David Rowe: Regulators' high-wire act

In a terrific column, David Rowe explains the high-wire act regulators perform when it comes to regulating the banking industry and why this act is prone to failure.

Mr. Rowe does this by looking at the complex rules for determining a bank's liquidity coverage ratio.  Rules that only the regulators can determine if a bank is in compliance with due to the lack of transparency into the bank's exposure details.

Regular readers know that the combination of complex rules and regulatory oversight have been substituted for the combination of transparency and market discipline.  This substitution makes the financial system dramatically more unstable.  A point that Mr. Rowe makes.

The recent easing of the Basel III liquidity coverage ratio ... highlights the difficult – perhaps impossible – regulatory challenge of striking the right balance in a world of too-big-to-fail banks..... 

When Basel III appeared in December 2010, it included proposals that would sharply increase holdings of liquid assets to cover stress-level net outflows from banks – the liquidity coverage ratio (LCR). ... 

The basic idea behind the LCR is to ensure banks hold enough high-quality liquid assets to meet potential net cash outflows over a 30-day period even in a crisis. The original proposal allowed little more than central bank reserves and government bonds to be counted as liquid assets. 

The new rule expands the range of eligible assets while, not surprisingly, introducing yet another layer of complexity. It defines three categories of assets: level 1, level 2A and level 2B. 

Level 1 assets are essentially cash and official obligations assigned a zero risk weight in the Basel II standardised approach. 

Level 2A and 2B assets may include lower-grade official obligations, corporate bonds rated as low as BBB– subject to different haircuts depending on their credit ratings, simple residential mortgage-backed securities rated AA or better (excluding structured products) and even certain equities subject to a 50% haircut. 

Other provisions deal with the added risk of exchange rate fluctuations for liquid assets that are not denominated in the bank’s home currency. 

The terms for calculating the potential net cash outflow were also eased. For so-called stable deposits, specific jurisdictions can lower the 30-day run-off assumption from 5% to 3%, provided that the national deposit insurance programme meets certain requirements and historical evidence can demonstrate a 30-day run-off of less than 3% under past periods consistent with the conditions specified in the LCR. Less stable deposits are subject to 30-day run-off assumptions of 10% or higher as determined by national supervisors. 

Finally, implementation is to be phased in, starting with 60% of the full requirement in 2015, rising to 100% in 2019. 

Basel III and the Liquidity Coverage Ratio are a prime example of the complex rules that do not make the financial system safer.

Needless to say, all these provisions will be subject to endless wrangling between banks and their national supervisors. 

How does an instrument qualify as being “traded in large, deep and active repo or cash markets”? What makes a deposit stable or less stable? 

More to the point, how can we be sure that supervisors will consistently strike the right balance between bank safety versus the socially essential functions of intermediation and maturity transformation? 

The simple answer is we cannot be certain of this. 

In fact, the very complexity of the regulations within which this balance must be struck virtually ensures that institutional momentum – both in the banks and the supervisory authorities – will be the dominant force. 

Please re-read the highlighted text as Mr. Rowe nicely lays out why the combination of complex rules and regulatory oversight fails.  This combination requires the regulators to do the impossible:  design rules that produce exactly the right outcome in the face of overwhelming political pressure from the banks.

It simply is not going to happen.

This is why your humble blogger has been saying that the regulation that is needed is to require banks to disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline on the banks so that they are adequately capitalized, retain enough liquidity for any temporary funding interruptions and also provide the credit that the economy needs.

As long as we continue to act as if bank failure is not an option, we cannot rely on the fear of failure as a disciplining force. 

Furthermore, the attempt to eliminate the risk of failure by uniform and highly complex regulatory requirements actually promotes a degree of institutional homogeneity that is conducive to systemic crises.... 

I remain completely unconvinced, however, that this continuing exercise in financial casuistry will do much, if anything, to prevent a future systemic crisis.

All of the complex rules will not prevent a future systemic crisis.  The only way to prevent a future systemic crisis is by requiring the banks to provide ultra transparency and bringing transparency to all the other opaque corners of the financial system.