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Before the financial crisis in 2008, asset markets were liquid and funding was easily available at low cost. However, the emergence of the crisis showed how rapidly market conditions can change, leading to a situation that several institutions – regardless of appropriate capital levels – experienced severe liquidity issues, forcing either an intervention by the responsible central bank or a shutdown of the institution.
As response to this crisis, the Basel Committee for Banking Supervision drafted a new regulatory framework (henceforth Basel III) with the purpose to achieve a more stable and less vulnerable banking system. Besides new rules for capital and leverage, the framework also specifies a short- and a long-term liquidity requirement as key concepts to reinforce the resilience of banks to liquidity risks.
Given the high run-off assumptions of interbank loans and the implied requirement to hold large amounts of liquid assets to balance these outflows, some observers are concerned that the LCR (Liquidity Coverage Ration) makes interbank loans relatively less attractive and thus hampers the effectiveness of monetary policy. Other observers argue that there would be no direct effect of the LCR on interbank loans with maturities shorter than 30 days, which make the largest part of the unsecured interbank money market. The reason for this is that any outflow (inflow) would be compensated by the respective inflow (outflow) within the LCR's 30-day horizon. For loans with maturities longer than 30 days, no repayments would occur within the horizon of the LCR and therefore these loans would have a direct effect.
The unsecured interbank money market plays an important role in the allocation and distribution of liquidity among financial institutions. According to Allen and Carletti (2008), the interbank money market allows liquidity to be easily transferred from banks with a surplus to banks with a deficit. Apart from this general function for the entire financial market, the ECB, the Federal Reserve and the Bank of England rely on the interbank money market interest rate as operating targets in monetary policy implementation.
Hence, some observers argue that a decrease of volumes or an increase of the interest rates in the unsecured interbank money market would negatively affect the liquidity distribution and therefore the liquidity risk exposure of banks, as well as the effectiveness of monetary policy.
However, because the interbank market was a critical source of contingent liquidity risk during the recent crisis, some of these implications on the interbank money market are intended and it is very likely that the positive effects of reducing banks' dependence on the short-term interbank market outweigh its potential negative implications on monetary policy.
Implications for the LCR
The purpose of the LCR is to increase banks’ liquidity risk bearing capacity under short-term liquidity shocks. The past crisis has shown that this is necessary. A quantitative liquidity rule will lead to the emergence of a more stable and resilient banking system, including a lower probability of banking and financial crises.
In particular, the current proposals regarding the European banking union show that harmonised regulation is necessary. This is not just true due to fact that a European Banking Union will lead to European supervision but also that the LCR is likely to reduce taxpayers’ costs of banking crises and bailouts of large institutions.
In order to tackle the unintended consequences, regulators should clarify the usage of the LCR's liquidity buffer alongside with establishing an extended buffer definition during stress.
Allowing banks to use their liquid asset buffer (and therefore to fall temporarily below their liquidity requirement) during stress would dampen the negative effects of a quantitative liquidity requirement on the interbank money market. The reason for this is that if banks can use their liquid assets to cover outflows (as actually intended by the LCR), the liquidity requirement would be less binding with banks facing fewer incentives to increase interest rates and cut lending. A similar effect can be expected when extending the definition of liquid assets during stress. A potential extension would make it easier for banks to comply with their liquidity requirement, again making the rule less binding and thereby reducing its negative effects during stress on the interbank money market and, more importantly, on the effectiveness of monetary policy.