13 July 2018

ECB: Benefits and costs of liquidity regulation

The prudential regulation of banks has changed dramatically since the global financial crisis. While the Basel III reforms of the quantity and quality of bank capital have been the most prominent, a number of other policy initiatives have also been pursued with the aim of making banks safer and avoiding future crises. In this paper, authors focus on one of these initiatives - a new regime of bank liquidity regulation - and examine if and how it can be beneficial for financial stability, at what cost, and how it interacts with other financial policy tools such as capital requirements and the Lender of Last Resort.

More specifically, they provide an empirical assessment of the benefits of liquidity regulation and a quantification -- based on macro-financial models and euro area data -- of its long-run macroeconomic costs. They also aim to shed light on the interactions with capital regulation and LOLR, and take these interactions into account in their evaluation of benefits and costs.

First, with the help of a simple conceptual framework and drawing on the academic literature, they explain how, in principle, liquidity requirements can make individual banks and the financial system as a whole safer. They argue that capital is best in dealing with solvency risk while, under idealized conditions, the LOLR is best in dealing with liquidity risk. When capital requirements can make banks perfectly safe or the LOLR can perfectly distinguish between insolvent and illiquid banks, liquidity regulation is redundant.

The second part of the paper provides an empirical assessment of the benefits of liquidity regulation. It investigates the extent to which the two main liquidity ratios (the Liquidity Coverage Ratio, (LCR) and the Net Stable Funding Ratio, (NSFR)) might have been effective in reducing liquidity take-up by European banks during the post-Lehman crisis as well as the European Sovereign Debt crisis.

In the third part of the paper, they estimate the cost for banks of complying with the LCR and NSFR. These costs turn out to be non-trivial but small, especially when compared with the costs of capital requirements. When they simulate the introduction of the LCR and NSFR in two structural macro-financial models (Van den Heuvel (2016) and 3D model as in Mendicino et al. (2016)), they find that the regulations would lead to relatively modest declines in lending and real activity. Their analysis therefore suggests that while the LCR and NSFR do not have financial stability benefits on a par with bank capital requirements, they are still useful due to their relatively low cost.

Full working paper

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