The Real Reason to Worry About Basel III Liquidity Rules

A seemingly technical rewrite to the Basel III liquidity rules has attracted a remarkable amount of attention, including a recent editorial from The New York Times, a newspaper usually too august to parse complex international banking rules. 

Much of this public scrutiny has pronounced the revised liquidity rules "watered down." In fact, they aren't, but one change still contemplated by the Basel Committee could not only dilute the liquidity rules, but also brew a heady cocktail for too-big-to-fail banks outside the United States. 

The liquidity rules are hard to parse, but important to understand – the 2008 financial crisis was driven at least as much by liquidity shortfalls as by capital inadequacy. As a result, it's a vital policy priority to make these rules work for big banks and the governments that shouldn't need to love them too much.

Out of mercy, I'll spare you the details of the revisions crafted on Jan. 7 by the Basel Committee to the 2010 liquidity standards.  The most important changes are:  1)  an extended transition schedule that puts off much in the rules except where, as in the U.S., regulators or markets demand them now; 2) a new category for "high-quality liquid assets" that to a very limited degree under stiff criteria may constitute some offsets to liquidity risk; 3) a revised set of outflow assumptions (how fast funds flee under stress) that largely reflect actual market experience during the 2008 crisis; and 4) "alternative liquidity approaches" nations can adopt if the basic Basel framework doesn't work for them. 

The U.S. will go its own way, but not to ease the Basel framework.  It's got two proposals in the works that say loud and clear that the U.S. plans a very stringent standard that goes well beyond Basel, including with regard to the longer-term "net stable funding ratio" Basel pushed away to think about some other day.  The pending systemic standards for big U.S. bank holding companies include a few of Basel's liberalized standards (e.g., re HQLAs), but then stipulate a far more stringent governance framework and numerous other far stiffer standards.

The new proposal for foreign banks doing business here is, if anything, even tougher, with the Fed making clear that the Basel rules are no more than a minimum against which foreign banks seeking to do business here will be judged.

So, the final Basel standards aren't much watered down and, where they are, the U.S. and several other nations will thicken them right back up. 

Where could the global standards go from a hoped-for set of reasonable minimum criteria into a back-door blessing for "too big to fail"? The answer lies in one issue Basel deferred for future negotiations: How to handle access to central-bank facilities like the Fed's discount window. 

Some of the new standards are already unduly flexible here, but the Committee is also considering a complete pass for banks with calls on a government-sponsored liquidity source. I'll spare you the technicalities here, but the decision point is clear:  If a bank is deemed liquid largely because it can call home to open taxpayer spigots, it's liquid only because Daddy says so. 

If, in contrast, the bank must exhaust all of its own liquidity resources before turning to taxpayers, then central banks are indeed the lenders of last resort  for which they are chartered, and banks are appropriately disciplined by markets up to the point at which short-term support under broad market stress is necessary to stop a panic. 

The liquidity rules are complex, but the dilemma they pose isn't. If banks can call on their central banks without first having to run through ample supplies of their own high-quality liquid assets, then they are too big to fail and, indeed, likely even too big to save because the huge size of a bank's operations in a country's economy is magnified by the scope of its direct draws from taxpayers. 

If, however, the central bank is a costly, last-ditch liquidity window open only to banks that are otherwise safe and sound, then banks are more likely to be viable private companies that can be shuttered even under systemwide stress. 

Global rules can't patch over these differences as Basel tried to do in the latest liquidity rules. It's time for an honest assessment of what global prudential rules can and can't do. 

As the liquidity rule demonstrates, Basel can't demand anything from countries that won't agree to tough standards and global regulators are all too willing to water down their rules to save the appearance, if not the reality, of global harmony.  Real rules require best-practice criteria, not complex, compromised ones that delay meaningful reform in countries willing and able to exact it.

Karen Shaw Petrou is a managing partner at Federal Financial Analytics Inc.