Turbulence on financial markets can make banks reluctant to assume counterparty risk and hence avoid lending to each other. This can lead to a liquidity shortage at one or several banks, which might then find it difficult to meet their payment obligations and hence put them at risk of default. Problems can then spread to other banks because of their tight interconnectedness. While central banks can supply liquidity aimed at saving one or several banks, in order to uphold financial stability, confidence in this or these bank(s) might already be lost. This loss of confidence can come at a great cost to society.
If central banks supply a bank with liquidity, this could bolster market confidence in that bank. At the same time, the central bank’s extraordinary supply of liquidity might in itself send a negative signal to the market. This can further fuel unease, if market participants interpret the action as an indication that the bank is in a worse state than they previously believed.
Notwithstanding how the market would act, it is crucial that the bank and the market as a whole can stand on their own feet, not least in light of the moral hazard among the banks. If a bank knows that it can always count on the central bank to step in, there is a risk that the bank will take greater liquidity risks. A bank’s need to stand on its own feet applies particularly in the shorter run, so that it could survive at least until any measures of authorities take effect.
Today, the Riksbank monitors the large banks’ levels of the legal liquidity metrics Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). LCR and NSFR were defined in the Basel Committee on Banking Supervision (2013) and the Basel Committee on Banking Supervision (2014), respectively. Using these metrics, the European Capital Requirements Regulation (CRR I and II) sets requirements for the banks. These metrics are essentially two different types of stress test that focus on the time periods 30 days and one year, respectively. In addition, the Riksbank performs its own stress tests on individual banks. All of these stress tests, legal and internal, show how an individual bank would cope with a specific stressed situation that is based on numerous specific assumptions. These metrics and stress tests are important, but they do not provide a complete picture of the liquidity risk to which the banks and the market as a whole are continually exposed to.
This Economic Commentary therefore aims to describe a complementary way of measuring liquidity risk in banks. The analysis is mainly performed by measuring how maturity on the liability side matches that on the asset side, for all time periods. By studying this, the Riksbank can for instance calculate when (that is, in which future time bucket “Time bucket” is defined as a future time range in which a contractual flow can arise, for example in five to six months. ) the greatest liquidity risks are present for individual banks, and also for the entire Swedish banking system. This is one of several important bases for the Riksbank in its assessments of the liquidity risks of various banks and in recommendations for new regulations. It also forms an important basis when the Riksbank determines if, and if so how much, liquidity needs to be supplied to the system or an individual bank in a crisis.
In section 2 we briefly discuss why liquidity risk is regulated and describe the two international liquidity metrics LCR and NSFR. In section 3 the new liquidity metric Deposit Loss Capacity (DLC) is presented, and the effect that LCR and NSFR have had on the banks. In section 3 we also present how the five large banks in Sweden are performing according to the new metric. Section 4 offers a summary in a concluding comment.