Bini Smaghi presented the following implications for financial markets:
· Markets will be affected by the new regulation in several ways. One way is the categorisation of assets into liquid and illiquid assets for the numerator of the liquidity coverage ratio. The currently foreseen regulation includes cash, central bank deposits, and high-quality government securities in the ‘liquid assets’ category. Corporate and covered bonds are included with a haircut. The choice of the assets to be considered as liquid is consistent with the evidence during the recent crisis, which has confirmed that the degree of liquidity can vary enormously across markets in periods of stress.
· The implementation of the new liquidity standard is intended (and expected) to favour those assets that are counted as liquid, and at the same time reduce incentives to hold assets that are considered less liquid. This will affect the functioning of the underlying markets. In particular, the yields of liquid securities are expected to decline relative to those of illiquid ones, so that yield spreads between liquid and illiquid assets would become wider.
· It can be expected that the categorisation of assets into certain classes of liquidity will lead to a ‘cliff effect’, by which the regulatory categorisation of assets as either liquid or illiquid plays a crucial role for the future of their market. Moreover, it implies that changes in market conditions, such as a downgrade, can move assets from one category into the other, leading to sudden changes in banks’ fulfilment of the liquidity coverage ratio. This could make their fulfilment somewhat unpredictable.
· Another way in which different segments of financial markets will be affected in an asymmetric manner by the regulation is the maturity profile, which is key for the denominator of the liquidity coverage ratio. Since the denominator consists of expected outflows in a stress situation over the following 30 days, shorter-term funding that needs to be repaid within that period will be penalised relative to long-term funding. This is an intended effect. The implication is that the relative size of wholesale funding markets for different maturities will change.
Conclusions:
· The regulation proposed by the Basel Committee on Banking Supervision should not be assessed in isolation, but in the context of the comprehensive set of measures to strengthen the resilience of the financial sector and to reduce its overall level of risk. Real economic activity will profit from such increased stability and outweigh the direct cost of the regulation, especially in the long run.
· The new regulation will have an impact on banks’ liquidity management and the markets for liquidity along several dimensions. This is actually the aim of the regulation. Had the result been ‘business as usual’, this would have made some market participants quite happy, but would have been a sign of failure. There is the issue of gradualism and calibration, with a view to avoiding the two extremes – an excessively abrupt adjustment and an everlasting phasing-out. However it seems that this issue has been dealt with in a reasonable way.
· The changes in the financial system caused by the regulation will have to be factored in also by the policy authorities. For central banks, the changes may be far-reaching, ranging from the transmission mechanism of monetary policy to interactions with several aspects of the operational frameworks. The ECB is actively working on these issues to ensure that our monetary policy continues to be conducted in an effective way, also in the new environment, so as to maintain price stability, its primary goal.
© ECB - European Central Bank
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