Basel III liquidity options

The Australian dilemma is that, even with a shift of the government budget into deficit for some foreseeable future, past years of surpluses mean that there is unlikely to be sufficient federal or state government debt to meet bank LCR demands. While, in aggregate, there may be enough debt on issue, the demands of other fixed interest investors (both domestic and foreign) mean that there will be strong competition – pushing government yields down. Good for the government, but not for the holders!

The response has been to obtain Basel approval for the “Australian solution” (also relevant for a few other countries in good fiscal shape). This involves banks being able to meet their LCR “gap” by inclusion of liquidity facilities, which they obtain for a “fair” fee from the RBA.

An Assessment of the LCR Requirement

The approach adopted places the onus for liquidity insurance upon the banking sector and private financial markets. The LCR approach does not envisage the banking system relying (at least initially) upon the safety valve of RBA liquidity provision via repurchase agreements etc. The logic of the approach can be questioned, in so far as it applies to system wide crisis scenarios rather than individual bank difficulties.

Consider a situation in which a liquidity crisis occurs and banks respond by selling their holdings of government securities. Such widespread action will push the prices of those securities down and their yields up, which is unlikely to be a desirable outcome in such a situation from the perspective of the RBA. Consequently, there is likely to be RBA operations in the cash market to inject liquidity by purchasing government debt or by repurchase agreements based on those or other eligible securities.

Consequently, the merits of an approach which assumes that the market can ensure enough liquidity in a crisis situation seems contradictory to the likely outcome, when the only ultimate provider of liquidity – the Central Bank – is likely to have to act. To the extent that this is the case, the exclusion of other repo-eligible securities from the LCR calculation can be questioned.

To the extent that the LCR is aimed at ensuring individual bank liquidity adequacy in a time of individual stress, there are also some questions that should be posed. First, are requirements based on a system-wide stress scenario appropriate? Second, the exclusion of a range of private sector assets from the calculation seems less warranted since their values would be little impacted by sales by one bank only.

The dilemma here is that the LCR appears to be one instrument aimed at achieving two objectives – one being individual bank liquidity adequacy in a single-name stress situation and the other being system wide liquidity adequacy in a generalized crisis scenario. A long standing tenet of policy formulation is that at least as many instruments are required as there are objectives if those objectives are to be fully met, rather than being constrained by a trade-off.

A number of other important issues arise from the planned implementation of the LCR.

Deposit Insurance Coverage: The stress scenario gives a very low “run-off” rate to insured deposits. The more is insured deposit funding, the lower will be the hypothetical scenario cash outflow and thus the lower required HQLA holdings. The higher is the “cap” decided upon for the Financial Claims Scheme (currently $1 million and to be re-set by October 2011). The higher will be the proportion of deposits that fall into this category.

The Australian Solution:
 There is a fundamental difference in the underlying philosophy implied by the solution to a shortage of HQLA of allowing banks to fill a LCR gap through contracted liquidity facilities at the RBA. Specifically, it allows for liquidity requirements to be met partially by having in place arrangements for tapping this RBA liquidity safety valve – rather than requiring liquidity protection to be purely by way of bank sales of liquid assets into the private markets.

The ultimate, aggregate, outcome may not be too different. If instead, in the absence of that facility, all banks are unloading government securities in a crisis and pushing prices down and yields up, the RBA may be compelled to step into the market as a buyer to meet its interest rate targets.Even if the crisis is a “flight to quality” with non-banks increasing their demand for government debt in exchange for bank deposits, the consequent liquidity adjustments of banks may create a need for RBA injection of liquidity. Aggregate liquidity would be increased, as would have been the case where the liquidity facility approach applied. While the adjustment process may be different, it is not apparent that the outcome would be different to a situation where repo-eligible securities are allowed to be counted to meet the LCR.