By Marco Troiano, Head of Financial Institutions

Basel III standards and post-GFC re-regulation have generally lowered reliance on short-term wholesale funding, which can be fickle, and introduced minimum rules and limits around liquidity. But the fact that these are based on modelled liquidity outflows clearly makes them sensitive to modelling assumptions.

For example, deposits (insured and uninsured) are assumed to be relatively sticky, at least in the short 30-day horizon of the Liquidity Coverage Ratio, the key ratio for the prudential supervision of liquidity. In an age of digital banking and social media, these assumptions look outdated.

This is not the only limit. By construction, regulatory LCRs inform on how a bank has managed its 30-day liquidity over the preceding 12-month period. Spot LCRs, which banks often also report, inform on a standstill basis i.e. how liquidity cover looks for the next 30 days. LCRs are typically disclosed together with quarterly earnings, a month or so after the end of the quarter. That makes them useless to gauge a bank’s liquidity position on a forward-looking basis.

They do have some value for credit analysis in that they offer a synthetic view on how banks manage short-term liquidity risk over the medium term. Do banks optimise LCRs for compliance with the regulatory minimum requirements or do they manage to a targeted buffer over the minimum? And how large is the buffer? They also act as a gauge of directional trends (or lack of thereof), both at sector level and at individual level, making it easier to spot outliers. Detailed LCR disclosures allow investors to gain greater insights into the composition of a bank’s deposit base. Banks seldom disclose the amount of insured deposits but LCR disclosures offer a reasonable proxy for stable deposits.

Deposit base composition, selected European banks

Source: Company data

The chart shows that there is a wide variation in the funding characteristics of European banks. Unsurprisingly, this is the result of well-defined business model characteristics. Private banks and banks with a greater corporate focus have a less stable funding base compared to former saving banks or retail lenders. But the very fact that LCRs exist should offer investors some comfort that liquidity risk is being measured, managed and supervised to some extent.

Whether the current LCR framework needs to be recalibrated, for example by applying more stringent assumptions on liquidity outflows, is an open question. Some argue that current weightings for deposit outflows are too lax; a higher LCR target would also strengthen banks’ survivability to funding stress.

While both these could help at the margin, they would be treating the symptom and not the cause of the problem. Modern commercial banks are, at their core, maturity transformation machines. They make money extracting term premiums from their core deposit-taking and lending activities. Liquidity risk is intrinsic to their very nature. Imposing liquidity requirements that are too high would have the unintended consequence of inducing banks to take greater risks elsewhere while at the same time pushing more of the vital economic function of liquidity transformation outside of the banking system into the unregulated or less regulated financial system.

Bank run risk can be tackled through structural reform

We are more constructive on regulatory initiatives that treat the root cause of banks’ short-term funding risk i.e. increasing the safety nets around deposits and limiting the incentives for bank runs, even for banks in difficulty.

The European Commission’s recent proposal on crisis management is a useful step in this direction, among other things because it seeks to harmonise the priority of claims in EU Member States by creating a super-preference for bank deposits relative to senior unsecured debt. Today, this is the case in eight of the 30 members of the EEA. This is an important step towards strengthening the Banking Union and will help make European bank deposit funding marginally safer.

Completing the Banking Union by moving forward on a common deposit insurance scheme would reassure depositors in countries where the sovereign is still assumed to be the backer of last resort for national deposit guarantee schemes. According to ECB Vice President de Guindos, the lack of a European Deposit Insurance scheme is “the main vulnerability for the European banking system”.

Another useful step would be to raise the thresholds for deposit insurance, as pointed out by Bank of England governor Bailey in April. This would increase deposit stability by changing the mix between insured and non-insured deposits, although it would come at a cost for the system. So far, appetite for such a measure seems limited outside of the UK.

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