Supervisors should look to develop standards that address structural liquidity mismatches between bank assets and liabilities, according to Jim Embersit, deputy associate director, division of banking supervision and regulation at the Board of Governors of the Federal Reserve.
Speaking at the Risk Europe 2009 conference in Frankfurt on June 4, Embersit said the management of liquidity risk exposures is high on the agenda of policy-makers following the financial crisis, and added there is a significant push to create more consistency with respect to liquidity risk supervision.
However, the primary focus of many regulators so far has been to develop guidelines to ensure banks have sufficient liquidity buffers to survive a specified stress period over a defined time horizon. This would require supervisors to specify certain parameters, such as survival horizon, scenario and severity - no easy task. "A lot of the devil would be in the detail," Embersit said. One danger could be that scenarios are set based on the "worst of the worst" events just experienced, leading to overly conservative inputs, he added.
By focusing on liquidity buffers, there is a risk regulators will overlook some of the structural mismatches between bank assets and liabilities. In other words, the regulations would prepare for liquidity events rather than prevent them.
"Thus far, the focus has been on liquidity buffers. Why? To ensure a bank can survive a liquidity event. That's very important, and every institution needs to do that and make sure it has a buffer. But there is a risk the focus on buffers may crowd out more structural reforms," said Embersit.
To tackle liquidity mismatches, Embersit suggested drawing up a supervisory standard that requires banks to hold an amount of stable funding based on the liquidity profile of assets and activities. He proposed a ratio of the available amount of stable funding, divided by the required amount of stable funding, with the ratio required to be above one.
In coming up with the inputs, 'required stable funding factors' would be used, whereby different categories of assets are specified based on quality and tenor. The required stable funding factors would be based on supervisory determinations, and could reflect the haircuts expected by major dealers in an extended stress scenario or be based on a multiple of current market haircuts, Embersit suggested.
By using a ratio of this type, supervisors would establish a minimum ratio for liquidity - and could even take corrective action in certain circumstances. "It's conceivable regulators would decide to take corrective action if the ratio falls below a certain level," Embersit said.
Embersit stressed this is just one suggestion to address the problem, and that other proposals may be forthcoming. However, he believes the moves to build up liquidity buffers should be accompanied by some type of structural reform.
"Both initiatives are complementary and need to be pursued at the same time. One concern is that any approach to address structural mismatches may be viewed as secondary to the short-term objective of buffers. I'm not sure there should be any ranking order to that," Embersit said.
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