Earlier this week New York Federal Reserve Bank President and Chief Executive Officer William Dudley gave a speech entitled, "Basel and the Wider Financial Stability Agenda," in `Remarks at the 2010 Institute of International Finance Annual Membership Meeting, Washington, D.C.. Dudley said, "Over the past year, important new regulatory initiatives have been advanced both at the national and international level. These include the recent agreement in Basel on stronger capital and liquidity standards for internationally active banks and the considerable regulatory changes embodied in the Dodd-Frank Act (DFA)."
He commented, "Turning next to the new Basel liquidity requirement, the new standard will likely necessitate a significant adjustment in behavior for those banks that historically relied on short-term wholesale funding and those that had negligible buffers but instead had relied on the Federal Reserve and the Federal Home Loan Bank System to be their liquidity backstops. However, the transition costs are likely to be quite manageable because, as was the case for the capital standards, there are many margins available for adjustment."
Dudley continued, "Before I assess the transition costs of the liquidity coverage ratio (LCR) standard, a few words about what the LCR is intended to do and how it operates. The notion behind the LCR standard is that large, internationally active financial institutions should have a liquidity buffer that enables them to operate for 30 days in a stress environment without having to rely on government support, including central bank liquidity backstops. Banks would have to have sufficient liquid assets that they could sell to be able to meet outflows stemming from deposit withdrawals; bank debt that matures and is unable to be rolled over; and drawdowns from committed credit and liquidity facilities provided to financial firms and other entities. The size of the required liquidity buffer depends, in part, on the maturity of the bank's assets and liabilities, the stickiness of its deposit liabilities, the amount of irrevocable liquidity backstops and composition of its assets."
He explained, "The adjustment costs associated with the LCR standard should be low because, like capital, there are different, relatively low-cost ways to adjust to the standards. For example, because the liquidity buffer only needs to last for 30 days, a bank that extends the maturity of its short-term wholesale borrowing or its deposit liabilities by a month or two will find that this goes a long way in helping to meet this standard. Banks could also cut the level of their backstop liquidity lines and other commitments to financial firms. The standard assumes that such lines of credit can be fully drawn upon and thus, count as potential draws against the buffer."
Dudley also said, "Because the common international liquidity standards are relatively untested, regulators are implementing LCR with an 'observation period.' What this means is that unanticipated and unintended consequences generated by the new liquidity standard will be closely scrutinized and, if necessary, adjustments will be made to the rules if undesirable effects become evident over time. For example, the tough requirements on backstop liquidity lines could potentially be modified if such rules generated unintended negative consequences for short-term corporate funding markets, such as the nonfinancial corporate commercial paper market."
Later in the speech, he commented, "In all of the reforms that we are implementing it is important that we pay close attention to the shadow banking system. By shadow banks, I mean the largely unregulated financial entities that take credit risk and/or engage in maturity transformation without access to explicit governmental backstops such as the Federal Reserve's discount window and or deposit insurance. As we saw in the crisis, without such support, these institutions are vulnerable to runs. When this occurred, the shadow banking sector imploded in a way that imposed significant costs on the regulated sector."
Finally, Dudley added, "The risk is that tighter capital and liquidity requirements for the large financial institutions could push much of the business of credit intermediation and maturity transformation from the regulated sector to the unregulated sector. However, this risk is mitigated by the fact that shadow banks heavily rely on credit support and liquidity lines from the regulated sector. The costs of such facilities will be affected by the new capital and liquidity standards for banks. Thus, the economics of the shadow-banking sector are likely to change in a way that makes such activities less attractive. In addition, by increasing transparency and requiring some risk retention by issuers, Dodd-Frank should make the securitization markets in which shadow banks operate less likely to support poorly underwritten credit. Taken together, these changes mean it is less likely that there will be widespread movement of credit and maturity transformation from the regulated sector to the unregulated sector. Nonetheless, as my colleague Governor Tarullo noted in a recent speech, more will need to be done to increase the stability of the unregulated sector, and developments in this area will need to be scrutinized carefully in the years ahead."
