Reserve Requirements Basel Style: The Liquidity Coverage Ratio

Over the last couple of decades, reserve requirements all but vanished as a means of bank regulation and monetary control. But now a new variation on reserve requirements is being introduced through the capital controls of the Basel Accords.

Canada, the UK, Sweden, Australia, New Zealand, and Hong Kong have all abolished traditional reserve requirements. In many other countries, reserve requirements have become a dead letter. In the U.S., for instance, the Fed under Alan Greenspan reduced all reserve requirements to zero except for transactions deposits (checking accounts), while permitting banks to evade reserve requirements on transactions balances by using sophisticated computer software to regularly “sweep” those balances into money market deposit accounts, which have no reserve requirement. In 2011 Congress went a step further by allowing the Fed to eliminate all reserve requirements if it so desired. The Eurozone, for its part, began with a reserve requirement of only 2 percent, which was reduced to 1 percent in January 1999.

There were good reasons for this deregulatory trend. Economists consider reserve requirements an implicit tax on banks, requiring them to hold non-interest earning assets, while central banks considered changes in such requirements too blunt an instrument for monetary control. The Fed discovered the latter shortcoming when, in the midst of the Great Depression, having just gained control over the reserve requirements of national banks, it doubled them, contributing to recession of 1937.

Ostensibly designed to keep banks more liquid, reserve requirements can prevent them from drawing on their liquidity when it is most needed. As Armen A. Alchian and William R. Allen point out in University Economics (1964): “To rely upon a reserve requirement for the meeting of cash-withdrawal demands of banks’ customers is analogous to trying to protect a community from fire by requiring that a large water tank be kept full at all times: the water is useless in case of emergency if it cannot be drawn from the tank.”

As reserve requirements became less fashionable, advocates of more stringent bank regulation resorted instead to risk-based capital requirements, as implemented through the international Basel Accords. More recently the increasingly widespread practice of paying interest on bank reserves has also given central banks an alternative and less burdensome means for inducing banks to hold more reserves.

But in Basel III, agreed upon in 2010-2011, there appeared a new kind of liquidity requirement that mimics reserve requirements in many respects. Known as the “Liquidity Coverage Ratio” or LCR, it requires banks to hold “high quality liquid assets” (HQLA) sufficient to cover potential net cash outflows over 30 days. In September 2014 the Fed, the Comptroller, and the FDIC finalized the rule implementing the Liquidity Coverage Ratio. The rule, which took effect at the beginning at 2015, must be fully complied with by January 2017.

Far from involving a simple ratio, as earlier reserve requirements did, the Liquidity Coverage Ratio is extremely complicated, filling 103 pages in the Federal Register. The rule does not apply to small community banks but instead to banks with more than $250 billion of assets, with a modified rule applying to the holding companies of both banks and savings institutions. The Fed also plans to impose a similar rule on non-bank financial institutions. But because a variant of the rule applies to bank holding companies on a “consolidated basis,” the Liquidity Coverage Ratio already affects most major investment banks, which are owned by bank holding companies.

Unlike traditional reserve requirements, the Liquidity Coverage Ratio does not call for any minimum quantity of cash reserves. Instead, it calls for a minimum quantity of various high quality liquid assets. Weighting bank assets according to their maturity, marketability, and riskiness, the LCR even counts as high quality some forms of corporate debt at half of face value. The LCR also differs in being applied, not just to bank deposits, but to nearly all bank liabilities, including large CDs, derivatives, and off-balance sheet loan commitments, according to their maturity.

In short, the Liquidity Coverage Ratio is designed to reduce maturity mismatches for large financial institutions in order to protect against the kind of panics in the repo and asset-backed commercial paper markets that occurred during the financial crisis of 2007-2008. In any case, the rule will still require banks to hold more reserves or short-term Treasury securities than they otherwise might prefer. Since the rule was under discussion by 2010, it could be another reason—along with interest on reserves and capital requirements—why U.S. banks have continued to hold more than 100-percent reserves behind M1 deposits.

Every time there is a financial crisis, the proposal to force banks to hold higher reserve ratios, if not 100-percent reserves, resurfaces. During the Great Depression, this proposal went under the name of the Chicago Plan and even received support from Milton Friedman in his early writings. The proposal was called “narrow banking” during the savings and loan crisis. Since the recent crisis, it has been advocated in one form or another by such economists as Laurence Kotlikoff of the Boston University, John Cochrane of the University of Chicago, and Martin Wolf of the Financial Times. All of these proposals hinge on the government paying interest on bank reserves.

The new Liquidity Coverage Ratio in one sense is less restrictive than these proposals but in another is more so. It is less restrictive in that it allows deposits to be covered by liquid securities other than cash equivalents, and in that sense is a bit reminiscent of the discredited real-bills doctrine that insisted the banks should make only short-term, self-liquidating loans.

But the Liquidity Coverage Ratio is more restrictive than conventional reserve requirements in so far as it applies to a much broader range of bank liabilities. Unlike such requirements, it is striving to prevent banks from engaging in significant maturity transformation, which involves bundling and converting long-term securities into short-term securities. That makes it closest in spirit to Cochrane’s reform proposal, which combines a 100-percent reserve requirement for deposits with a 100-percent capital requirement for all other bank liabilities. Cochrane’s proposal really would eliminate all maturity mismatches; indeed, it would make all banks resemble combinations of safe-deposit businesses on the one hand and mutual funds or, for that matter, Islamic banks, on the other.

Will the Liquidity Coverage Ratio ultimately work? Although the question requires further thought and study, I doubt it. Several monetary economists, considering the rule’s implementation in Europe (here and here), are more optimistic than I am, and a few even think that it will not be restrictive enough. But they may be overlooking the long-term downsides.

As with so many past banking regulations, this one could ultimately end up being non-binding. Banks may find loopholes in the rule, or may innovate around it, and the rule’s very complexity and supposed flexibility is likely to make doing these things easier. On the other hand, when the next financial crisis hits, by hobbling a bank’s discretionary control over its balance sheet, the rule may well exacerbate the crisis. To the extent that the rule is binding, it changes the fundamental nature of banking in a way that may curtail efficient financial intermediation. Whatever happens, it definitely increases the government’s central planning of the allocation of savings. In the final analysis, it is another futile attempt to use prudential regulation to overcome the excessive risk taking resulting from the moral hazard created by deposit insurance and too-big-to-fail.

[Cross-posted from Alt-M.org]