussion.

Stakeholder Input is Most Meaningful at the Early Stages of Policy Development

Policymakers should begin con sidering broad stakeholder input from the earliest stage. Soliciting feedback from all relevant parties at the earliest stage of any holistic review will best position regulators to avoid unintended consequences that might result from changes to liquidity regulations.  For example, a natural and intuitive in itial reaction to the SVB failure was to call for increased LCR requirements, i.e., additional HQLA requirements, particularly for banks over $100 billion in a ssets.  But this would not have solved the problem and could even have exacerbated the challenges on SVB’s balance sheet. As we have pr eviously explained, increasing SVB’s HQLA requirement would simply have led it to shift its investments slightly toward longer-term Treasuries and Ginnie Maes and slightly away from Fannies and Freddies, leaving its total holdings of these securities unchanged and doing nothing about the interest rate risk that led to its failure.  Collecting thoughts and ideas from a broad set of stakeholders will best position regulators to craft revisions that a ppropriately mitigate liquidity risk while fostering economic activity and avoiding unintended consequences.

Therefore, the public interest w ould be well served by regulators issuing a formal request for information or an advance notice of proposed rulemaking as part of any holistic liquidity review .  This type of comment process would enable the public to provide the information that would be most helpful to the agencies as they begin to conside r revisions, spark interesting and productive public discourse, and create the broadest opportunity for stakeholder engagement at the point in the rulemaking p rocess at which various thoughts and ideas could meaningfully inform the ultimate proposal.

An RFI or ANPR with respect to liquidity policy c hanges would likewise enable all stakeholders to improve the agencies’ understanding of the relative costs and benefits of different alternatives under c onsideration.

Once a proposed rule has been issued, it is rare that the agencies make significant changes to the structure or framework of th e regulation prior to its finalization. Given the scope of potential changes being considered, as well as the relative speed with which proposed changes may be issued in response to recent bank failures, limiting time for public input and discussion in advance of a proposed rule, it is imperative that the agencies is sue an ANPR or RFI to allow for a more comprehensive public discussion.  In fact, the agencies could go further than an ANPR or RFI given liquidity&rs quo;s importance, and host a public conference and series of stakeholder meetings to get feedback from those that would be most affected by changes to the liqu idity framework. Importantly, soliciting a broad range of perspectives would also ensure that a holistic review is in fact holistic.