Banks play a central role in all modern financial systems. To perform it effectively, banks must be safe and be perceived as such. The single most important assurance is for the economic value of a bank’s assets to be worth significantly more than the liabilities that it owes. The difference represents a cushion of “capital” that is available to cover losses of any kind. However, the recent financial crisis underlined the importance of a second type of buffer, the “liquidity” that banks have to cover unexpected cash outflows. A bank can be solvent, holding assets exceeding its liabilities on an economic and accounting basis, and still die a sudden death if its depositors and other funders lose confidence in the institution.
A key part of the regulatory reforms in the United States and globally in response to the financial crisis has been to establish formal, quantitative requirements for the liquidity levels that banks must attain. This paper explains these requirements and how regulators try to balance the safety benefits and the economic costs of these new mandates.
Readers may also be interested in the transcript, video archive, and presentations from an event that we ran at the Brookings Institution at the end of April 2014 on bank liquidity requirements, central bank lender of last resort facilities, and the interplay between them. Ben Bernanke, former Chairman of the Federal Reserve Board, and Mary Miller, Undersecretary of Treasury for Domestic Finance, gave keynote addresses, and a number of distinguished experts served on various panels. More information can be found at https://www.brookings.edu/events/2014/04/30-liquidity-role-lender-of-last-resort .
This paper is organized around the following questions:
- What is liquidity at a bank?
- Why do we care about it?
- Why are banks prone to runs?
- How can banks achieve adequate liquidity?
- How much liquidity is enough?
- What is the economic value of maturity transformation?
- What are the new liquidity requirements?
- How does the Liquidity Coverage Ratio work?
- What are the policy issues around the LCR?
- How does the Net Stable Funding Ratio work?
- What are the policy issues around the NSFR?
- How does the Fed’s Comprehensive Liquidity Analysis and Review work?
- What is the role of central banks like the Federal Reserve in providing liquidity?
- Can we distinguish between solvency and liquidity? How?
- How do liquidity requirements, capital requirements, and bank resolution rules interact?
- How have bank liquidity levels changed in recent years?