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The undeniable reality is that bank runs today are not cash oriented, they are digital in nature. Unlike the famed bank run in "It's a Wonderful Life" where depositors line up at the institution's doors to take out their cash deposits,
The speed will become almost unmanageable when online real-time payment streams like FedNow are adopted heavily.
So, let's return to the question, what should we be doing to address ongoing liquidity issues? Here is a common-sense approach that focuses on seven key issues that need to be addressed.
Financial Institutions need to adopt time-sequenced liquidity. This issue should be noncontroversial. Since liquidity runs now will be digital and extremely fast, liquidity must be measured against time. Financial Institutions should measure liquidity at minute one, day one, week one and month one. This expands on the call for five-day liquidity that acting Comptroller Hsu recently called for. Minute-one liquidity is the cash available in the Fed master account plus cash and cash equivalents. Day one includes minute one plus immediate borrowing capacity. Week one includes all of day one plus any remaining on-balance sheet liquidity and some modest amount of brokered and listing deposits. Month one includes all of the above plus the ability to raise a lot of brokered and listing deposits, sell loans and raise deposits generally. All of these require detailed study to ensure availability.
Insure all deposits. Much of the liquidity run on Silicon Valley has been placed on its extremely high level of uninsured deposits. Insuring all deposits will reduce the runoff risk experienced during the March 2023 banking crisis by increasing consumer confidence and reducing the contagion associated with reputational risk. This can be achieved in two ways.
First, the FDIC should enhance insurance limits to insure all deposits. Deposits over $250,000 will incur a higher insurance premium than traditional insured deposits to price in the risk (and eliminate the thought that full deposit insurance is just being given away to the wealthy). This should be equivalent to the cost of private solutions, or 12 to 15 basis points. Second, if the FDIC can't get congressional authority to insure all deposits, the industry must make a concerted effort to move all uninsured deposits into private insurance solutions that provide a mechanism to move uninsured deposits into insured deposits by distributing balances widely to a number of banks.
Lawmakers on both sides of the aisle pulled back from criticizing the Federal Home Loan banks, seemingly taking off the table the idea of changing the system's role as a lender to troubled banks.
Regulators should acknowledge that pledged, but unencumbered assets (assigned to a specific borrowing) should count as on-balance sheet liquidity. Bank investment policies often center on holding investments as a secondary source of liquidity (on-balance sheet liquidity). With the unrealized loss position in investment portfolios, reputation risk associated with a loss trade and the proliferation of the Bank Term Funding Program, selling securities for liquidity purposes has moved down the liquidity waterfall.
The most logical liquidity strategy with the investment portfolio is to maximize borrowing capacity by pledging eligible unencumbered securities to the Bank Term Funding Program, and if ineligible the Discount Window or a Federal Home Loan bank, to increase secured contingent liquidity capacity. Federal regulations already provide for counting pledged, but unencumbered assets as a highly liquid asset. It states an asset is unencumbered if it is pledged to a central bank or a U.S. government-sponsored enterprise, to the extent potential credit secured by the asset is not currently extended by such central bank or U.S. government-sponsored enterprise or any of its consolidated subsidiaries. As such, banks must continually monitor and report on pledged but unencumbered securities as a source of on-balance sheet liquidity.
Add longer term options to the Fed discount window, in effect, making it comparable to the Federal Home Loan banks. Amid uncertainty surrounding the mission of Home Loan banks and the scheduled expiration of the Bank Term Funding Program, the discount window will be an essential source of contingent liquidity and stability for the industry in the future. The discount window was constructed to help depository institutions manage their liquidity risks efficiently, but the lack of term options in place provides limited flexibility to the industry in doing so. The Federal Reserve should introduce term-structured products, similar to those at other lending facilities, to effectively execute its mission with the program. Minimally add one month, three month, six month and one year. (Possibly adding multiyear terms as well.) As important, the discount window must become an acceptable tool for managing bank liquidity by eliminating its negative reputation. Adding term options and a healthy marketing campaign endorsing this funding vehicle will be required.
Allow banks to offer certificates of deposit that are contractual like brokered deposits. The industry learned that the liquidity risk from the optionality of non-maturity deposits and, to a lesser extent term deposits, proved to be detrimental to liquidity for the failed banks in 2023. Early withdrawal optionality on term deposits should be eliminated to remove option risk from maturity deposits, which would provide banks more transparency around the liquidity risk of their liabilities. This should be an option for consumers. Removing early withdrawal options from term deposits would mirror the structure of the brokered CD market and make this funding source stable for interest rate risk and liquidity purposes.
Standardize the liquidity measurement criteria. The denominator for liquidity ratios varies across institutions. The industry should enhance and standardize liquidity ratios, so all institutions hold contingent liquidity sources against the level of non-term funding. All term funding is already contractually contained in the bank's cash flow and cannot be immediately withdrawn. As such, we do not need to hold liquidity against this type of funding. This methodology is only viable if early withdrawal optionality on all term deposits is eliminated and would demystify and standardize the amount of liquidity institutions are holding based on the amount of funds that could be withdrawn immediately.
Implementing these recommendations will not be easy or quick, but would materially prevent another liquidity-driven bank failure. So rather than ignore the new liquidity reality, let's take it on headfirst.
