New Capital Requirements for Banks

Économiste Monétaire · 13-09-2010 3:04pm #1

http://www.bis.org/press/p100912.htm

Group of Governors and Heads of Supervision announces higher global minimum capital standards

12 September 2010

At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November.

The Committee's package of reforms will increase the minimum common equity requirement from 2% to 4.5%. In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%. This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitisation activities to be introduced at the end of 2011.

Mr Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, said that "the agreements reached today are a fundamental strengthening of global capital standards." He added that "their contribution to long term financial stability and growth will be substantial. The transition arrangements will enable banks to meet the new standards while supporting the economic recovery." Mr Nout Wellink, Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank, added that "the combination of a much stronger definition of capital, higher minimum requirements and the introduction of new capital buffers will ensure that banks are better able to withstand periods of economic and financial stress, therefore supporting economic growth."

Increased capital requirements

Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period. (Annex 1 summarises the new capital requirements.)

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% - 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.
These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. In addition, work is continuing to strengthen resolution regimes. The Basel Committee also recently issued a consultative document Proposal to ensure the loss absorbency of regulatory capital at the point of non-viability. Governors and Heads of Supervision endorse the aim to strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital instruments.

Transition arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels. However, preliminary results of the Committee's comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements. Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards.

The Governors and Heads of Supervision also agreed on transitional arrangements for implementing the new standards. These will help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy. The transitional arrangements, which are summarised in Annex 2, include:

National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):
3.5% common equity/RWAs;

4.5% Tier 1 capital/RWAs, and

8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015. On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%. The Tier 1 capital requirement will rise from 4% to 4.5%. On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%. On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements. The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in. The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital.

The regulatory adjustments (ie deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.

In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

Capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point: (1) they are issued by a non-joint stock company 1; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.

Only those instruments issued before the date of this press release should qualify for the above transition arrangements. Phase-in arrangements for the leverage ratio were announced in the 26 July 2010 press release of the Group of Governors and Heads of Supervision. That is, the supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.
After an observation period beginning in 2011, the liquidity coverage ratio (LCR) will be introduced on 1 January 2015. The revised net stable funding ratio (NSFR) will move to a minimum standard by 1 January 2018. The Committee will put in place rigorous reporting processes to monitor the ratios during the transition period and will continue to review the implications of these standards for financial markets, credit extension and economic growth, addressing unintended consequences as necessary.
The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. It seeks to promote and strengthen supervisory and risk management practices globally. The Committee comprises representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.
The Group of Central Bank Governors and Heads of Supervision is the governing body of the Basel Committee and is comprised of central bank governors and (non-central bank) heads of supervision from member countries. The Committee's Secretariat is based at the Bank for International Settlements in Basel, Switzerland.
Annex 1: Calibration of the Capital Framework (PDF 1 page, 19 kb)
Annex 2: Phase-in arrangements (PDF 1 page, 27 kb)
Full press release (PDF 7 pages, 56 kb)

noodler · 14-09-2010 11:59am

So our targets are still more robust?

We have an 8% target with 7% of that as equity.

Of the 7 required under the new guidelines above what % of that has to be equity? 4.5% or 7%? I find the PR a little confusing.

EDIT: In addition, I assume domestic targets or regulations take precident over this? I mean our banks have a target of 8% already so that is what they will continue to aim for? Who exactly has the final say?

Économiste Monétaire · 14-09-2010 8:56pm

This is my understanding of it. Ireland:

Equity Tier 1: 7% (of risk weighted assets (RWA))
Core Tier 1: 8%

Basel 3:

Equity Tier 1: 4.5%
Tier 1: 6%.

Then add on the 'conservation buffer':

Equity Tier 1: 4.5% + 2.5% = 7%
Tier 1: 6% + 2.5% = 8.5%

(Note that it's 8.5% for total Tier 1 for Basel 3, and 8% for Core Tier 1 for Ireland.) There's also a 'countercyclical buffer', in the range of 0 to 2.5% (for Equity Tier 1), which appears to be at the discretion of individual regulators, and would be a function of 'excessive' credit growth. I don't know what constitutes 'excessive', though.

noodler wrote: »

EDIT: In addition, I assume domestic targets or regulations take precident over this? I mean our banks have a target of 8% already so that is what they will continue to aim for? Who exactly has the final say?

Basel would be the minimum expected, and anything above that is up to domestic regulators, I think.

Économiste Monétaire · 29-09-2010 10:40pm

A member of the ECB executive board, Lorenzo Bini Smaghi, delivered a speech on how Basel III will affect monetary policy. For those interested:

Ladies and gentlemen,

In the past three years, researchers have made considerable progress in explaining the causes of the recent financial turbulence and the mechanisms by which instability spread through the financial system. The events have spurred thinking on banks’ risk management practices, on the incentives for excessive risk-taking, and on the reasons for the failure of regulation and supervision of the financial sector to prevent such events. Numerous national and international bodies have proposed new regulations. This conference provides an excellent opportunity to reflect on the impact of the new banking regulations.

In my remarks today I will focus on the one aspect of the proposed regulation put forward by the Basel Committee on Banking Supervision which has received less attention from the international media, but which is very relevant for monetary policy, i.e. liquidity standards. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.2"]2[/URL The implementation of those standards will cause banks to change their investment behaviour and may change the structure of some financial market segments, thereby affecting the transmission channels of monetary policy. It is very important that any such changes are well understood if they are to be factored into monetary policy decisions.

After briefly describing the proposed measures, I will first focus on the impact of the regulation on financial markets, then analyse the implications for economic activity and the financial system, and finally, turn to the implications for monetary policy, including the possible interactions with the central bank’s operational framework.

1. The proposed liquidity regulation

One of the key problems that financial institutions faced when the financial turbulence started in mid-2007 was the urgent funding need that resulted from a high degree of maturity mismatch. While assets tended to have a rather long-term horizon, funding of these investments was often done at the very short end of the yield curve in the wholesale markets for liquidity. This implied a need to rely continuously on the roll-over of short-term liabilities in the wholesale money market. Prior to the crisis, this posed no problem. The financial system had ample liquidity, as measured, for instance, by compressed spreads and low volatility. Financial innovation, in particular asset securitisation, and the rapid growth of the so-called shadow banking system were the main drivers. However, they also became the main cause of banks’ fragilities. The financial crisis has exposed the inadequacy of banks’ liquidity risk-management practices. It has shown that the build-up of contingent liquidity claims, arising for instance from off-balance sheet financing vehicles, and excessive reliance on financial markets for providing funding are conditions doomed to generate financial instability.

When the markets for liquidity dried up suddenly and unexpectedly – most markedly at the beginning of the crisis, and after the bankruptcy of Lehman Brothers – many institutions faced difficulties in refinancing the large amounts to be rolled over. The resulting funding problems spilled over to other segments of the financial market. The state-dependent nature of market liquidity took many by surprise. Markets that seemed to be working smoothly suddenly dried up. Indeed, many securities that were regarded as highly liquid in pre-crisis times suddenly became illiquid. The underlying characteristics of the assets, such as their complexity, turned out to be crucial for their liquidity under stress. This points to the fact that the concept of liquidity itself is not straightforward. What seems liquid today may be less liquid tomorrow or under specific circumstances. We witnessed this phenomenon also in the market for some sovereign signatures in Europe, which abruptly became illiquid.

The causes and consequences of this sudden drying-up of liquidity have been discussed extensively in the academic literature of the past two years. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.3"]3[/URL New regulations have been proposed. I will consider the liquidity regulation proposed by the Basel Committee of Banking Supervision.

The Basel proposal is centred on two new standards to establish minimum levels of liquidity for internationally active banks. The standards aim to promote the resilience of banks’ liquidity risk profiles. The first standard aims to raise the buffer of high-quality liquid assets so that the banks can withstand stress scenarios. This standard, called the liquidity coverage ratio , measures whether banks hold an adequate level of unencumbered, high-quality liquid assets to meet net cash outflows under a well-defined stress scenario persisting for a period of one month.

The second standard is of a more structural and longer-term nature. It tries to ensure a closer alignment of the funding of longer-term assets or activities with more stable medium or longer-term liability and equity financing. The standard, called net stable funding ratio , sets a minimum amount of funding that is expected to be stable under conditions of extended stress. This minimum amount depends on the liquidity characteristics of various assets that the institutions hold over a one-year horizon.

The two standards are complemented by a set of tools for monitoring the liquidity risk exposures and for exchanges of information among supervisors. The two standards aim to make banks more resilient to liquidity shocks by matching the maturity profile of in- and outflows more closely, and by setting aside a buffer of high-quality liquid assets. The overall goal is to strengthen the resilience of the individual financial institutions and, more broadly, markets, and to avoid illiquidity spillovers to other institutions or market segments, which could lead to a systemic crisis. Their implementation should be seen in the context of broader regulatory reforms, in particular those agreed upon by the Group of Governors and Heads of Supervision earlier this month.

An issue to be considered is whether the intended changes in banks’ behaviour resulting from the new regulation may have some unintended consequences. Since market participants will adjust to the new regulation, it is possible that the changes affect market structures, perhaps fundamentally so, and not necessarily in ways that are foreseen or desired by the regulators. Therefore, it is necessary to think carefully how banks may change their behaviour and to make sure that the new regulation will achieve its goal. From a central bank perspective, it is also important to assess the implications for the conduct of monetary policy. In particular, the new rules are likely to impact on the markets for liquidity and on the demand for central bank refinancing, thereby affecting the transmission mechanism of monetary policy.

Below, I will mainly focus on the impact of the liquidity coverage ratio, as its implementation is likely to have the most relevant effects for central banking, and its formulation is currently more advanced than the one for the other liquidity standard.

2. Implications for financial markets

Markets will be affected by the new regulation in several ways. One way is the categorisation of assets into liquid and illiquid assets for the numerator of the liquidity coverage ratio. The currently foreseen regulation includes cash, central bank deposits, and high-quality government securities in the ‘liquid assets’ category. Corporate and covered bonds are included with a haircut. The choice of the assets to be considered as liquid is consistent with the evidence during the recent crisis, which has confirmed that the degree of liquidity can vary enormously across markets in periods of stress.
The implementation of the new liquidity standard is intended (and expected) to favour those assets that are counted as liquid, and at the same time reduce incentives to hold assets that are considered less liquid. This will affect the functioning of the underlying markets. In particular the yields of liquid securities are expected to decline relative to those of illiquid ones, so that yield spreads between liquid and illiquid assets would become wider.

At the moment, it is difficult to quantify the impact on the different market segments, or to judge whether the adjustment will take time or be abrupt. But it can be expected that the categorisation of assets into certain classes of liquidity will lead to a ‘cliff effect’, by which the regulatory categorisation of assets as either liquid or illiquid plays a crucial role for the future of their market. Moreover, it implies that changes in market conditions, such as a downgrade, can move assets from one category into the other, leading to sudden changes in banks’ fulfilment of the liquidity coverage ratio. This could make their fulfilment somewhat unpredictable. The cliff effect could also imply sudden changes in the market conditions for the asset in question, which could suffer from a sudden drying-up of market activity or liquidity. In the latest revision of the proposal of the liquidity coverage ratio, some attempts were made to introduce intermediate categories of liquidity. This somewhat reduces the cliff effect, but it still remains significant. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.4"]4[/URL

Another way in which different segments of financial markets will be affected in an asymmetric manner by the regulation is the maturity profile, which is key for the denominator of the liquidity coverage ratio. Since the denominator consists of expected outflows in a stress situation over the following 30 days, shorter-term funding that needs to be repaid within that period will be penalised relative to long-term funding. This is an intended effect. The implication is that the relative size of wholesale funding markets for different maturities will change. Ultimately, the interaction of demand and supply effects will determine the overall impact on the volume and liquidity of the different segments of the money market. At this stage it is difficult to draw clear conclusions, but it may well be the case that activity at the short end of the money market will decline. As regards interest rates, the increased demand for and lower supply of longer-term financing (relative to short-term financing) stemming from the introduction of the liquidity coverage ratio is expected to lead to a relative increase of interest rates for maturities longer than the threshold established by the regulation (30 days) as compared with shorter maturities. This would imply a steeper money market yield curve.

Such effects are important for central banks – a point I will consider later on. First, less active money markets, and a corresponding higher volatility of short-term interest rates, could make the transmission of monetary policy signals more difficult and less precise. Second, an increase in the steepness of the money market yield curve would affect the transmission mechanism and the information extracted from the yield curve for monetary policy purposes. To the extent that this effect is well understood and anticipated, central banks will be able to adjust their policies to the changed market environment. Transitory changes during an adjustment period may pose however some challenges.

3. Implications for economic activity

Let me now turn to the implications for real economic activity associated with the new regulation. There is a widespread perception that the new measures will act at the macroeconomic level as a significant negative supply shock. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.5"]5[/URL Higher bank holdings of liquid-and-low-return assets and higher funding costs due to the lengthening of the maturity structure of banks’ liabilities are regarded as additional operating costs that banks will try to pass on to their retail business along all margins: higher lending rates, tighter lending standards, and active shedding of loans in order to leave room for liquid assets in banks’ balance sheets – something akin to a credit crunch.

According to this mechanistic view of the impact of the new measures, policy-makers face a trade-off between the degree of safety of the banking system and economic activity. I believe that this reasoning suffers from what I would call a ‘partial equilibrium’ and ‘static’ perspective. It is ‘partial equilibrium’ because it does not allow for banks’ adjustment to the potentially higher costs of intermediation in other ways, such as efficiency gains, reductions in compensations, business restructuring. And also because it does not consider that the higher degree of banks’ safety brought about by the new regulation implies that premia required by investors to fund banks may undergo a generalised decline. It is a ‘static’ perspective because it does not balance the transient costs that may arise along the transition phase with the permanent benefits associated with a more stable and safer financial environment. More generally, any analysis of the costs of achieving a sounder financial system for economic activity should take into account the costs that taxpayers have to bear when a financial crisis occurs, and the impact it has on growth potential.

Recently published studies carried out by the working groups established by the Basel Committee on Banking Supervision and the Financial Stability Board attempted to perform such a cost/benefit analysis. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.6"]6[/URL The benefits are measured by combining the decline in the probability of banking crises made possible by the new regulation with the average output losses associated with banking crises. It is found, for instance, that a 25% increase in the ratio of liquid assets over total assets could reduce the probability of banking crises by about one percentage point. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.7"]7[/URL This result has to be combined with the other finding that, for each percentage point reduction in the probability of a banking crisis, the expected annual economic benefit ranges from 0.2% of GDP (if the crisis results only in temporary output losses) to 1.6% of GDP (if output losses are permanent).

As regards the costs, it has been found that a 25% increase in banks’ holding of liquid assets over total banks’ assets would lead to a loss in GDP of about 0.1% per year. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.8"]8[/URL I should add, though, that these results are characterised by high uncertainty because of the lack of consistent historical data. In addition, the methodology used to quantify the costs is likely however to overestimate the true costs. First, it assumes that premia embedded in banks’ funding costs will not decline. Second, it assumes that banks will respond mechanically by maintaining their return on equity at pre-crisis levels. Third, it does not consider that banks may fully adjust by downsizing the trading book with little impact on their retail business, as the recent Swiss experience with the new capital requirements seems to suggest. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.9"]9[/URL Fourth, the analysis does not consider that there may be offsetting factors. For instance, it is likely that the new regulation will lead to a higher demand from banks for government bonds to fulfil the liquidity ratios. This could exert downward pressure on ‘risk-free’ interest rates, especially at medium and long-term maturity. These generally form the basis for pricing mortgages and other banks’ lending rates with long-term initial rate fixation. Finally, the results are predicated on the assumption of no monetary-policy reaction. This modelling choice helps to clearly distinguish macroeconomic developments from a possible policy reaction to such developments. However, this implies that the results may overestimate the costs associated with the new measures, if they affect risks to price stability and monetary policy reacts to them.

4. Longer-term implications for the financial system

It might be argued that my discussion of the net benefits associated with the new regulation still suffers from some ‘partial-equilibrium’ shortcomings. It does not consider that the endogenous banks’ response to the new regulation may run against the ultimate goal of making the financial system more stable. The fear is that liquidity risks may be simply shifted outside the perimeter of regulated entities. Such regulations could simply end up inflating the unregulated sector.

The assumption here is that the total amount of risk in the financial system is somehow exogenously given, and that the amount of risk in the banking sector and in the unregulated sector are inversely related. Therefore, a pessimistic assessment of the new regulation may contend that it will only lead to a transfer of risk, trading off a reduction in the risk borne by the banking sector with a corresponding increase in the one borne by the unregulated sector. To put it differently, policy-makers may choose the desired point on the downward sloping frontier linking the amount of risk in the regulated and unregulated sectors, but might not be able to shift the frontier downward.

While I agree that any banking regulation may set in motion some form of risk transfer across sectors, I believe that the new framework takes a step forward in making the financial system more stable. Let me provide two examples of how the new measures aim at preventing banks from simply transferring their risk to the unregulated sectors. First, banks may try to unload part of their risk via off-balance sheet constructs. But the new regulation makes it harder to do so. Both the liquidity coverage ratio and the net stable funding ratio take into account the potential impact of off-balance sheet exposures on banks’ liquidity conditions. In particular, the stress scenario underlying the liquidity coverage ratio includes an increase in derivative collateral calls and substantial calls on contractual and non-contractual off-balance sheet exposures, including committed credit and liquidity facilities. And the net stable funding ratio determines, for each off-balance sheet class, a reserve of stable funding, which depends on the characteristic of each off-balance sheet exposure. Having said that, one has to admit that there are probably no limits to creativity when it comes to financial innovation.

Second, banks may try to reduce the maturity of the loans they grant to corporates, small and medium-sized enterprises, and households in order to shift the roll-over and liquidity risk to the final users of financial services. But the new regulation is designed to make this strategy unattractive for banks, as only a part of these loans needs to be financed by stable funding. Furthermore, the Governors and Heads of Supervision have decided that the final implementation of the new liquidity measures will be preceded by a long ‘observation period’ during which supervisors will monitor any unintended consequences of the new measures and modify the regulation accordingly. The observation period for the liquidity coverage ratio is from 2011 to 2014, after which it is to be applied as a minimum regulatory measure. For the net stable funding ratio, the observation period starts in 2012, and it won’t become a minimum standard until 2018.

5. Implications for monetary policy

What would be the implications of the new liquidity regulation for the central bank’s operational framework and for the conduct of monetary policy?

5.1 Implications for the central bank operational framework

I will first turn to the possible interaction of the new regulation with the central bank operational framework. Let me remark that here, as a benchmark scenario, I’ll consider a hypothetical situation in which the ECB has returned to the pre-crisis framework. That is, to a system whereby it determines the aggregate liquidity provided to the banking sector in each open market operation by conducting variable rate tenders, with a fixed liquidity supply and a variable rate.

There are three areas in which the new regulation can interact with the central bank’s operational framework. First, the demand for reserves. Second, the participation in the central bank’s longer-term operations. Third, the impact on the collateral pledged to the central bank.

5.1.1 Demand for reserves

The changes in the liquidity regulation can have an effect on the demand for central bank liquidity, because funds on central bank accounts obtained through open market operations or through a lending facility (discount window) will count as liquid assets for the liquidity coverage ratio. Therefore, the newly proposed regulation would make it more attractive to acquire liquidity from central banks. A structurally higher demand for central bank refinancing combined with an unchanged liquidity supply by the central bank would however cause tender rates at central banks’ open market operations to increase. The ECB could accommodate this demand by increasing the size of its open market operations. While in times of crisis, a stronger intermediation role by the central bank can be beneficial, in the long run it might crowd out market activity, and reduce incentives for peer monitoring. This could in turn increase risk-taking behaviour. These are of course side-effects of the proposed regulations which should not be neglected.

Not only the volume, but also the variation, of demand for central bank funding over time could be affected by the regulation. This might also play a role in determining the appropriate size of open market operations. It’s possible that on some days banks will seek financing from the central bank for regulatory purposes more than they do on other days. This would lead to a time-varying demand for liquidity in central banks’ open market operations and a higher volatility of interest rates. In particular, such effects would depend on the enforcement of the regulatory measures, whereby calendar effects with temporary peaks in demand could arise, which tend to ‘pollute’ the control of short-term interest rates.

5.1.2 Participation in longer-term operations

A second area of interaction of the new regulation with the central bank’s operational framework arises from the maturity structure of the central banks’ operations. Let me point out that in the liquidity coverage ratio, banks’ liquid assets are put in relation to expected outflows over a 30-day horizon; for higher outflows within this period, banks would need to hold more liquid assets. Thus, the question of whether funds obtained in open market operations need to be repaid to the central bank before or after this horizon will play a role in the fulfilment of the ratio.

This will make central bank refinancing for longer maturities more attractive than for shorter ones. In particular, liquidity obtained in the Eurosystem longer-term refinancing operations, which have a three-month maturity, would not count as liquidity outflow, at least not for the first two months in which the outstanding maturity is still longer than 30 days. For regulatory purposes, banks might thus try to shift their participation in the ECB’s open market operations from the one-week to the three-month operations. The expected increase in total demand for central bank refinancing, which I mentioned before, is therefore likely to materialise, especially in longer-term operations.

With an unchanged composition of the maturity structure of ECB operations, shifts in the demand from short- to longer-term funds would lead to changes in marginal auction rates. Tender rates for longer-term operations would increase, and those for shorter-term operations would be reduced. Thus, the ‘term structure of tender rates’ would become steeper, similar to the term structure of money market interest rates.

However, the rates on the main refinancing operations (with a one-week maturity) convey the monetary policy stance. For this reason, the ECB will monitor carefully whether a shift in demand from short-term to longer-term operations will take place that could lead to reduced participation in the main refinancing operations. Should this reduction occur – which seems highly unlikely, but at this juncture it is difficult to quantify the precise extent – the ability of the central bank to control short-term rates, and thus to signal its monetary policy stance, might be affected. The ECB could adapt its liquidity management practices in order to guarantee a continued high demand for short-term refinancing.

5.1.3 Collateral pledged to the central bank

The third area in which the new regulation could interact with the central bank’s operational framework is the collateral pledged to the central bank. As you know, all refinancing by the Eurosystem is provided only against the provision of adequate collateral, so as to protect it from losses should a counterparty default. At the same time, collateral should be available to a wide set of counterparties. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.10"]10[/URL For this purpose, the criteria for assets to be eligible as Eurosystem collateral are quite broad. Government securities, corporate and bank bonds, as well as high-quality asset-backed securities and some other assets are accepted as collateral. In addition, risk management tools are applied to ensure protection of the Eurosystem against credit risk. The wide range of eligible assets proved to be extremely valuable in recent years, when markets for certain types of security became very illiquid, but banks continued to refinance themselves via the Eurosystem.

As discussed before, the liquidity coverage ratio is supposed to induce banks to hold more liquid assets. One way for banks to boost their ratio is to keep their most liquid assets on their balance sheets, and to pledge the more illiquid ones as collateral in ECB liquidity-supply operations. This is possible as long as the definition of liquid assets is narrower than the criteria for eligibility in Eurosystem operations. This implies that banks may try to circumvent the spirit, if not the letter, of the new regulation by shifting more of their risky assets to the Eurosystem. The argument that central banks are in a better position to bear liquidity risks by their ability to create money should not be turned into a justification for regulatory arbitrage. This is especially true when considering that also credit risk could be shifted to central banks as a consequence of this (mis)behaviour.

5.2 Monetary policy and the build-up of financial risk

The interaction between monetary policy and the amount of risk in the economy is not confined to the details of the collateral framework. It extends also to the interest-rate setting itself.

Unfortunately, most macromodels are not well suited to analyse the relationship between monetary policy and the build-up of financial imbalances. They generally assume that monetary policy works via the impact of the short-term policy rate on long-term interest rates and the exchange rate, possibly amplified by the so-called credit channel. However, recent research has challenged the traditional wisdom by suggesting that in reality there are other channels at work which are relevant to understanding the interaction between monetary policy and financial imbalances. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.11"]11[/URL

First, it has been suggested that policy rates would be crucial in their own right. The reason is that financial institutions normally tend to maintain very low spare capacity on their balance sheets – for cost reasons – making wholesale funding the only readily available source of funds to finance at the margin an additional unit of investment. The close association of money market rates to policy rates implies that the central bank has a direct grip on the marginal price of financial institutions’ leverage. And leverage is one of the key factors that determine the amount of risk and the extent of vulnerability present in the financial system. Second, it has been suggested that monetary policy works also via the so-called ‘risk-taking’ channel, whereby low levels of policy rates tend to induce excessive risk-taking by financial institutions. URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.12"]12[/URL.

These new insights can shed light on the effects that very expansionary monetary conditions can have on financial imbalances, fuelling in particular the build-up of maturity mismatches via excessively low interest rates. And these insights also make clear the hazard to which the central bank is constantly exposed. If a liquidity crisis occurs, the central bank may have to step in and provide abundant liquidity to preserve the functioning of the transmission mechanism and counteract risks to price stability emanating from systemic instability. Anticipating this policy response, the private sector may in normal times under-price the value of liquidity, which in itself increases the probability of a liquidity crisis in the future.

Giavazzi and Giovannini URL="http://www.ecb.int/press/key/date/2010/html/sp100929.en.html#footnote.13"]13[/URL have recently described this hazard as a ‘trap’, which ultimately arises from an asymmetric response of monetary policy to liquidity conditions: benign neglect during the build-up of liquidity risk, and forceful interventions during a liquidity crisis. They conclude that monetary policy can avoid this situation by setting the interest rate at a higher level than the one suggested by macroeconomic conditions, as measured by standard indicators. In particular, they recommend following a Taylor rule appropriately modified to counteract excessive liquidity transformation by the financial sector. They do not discuss however how to make this prescription operational. But I am sure that these insights will spur further research and policy discussions.

Since the inception of monetary policy in the euro area in 1999, the ECB has taken a pragmatic approach to limit asymmetries in its policy response. Its two-pillar monetary policy strategy accords a prominent role to the analysis of money, credit and liquidity conditions, thus explicitly including in its assessment factors that tend to be empirically associated with the build-up of risk and financial imbalances.

Conclusion

The regulation proposed by the Basel Committee on Banking Supervision should not be assessed in isolation, but in the context of the comprehensive set of measures to strengthen the resilience of the financial sector and to reduce its overall level of risk. Real economic activity will profit from such increased stability and, in my view, outweigh the direct cost of the regulation, especially in the long run.

To be sure, the new regulation will have an impact, in particular on banks’ liquidity management and the markets for liquidity along several dimensions. This is actually the aim of the regulation. Had the result been ‘business as usual’, this would have probably made some market participants quite happy, but would have been a sign of failure. There is of course an issue of gradualism and calibration, with a view to avoiding the two extremes – an excessively abrupt adjustment and an everlasting phasing-out. But it seems to me that this issue has been dealt with in a reasonable way.

The changes in the financial system caused by the regulation will have to be factored in also by the policy authorities. For central banks, the changes may be far-reaching, ranging from the transmission mechanism of monetary policy to interactions with several aspects of the operational frameworks. At the ECB we are actively working on these issues to ensure that our monetary policy continues to be conducted in an effective way, also in the new environment, so as to maintain price stability, our primary goal.

Thank you for your attention.

http://www.ecb.int/press/key/date/2010/html/sp100929.en.html

New Capital Requirements for Banks

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