Evidence from the UK: Liquidity supervision leads to a substantial increase of the Liquidity Buffer

In October 2014 an interesting working paper has been published on the impact of liquidity regulation. The paper contains some remarkable outcomes. The most important conclusion is that liquidity supervision matters.

The authors (Ryan Banerjee and Hitoshi Mio) have looked at the implementation of liquidity regulation in the UK, where some banks have been affected by this regulation and others not. This situation provided the authors an ideal laboratory in which they could gauge the impact of the regulation on outcome variables such as the size of the liquidity buffer and lending rates.

In the UK, the Financial Services Authority (FSA) introduced Individual Liquidity Guidance (ILG) in 2010 in which banks were required to hold a stock of high quality liquid assets (HQLA). This liquidity buffer should be sufficiently large so that the bank can withstand a liquidity stress scenario. The Basel Committee on Banking Supervision has introduced a similar measure, the Liquidity Coverage Ratio (LCR), only in 2013. The main difference between the ILG measure and the LCR is the duration of the stress scenario. The FSA uses two scenarios with durations equal to 14 days and 3 months, whereas the LCR has a duration of 30 days.

The liquidity ratio analysis is part of a larger framework for liquidity risk management that is internationally designated in different but similar names such as Individual Liquidity Adequacy Assessment (ILAA) or Internal Liquidity Adequacy Assessment Process (ILAAP).

Liquidity regulation leads to a larger Liquidity Buffer

In UK the FSA has exempted some banks from the liquidity regulation. These banks function as a control group in the research on the impact of liquidity regulation in the UK.

The authors find that UK banks that have been submitted to liquidity regulation have responded in a number of ways. Their most prominent conclusion is that banks have increased their liquidity buffer in a significant way. Banks without liquidity regulation have an average HQLA buffer equal to 6% of their total assets, for banks that have been submitted to this regulation the percentage is equal to 11%, a difference of 5 percentage points. The difference is even larger after controlling for other independent variables such as balance sheet structure. The authors then find a difference in HQLA that can be attributed to the introduction of the liquidity regulation of 12 percentage points.

The consequence of this increase in HQLA is not a decrease in lending to the non-bank industry but a decrease in short-term financial loans. So the good news is that banks will become less interconnected (which reduces the probability of a system crisis) and that the level of lending to the real economy is not affected.

Influence of liquidity supervision (source: BIS Working Paper 470, The Impact of Liquidity Regulation on Banks, R.N. Banerjee, H. Mio, Oct 2014)

Influence of liquidity supervision (source: BIS Working Paper 470, The Impact of Liquidity Regulation on Banks, R.N. Banerjee, H. Mio, Oct 2014)

Lending rates remain unaffected

And the good news does not end here. The authors also find that lending rates to the real economy did not increase significantly as a result of the increase of the liquidity buffer.

An open question is whether these results can be generalized to other jurisdictions. In the UK banks have responded to the liquidity regulation by increasing their HQLA and, more specifically, the holdings of central bank reserves. During the observation period starting in 2010 these reserves were remunerated in the UK (by the ‘Bank rate’). If central bank reserves are not remunerated (or even penalized) banks will be more reluctant to increase their HQLA and, if they do so, they will be faced with additional liquidity buffer costs. Liquidity risk management standards require that they pass on these (indirect) liquidity buffer costs to their lending products with the help of an add-on on the Funds Transfer Price.

The evidence from the UK is interesting since it clearly points out how banks adjust their balance sheet after the introduction of liquidity regulation. Especially the mechanism in which banks increase their liquidity buffer and reduce their interconnectedness have important benefits since the risk of a system crisis is reduced.

However, further evidence is needed regarding the impact on the lending rates. I suspect an FTP impact as soon as central banks reserves are not remunerated (or even penalized).

 

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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