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Basel III and the liquidity ratio mess 

October 14, 2014
JP MarĂ­n Arrese, The Corner

The Lehman Brothers example showed all too vividly how a credit institution might collapse should it find its coffers empty. Lack of confidence or sheer insolvency trigger financial crises. Yet the implosion always happens when depositors are unable to cash out their money. No wonder Basel III emphasized the need for banks to set up robust liquidity buffers.

As is often the case, this concern soon led to overshooting. Harnessing banks in bulletproof jackets against potential outflows proved both delusive and detrimental. Moreover, the attempt to draw a fixed borderline between liquid and illiquid assets was wholly misguided. For, in times of attrition and upheaval, only coins and banknotes can survive the ordeal. In a systemic crash, only the central bank can keep banks afloat.

Basel III enacted rules that were too strict to provide comfortable cushions. They aimed at keeping banks running under severely stressed conditions for 30 days. Extensive potential withdrawals were tackled by keeping high liquidity levels, coupled with a narrow definition of assets likely to be sold on the spot at no loss. Only tradable securities could safely fulfill such stringent requirements. Thus, the rules resulted in a cliff effect on credit, penalizing the usual business banks performance.

Read more: The Corner

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