Liquidity regulation

Over time there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid, but eventually resulted in poorly underwritten subprime mortgages - a classic adverse feedback loop ensued.[2] This led to the fall of the housing market and the financial crisis of 2008. In response to this failure of liquidity regulations, there has been recent progress in developing new measures to further reinforce the core role of liquidity regulation.

In 2010, the UK Financial Services Authority (FSA) introduced a new liquidity regulation known as the Individual Liquidity Guidance (ILG). In 2013, the Basel Committee on Banking Supervision agreed on a Liquidity Coverage Ratio (LCR), which is similar in design to the ILG but plays a role in an international playing field. The purpose of ILG is to make the banking system more resilient to liquidity shocks by requiring banks to hold a minimum quantity of high quality liquid assets (HQLA). These HQLA consist of cash, central bank reserves and government bonds to cover net outflows of liabilities under two specific stress scenarios, lasting 14 days and 3 months respectively. This way it is assumed that banks that are more heavily dependent on short-term wholesale funding, especially from foreign counterparts, would experience greater funding outflows and therefore need to hold a higher ratio of HQLA to total assets, to ensure immediate survival in stressed funding conditions.[3] The U.S. banking agencies have worked with other regulators in the Basel Committee on Banking Supervision to develop the Net Stable Funding Ratio (NSFR), which is the available amount of stable funding, relative to the required amount of stable funding. It is assumed that this ratio should be at least 100% on an on-going basis. The ratio can be calculated with the following formula:

${\displaystyle {\frac {Available\ amount\ of\ stable\ funding}{Required\ amount\ of\ stable\ funding}}}$ ≥ 100%

In this case, the ‘available stable funding’ is defined as the portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR, which extends to one year. The amount of such ‘stable funding required’ of a specific institution is a function of the liquidity characteristics and residual maturities of the various assets held by that institution, and those of its off-balance sheet exposures.[4] In short, the NSFR will require banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.[4] Together, the LCR and NSFR are designed to mitigate the risks associated with banks' reliance on unstable funding structures and to encourage them to embrace more resilient funding models.[2] The difference between the two is that the LCR is specifically designed to improve the short-term resilience of banks against liquidity shocks and the NSFR, on the other hand, is designed to limit the risks emanating from excessive maturity mismatches over the medium to long term [5]