Banks agree minimum liquidity rules

Banks around the world will now have to maintain access to certain levels of cash

Financial regulators and central bank governors from the world's biggest economies have made history by agreeing rules on the minimum quantities of cash and liquid or sellable assets that all banks must hold. It is an attempt to make banks less vulnerable to the kind of runs that shattered Northern Rock and Lehman Bros.

There is an oddity at the heart of today's historic agreement by the oversight body of the Basel Committee on Banking Supervision, which for the first time will impose new minimum requirements for the amount of cash and liquid assets that banks all over the world will have to hold.

The oddity is that most banks already hold considerably more than the new minimum requirement - but the reason they already pass this threshold is because we continue to live in strange and perilous times, with many Western economies parlously weak and the financial system still stressed.

Or to put it another way, over the past four years central banks - such as the Bank of England, European Central Bank and US Federal Reserve - have enormously increased their lending to counteract the weakness of commercial banks and of economies.

And, as a matter of definition, when central banks expand their respective balance sheets they create liquid assets for commercial banks.

So the ample liquidity held by big banks simply reflect the depressed times we live in, where banks are frequently reluctant to make loans to the real economy and deplete their liquid reserves.

Inadequate funds

To put it another way, this is the worst possible time to judge whether the liquidity reform will be useful.

More relevantly, the new rules would force banks to hold vastly more liquid assets than they did in the summer of 2007. Back then big banks barely had enough cash to meet demands for repayment from relatively small numbers of depositors and creditors.

That shortage of cash played a role in taking Northern Rock to the brink of collapse, made it impossible for HBOS and Royal Bank of Scotland to survive without emergency loans from the Bank of England, and was an important factor in the collapse of Lehman Bros.

Even so, and as pointed out by Sir Mervyn King - the governor of the Bank of England who chairs the oversight body of the Basel Committee, which is known as the Group of Governors and Heads of Supervision (GHOS) - the fundamental cause of the crises at these banks and others was that they had too little capital to absorb losses.

Their inadequate holdings of cash was more a trigger or precipitator of their woes, rather than their most basic flaw.

'Troubling paradox'

Perhaps the most striking characteristics of today's agreement - which amends a draft first published in 2010 - is that banks will be allowed to include corporate bonds, some shares and high-quality residential mortgage backed securities in their permitted stocks of liquid assets.

This goes against the grain of central banking and regulatory orthodoxy. In particular, the inclusion of mortgage-backed securities will be seen by some as odd, since these proved to be wholly illiquid and unsellable in the summer of 2007.

That said, arguably there is a much more basic and troubling paradox at the heart of the new rules. Which is that they define cash, central bank reserves and some marketable securities backed by sovereigns and central banks as the highest quality liquid assets.

If you believe that quantitative easing and the unprecedented creation of new money in much of the West - including the UK and US - risks debasing these assets over the long term, or if you believe that the credit worthiness of most Western governments is not what it was, then you would argue that banks are being encouraged to hold excessive stocks of assets that could end up becoming seriously and dangerously loss-making for them.