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    FED Note Discusses Impact of LCR Introduction on Bank Liquidity

    February 26, 2020

    FED published a note that examines the changes in liquidity management at banks and non-bank financial firms in the United States, post the proposal and finalization of the liquidity coverage ratio (LCR) requirement in 2014. The note concludes that introduction of the LCR liquidity requirement has had a profound effect on liquidity positions of banks. Large banks subject to the LCR dramatically increased their holdings of high-quality liquid assets to match their liquidity risks, including those that stem from providing credit lines to the business sector. In contrast, smaller banks not subject to the LCR have decreased liquid asset holdings in the post-crisis period, even though they also have been increasing their exposure to nonbank financial firms.

    While banks increased their liquid assets to meet the new regulatory liquidity requirements, nonbank financial institutions—such as insurance companies, finance companies, real estate investment trusts, pension funds, asset managers, mutual funds, and others—decreased their liquid assets and increased their reliance on bank credit lines to manage their liquidity risks. This shift in liquidity management at nonbanks presents a puzzle because the post-crisis regulatory framework imposes much higher capital and liquidity requirements on undrawn credit lines to nonbanks. Therefore, all else equal, the supply of credit lines to nonbanks would have been expected to decrease after introduction of the LCR. One potential explanation is the increasing opportunity cost of holding liquid assets in the post-crisis period. If the relative cost of holding liquid assets exceeded the cost of obtaining and maintaining credit lines with banks, then nonbank financials would reduce their own liquidity and increase their reliance on bank credit lines. 

    The role of the banking system as a provider of corporate liquidity through credit lines has increased after introduction of the LCR requirement and other post-crisis regulations. From a financial stability perspective, those post-crisis regulations have increased resilience. Banks' historically large liquidity positions ensure that draw-downs on the credit lines would be supported by higher levels of liquidity in the next debt market collapse. Furthermore, the stress testing regime of FED and the U.S. implementation of the Basel III standardized approach require banks to account for undrawn credit lines in their capital planning in ways that did not exist before the crisis.

    Finally, to the extent that there are economies of scale of concentrating liquid assets at large banks and pooling liquidity risks of the corporate sector, the provision of liquidity insurance through credit lines to the rest of the corporate sector would be more efficient than in the pre-crisis period. That said, significant financial stability risks remain. The unused committed credit lines to the corporate sector will likely be drawn in a highly correlated manner during a period of debt market distress materializing as on-balance sheet bank loans, and they will absorb a significant part of banks' liquidity and capital buffers. Moreover, to the extent that nonbanks financials lend to riskier borrowers that are more likely to default in a downturn, the higher credit risk of nonbanks' loan portfolios would be transferred to banks when those non-banks draw their credit lines.

     

    Related Link: Note

    Keywords: Americas, US, Banking, LCR, Basel III, Liquidity Risk, Stress Testing, Research, FED

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