Still Don’t Get It

Capital ratios are meant to help define a “good bank” for the public. The thought being a bank widely recognized and accepted as a good one will be far less susceptible to a run. But it’s the run regardless of capital ratios that destroys good banks as well as bad. The issue is, by and large, liquidity.

Officials have erred in one part because of how they view the banking system. To them, it’s still 1930 and depositors are the biggest bank concern. Bank regulation remains devoted to convincing the public the system is sound.

Both Lehman Brothers and Bear Stearns were “well capitalized” by all regulatory definitions. Neither is with us any longer because depositors just don’t matter as much. Capital ratios were at best unhelpful, at worst in 2008 a wedge of mistrust. If Bear was really capitalized, and it was, all that “toxic waste” must be hidden everywhere.

In the aftermath of crisis, regulators have focused in on liquidity. They’ve done so in the same fashion and from the same prospective that led them to capital ratios. A couple of new measures have been developed which are supposed to answer for past holes in the supervisory burden.

Primary among them is something called the Liquidity Coverage Ratio, or LCR, drawn from Basel 3. This is the centerpiece of Janet Yellen’s confident declaration that another 2008 isn’t likely “in our lifetimes.” The banking system is so much better for how much authorities have learned from the last big one; which only begs the question, how could there have been the last big one?

This focus on liquidity is gleaned from that one simple truth. It isn’t losses that kill firms, good or bad ones, it is illiquidity. Lehman ultimately failed because like AIG it couldn’t meet collateral calls from its triparty custodian. You might think that would require some thought about the custodian’s role and how it operates rather than what happened specifically at Lehman.

The LCR was designed to fix this liquidity “flaw.” Banks are required to now hold High Quality Liquid Assets (HQLA) equal to 30 days of cash flow requirements. Meaning, if you today anticipate that you will have to fork over $100 for all business reasons you will, therefore, have to have today at least $100 in HQLA.

The Basel rules are specific about a “stress scenario” and what it might mean. If wholesale funding sources dry up for specific firms, should they be in compliance they will still survive 30 days which is figured to be more than enough for that stress scenario to be handily solved.

I know what you are already thinking, 30 days? As per usual, the Basel designers are already attacking the last problem from the position that central banks performed admirably when in reality it got as bad as it did because of their inadequacies (Eurodollar University Part 2); systemic deficiencies as opposed to idiosyncrasies.