Liquidity, Bank Capital and Market Reform

A friend forwarded some thoughts on liquidity that are worth sharing here, as liquidity is central to the utility of assets as bank capital and to stabilising markets under stress. My friend's points are in bold, with my commentary below.

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

Liquidity means you can generate cash from a physical asset or paper claim.

If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.

Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.

Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

Liquidity means that proceeds of sale will be paid as funds to your account in a currency you can use widely to meet obligations.

If you can only sell your asset into a market denominated in a currency which itself is not liquid and not legal tender for meeting your obligations, then you haven't got liquidity vested in the asset. A lot of investors in emerging markets are probably going to find that liquidity in those markets is a lot less than they might think, despite advances in exchange trading of emerging market assets, and the currencies might be less liquid too in a falling market. If they require funding in their home currency, they risk taking a big hit on sale and FX spreads when they realise the asset under stress.

Liquidity is measured by size, speed and spread - not by price levels.

Whatever the market price, a market isn't liquid if those holding assets in size cannot deal in size. A market is not liquid if those holding assets cannot sell at the time the sell decision is made, but must wait to identify or attract sufficient buyers. A market is not liquid if the spread between the bid and ask is so wide that buyers will be deterred from the market by the risk of never recovering the spread in appreciation or returns. The way that markets have levitated on minimal volumes in 2010 and 2011 is no indication that the markets are liquid. As we've seen in August, even mild selling can have a massive effect on prices in an illiquid market.

Short sales are an attribute of liquid markets. If a market can't be shorted, then the market will fail as prices fall.

Short sellers will come in to buy assets in a falling market to realise a profit. They provide liquidity when everyone else is too scared to deal.

Securities markets regulators and central bankers need to think through liquidity as an attribute of market structure in the public interest. Idiosyncratic, illiquid, ill-transparent deals and instruments which have dominated market growth for the past two decades are behind the weakness of bank capital and market recovery. The regulatory incentives should be toward standardisation of securities terms and offering documents, much larger issues of securities and series of bonds, and fungibility of asset types within a class. Exchange trading should be encouraged, fragmentation discouraged. Exchanges should provide rigorous listing rules, timely reporting of market relevant information, full price transparency and two-way quote obligations on market makers. If we got that right, then much of the misrepresentation, mispricing, inefficiency and fraud of the past would become impossible in future.

Basel Faulty: Sovereign Defaults and Bank Capital*

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. - Ralph Waldo Emerson

When historians of the future look objectively at the era preceeding this long financial crisis, they might well conclude that failure of the globalised capital system is traceable to the Basel Accords.** The unreasonable assumptions and myriad distortions introduced in this one-size-fits-all paradigm of bank capital adequacy fatally undermined the practice of independent judgement in assessing credit risk and prudential supervision of banks.

Bankers of the past had to assess the creditworthiness of a debtor or counterparty based on balance sheet, revenue potential and management reputation for competence. They husbanded their scarce capital, aware that each dollar lent remained at risk until repaid, with cash reserves proportional to the bank's assets usually 8 to 10 percent.

A primary fallacy of the Basel Accord is that OECD government debt is risk free and requires no bank reserves. Better yet, the banks can count the government debt they hold as Tier 1 capital, reserving against other debt assets. The Basel Accords assume all OECD government debt is a cash proxy, being liquid in all market conditions.

Walter Wriston's 1970s dictum that "sovereigns can't default" was disproved in the Third World Debt Crisis of the 1980s, but somehow the BIS Committee on Bank Supervision still embraced it when applied to OECD state debts.

Roughly, the risk weights of the main asset classes under Basel I were:
- zero for Zone A (EEA and OECD) government debt of all maturities and Zone B (non-OECD) government debt of less than one year;
- 20 percent for Zone A inter-bank obligations and public sector entity debt (e.g. Fannie Mae, Freddie Mac, et al.);
- 50 percent for fully secured mortgage debt;
- 100 percent for all corporate debt.

The post-Basel bank supervisors applied their prudential supervision models unthinkingly, to rubberstamp the bankers' leveraging of their balance sheets toward ever greater excess. No one bothered to ask whether Basel Accord assumptions made sense. They were the harmonised norm for prudential supervision and too deeply embedded in the fabric of international finance to adjust, except to allow more and greater leverage in Basel II through liberal recognition of derivatives. Basel II allowed the banks to offset even more risk exposure with even less capital through collateral, securitisation, credit default swaps, and recognition of the validity of internal asset valuation models.

Global harmonisation of prudential supervision around the Basel Accord meant that the hobgoblin of excess leverage became systemically entrenched in all markets, in all nations. The foolish consistency of harmonised capital adequacy was adored by little minds of global bankers and central bankers worldwide.

The zero weight for OECD government debt must have appeared a harmless subsidy to OECD governments in 1988, promoting liquid government debt markets and enhancing the competitive positioning of OECD-based global banks who stood to gain most from the harmonisation of global bank regulation and capital rules.

Leveraging their balance sheets to work every dollar of capital harder became the obsessive preoccupation of two generations of bank executives once the Basel Accords were adopted. Risk management departments were less about controlling exposure to adverse credit events than about identifying deal structures which would minimise the amount of regulatory capital allocated to any exposure.

Fannie Mae, Freddie Mac, and their ilk were an early mechanism to reduce the reserves required from 50 percent on an individual mortgage to twenty percent or even zero, allowing the banks to write more and more mortgages with less and less capital. When these entities proved inadequate in the go-go 1990s, asset back securities allowed banks to get sub-prime mortgages - and thereby the capital requirement - off their books entirely, passing the risks to yield-hungry investors. With Basel II they could reduce capital even further by writing each other a daisy chain of credit default swaps for all categories of exposure. Who could have known that it would end badly?

OECD government debt is zero risk weighted and accounts for a disproportionate bulk of Tier 1 capital of major banks. A default by any EEA or OECD government will force banks and central banks to recognise that government debt has inherent risk like all other debt. This would force recognition of a positive risk weighting, and bring into question the assumption that government debt can be counted as a cash-proxy in Tier 1 reserves. The illiquidity of impaired or defaulted government debt would undermine its role as a Tier 1 reserve asset in bank capital models.

At this writing the OECD governments at risk of default are Greece, Portugal, Spain and Ireland, with other states queuing up in the wings. Already the ECB is the only buyer in the market for much of the impaired government debt.

If any OECD state were to default there would be very serious implications:
- The Basel Accord zero risk weight of government debt would be proved fanciful;
- The assumption of government debt as a liquid asset suitable for bank Tier 1 reserves to meet unanticipated and sudden cash demands will become unsustainable;
- Banks would be forced to recapitalise at much higher levels, forcing even sharper deleveraging and contraction of lending;
- Governments would lose the captive, uncritical investor base they have relied on to finance excess public expenditure for the past 30 years;
- Central banks could be forced to suddenly monetise even more government debt if required to meet the cash demands of a run on their undercapitalised banks.

Looked at this way, you should be able to understand why the ECB keeps repeating that there can be no Eurozone sovereign default, and why the UK and US are staunchly behind them in preserving the illusion of state solvency for all Eurozone states.

It will likely prove impossible to reform the bankers and central bankers dependent on the Basel Accords for their business models and careers. Harmonisation of global standards was supposed to make the world safer. A foolish consistency on bad policy and bad practice led instead to a world on the edge of financial implosion.

This hobgoblin haunts us all.
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* Hat tip to Tracy Alloway at FTAlphaville for suggesting a revision to the title for this post.
** Several commenters questioned my spelling of Basle Accords in the original post. I prefer the British/French Basle which was standard in my youth on Basle Accord documents, to the German/American Basel more common and current today. Nonetheless, I yield to the customs and usage current today in changing the spelling to Basel.