Banks' win on liquidity coverage ratio calls into question central bank role as lender of last resort

Across both the mainstream media and the blogosphere it has been unanimously concluded that the banks "won" when the Basel Committee dramatically loosened both the definition of securities that qualify for inclusion in the liquidity coverage ratio and delayed when LCR becomes effective.

Only Bloomberg reported the far more interesting implication for central banks in their lender of last resort role.

The LCR would force banks to hold enough easy-to-sell assets to survive a 30-day credit squeeze. It’s a key component of a package of capital and liquidity measures, known as Basel III, drawn up to avoid a repeat of the 2008 financial crisis.... 

“The committee and the regulatory community more generally felt it was appropriate to broaden the class of liquid assets,” King said. “That doesn’t mean to say it’s a loosening of the whole regime.” 

The additional securities will get bigger writedowns to their value than those that would have been eligible under the 2010 LCR. They also won’t be allowed to count for more than 15 percent of a bank’s LCR buffer. 

Supervisors will have discretion to decide whether the reserves lenders keep with central banks will count towards the LCR. Regulators will also continue to assess how the LCR will interact with liquidity support measures provided by national central banks, the GHOS said. 

“It became clear during the process of discussing all this that it didn’t make sense really to think about an LCR without having a clear view about what to make of access to central bank facilities,” King said.

Please re-read the highlighted text again as Mr. King has just pointed out the simple fact that banks have infinite liquidity due to their ability to borrow from their central banks.

Plus, borrowing from central banks has long been part of implementing monetary policy.  Thirty plus years ago when Paul Volcker led the Fed in its fight to break the back of inflation, banks would routinely borrow at the discount window if they did not have enough reserves.

The entire discussion of LCR exists because of central bank's lender of last resort role.

As a lender of last resort, central banks are suppose to lend at high interest rates against good collateral. The problem is how does a central bank know what is good collateral.

LCR is a method for the central banks to ensure themselves that the banks are carrying a certain amount of good collateral.

Everyone knows that the liquidity held under LCR is inadequate to address a run on the bank.  LCR is discussed in terms of what happens if a bank cannot role over its funding from the capital market.  It doesn't address the issue of what happens if depositors line up around the block.

As I said, LCR is about nothing more than assuring the central banks that banks are holding some good collateral.

The alternative to LCR is to simply require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, market participants will value all of the assets on each bank's balance sheet.  This directly answers the question of how good is the bank's collateral.

Bottom-line:  the banks 'won' because LCR is nothing more than the substitution of a complex regulation for transparency.