Don't Undermine Liquidity for the Sake of Capital

One of the lessons of the 2008 financial crisis is that our financial institutions need more risk-bearing capital to absorb financial losses without putting depositors or taxpayers at risk. Another important lesson is that banks need to hold more high-quality liquid assets, as even our healthiest institutions were at risk of failing due to insufficient holdings of cash and cashlike assets when external funding sources were constrained.

Congress, the Group of 20 major economies, the Basel Committee, the Financial Stability Board and financial regulators, domestic and international, have in recent years called for and passed various measures to strengthen capital and liquidity for the safety and soundness of our banking institutions. Banks are currently holding record amounts of liquidity, partly due to historically favorable terms resulting from the policies enacted after the financial crisis. But this situation may not last as markets conditions return to historical norms.

Our banking regulators should be commended for moving closer to final rules on the supplemental capital requirements for our largest and most complex banks. However, proposals for a supplemental leverage ratio from the U.S. regulators and the Basel Committee would treat cash, and the safest cashlike assets, like any other risky asset. This may actually discourage banks from keeping their current high levels of liquidity when pressed to boost their leverage ratios. Furthermore, forcing banks to allocate higher amounts of capital against holdings of cash and cashlike assets makes it costlier for them to hold the very same assets that would make them safer and more resilient in future crises.

True, holding cash and cashlike assets carries costs, and is not entirely risk-free. There is some counterparty risk, for example, since a bank must deposit cash with another bank or hold a government bond in a custodial account. There's also the risk of losing money on these investments if funding costs exceed yields.

The mere thought of a U.S. government default is deeply troubling, but assuming with confidence that a resolution will be found and the debt ceiling will not be breached, the ordinary risks of cash and cashlike assets are manageable. Banks have mitigated the counterparty risks with concentration limits, maturity limits, and sometimes collateral. And well-capitalized banks with abundant liquidity are rightly viewed as safer options by investors and creditors, and this translates to lower funding costs that dilute the risk of negative carry.

Regulators are also committed to adopting a liquidity coverage ratio rule as per the Basel Accords, which would force banks to hold a minimum amount of liquidity to cover obligations during stressed market conditions for as long as 30 days. The LCR would certainly be a step in the right direction.

However, consistent with the Basel Committee's views, the LCR is only meant to serve as a strict minimum. Furthermore, as was proven during recent financial crises, such requirements may fall short of actual needs during even a mild financial crisis, and may not be sufficient to avoid future government intervention. Financial regulators should, therefore, look beyond regulatory minimums, and consider other measures, to encourage banks to maintain abundant levels of liquidity even as they face higher capital requirements. This could be done by enhancing the proposed rule or through a separate measure.

Congressman Gregory W. Meeks, D-N.Y., is a senior member of the House Committee on Financial Services and is the ranking member on the Subcommittee on Financial Institutions and Consumer Credit.