Why is liquidity risk regulated?
Published: 9 May 2022
According to the Basel Committee, it is the liquidity risk in internationally active banks that should be regulated. See inter alia Basel Committee on Banking Supervision (2013). Note that the Basel Committee’s standards define both capital requirements and liquidity requirements for internationally active banks. How “international activity” should be defined is debatable. When the EU implemented the Basel global standards in the Capital Requirements Regulation, they chose quite simply to include all banks. See EU (2013) in which certain investment firms also are covered by the liquidity regulations.
What is it, therefore, that defines a bank? The definition in the Capital Requirements Regulation is brief: “An undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account”. See EU (2013), Article 4.1.1. There are however several other types of firms in Sweden that can grant credits, besides banks. For example, consumer credit institutions can grant credits in Sweden. At the beginning of 2022, there were 74 such firms in Sweden according to fi.se. However, it is essentially only banks that are authorised to take deposits from the public. Deposit firms can also take deposits from the public, but only up to a limited amount per customer. These types of firms are however being wound up as of 1 January 2021. It is thus only the firms that may take deposits from the public – that is, the banks – that are covered by the Basel liquidity and capital regulation standards.
Deposits make up a substantial part of funding for almost all major banks globally. Deposits differ from other funding because most of them are on demand – that is, they can be requested back immediately by the customer. Deposits are also nominally determined, which means that the depositor can request back the deposited amount (adjusted for agreed interest), irrespective of the performance of the bank’s asset side. This can make the bank sensitive to a bank run; that is, numerous customers withdrawing their money at the same time. The sensitivity ensues from the money potentially not sufficing if the bank does not hold sufficient liquid funds in such a situation. In that case, even a solvent bank could default and be put into resolution or go bankrupt, because a bad reputation or a single item of bad news can suffice to fuel a bank run. The run can then be very sudden, giving the banks limited possibilities to act to reduce its impact.
It is harmful to society if banks suddenly collapse, because many of them are important to the functioning of the payment system and for upholding lending. Through resolution, negative effects can be alleviated but not entirely counteracted and for this reason bank defaults must be prevented.
The deposit guarantee is a preventive measure that has been introduced in many countries, one purpose being to reduce the risk of bank runs. Besides this measure, central banks can also support banks by granting them emergency liquidity assistance. Governments can also act by issuing guarantees for part of the bank’s funding. This can reduce investors’ credit risk and hence improve their willingness to fund the bank. However, this causes a moral hazard. The banks have an incentive to increase their risk in their business to earn more money. If things take a bad turn, they might expect to be bailed out by the authorities through liquidity assistance, at least if the bank is large and considered systemically important. To resolve this dilemma, regulations are introduced that limit the banks’ risk-taking. The rules in the Capital Requirements Regulation cover liquidity risks, but also risks that place demands on greater capital, for example credit risks and market risks.
One way of summarising the task of a regulator is their need to find a sufficiently decent level of capital and liquidity to enable the banks themselves to bear losses or loss of liquidity in most crises that arise. This creates confidence in the banks, hence putting them in a good position for well-functioning operations with a low probability of a bank run.