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Some Key Principles of Bank Liquidity Regulation

The recent severe financial crisis demonstrated yet again that banks need to maintain conservative levels of liquidity in order to protect themselves against large, unexpected calls for cash. Prior to the last crisis, many financial institutions acted on the assumption, supported by the experience of a number of years, that liquidity would always be readily available in the markets. When that liquidity dried up, they ran into serious trouble, including outright failure.

This Policy Brief outlines my views on the key policy issues surrounding bank liquidity requirements. It complements a lengthy primer on liquidity requirements (see https://www.brookings.edu/research/papers/2014/06/23-bank-liquidity-requirements-intro-overview-elliott). This brief makes the following points:

  • Quantitative regulatory bank liquidity requirements are necessary
  • The Basel Committee’s approach is broadly appropriate
  • The Liquidity Coverage Ratio is a quite useful test
  • The Net Stable Funding Ratio can also be useful if focused on avoiding extreme mismatches
  • Stress testing is a necessary complement to the Basel ratios
  • Capital and liquidity requirements should be coordinated
  • The responsibility for liquidity management must be divided sensibly between banks and central banks
  • Good cost/benefit analysis is necessary when setting the rules
  • Banks must be allowed to dip into liquidity in a stress period
  • Liquidity rules will have important incentive effects
  • Global comparability must be balanced with national circumstances
  • Supervisory discretion will be need to be used appropriately
  • Counter-cyclical liquidity requirements should be considered eventually

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