Fed's Quarles Talks on Liquidity
Federal Reserve Vice Chairman for Supervision Randal Quarles spoke Friday on "Liquidity Regulation and the Size of the Fed's Balance Sheet." He commented on "Liquidity Regulations," saying, "Let me now back up to the time just before the financial crisis and briefly describe why liquidity regulations are necessary for banks. Banking organizations play a vital role in the economy in serving the financial needs of U.S. households and businesses. They perform this function in part through the mechanism of maturity transformation -- that is, taking in short-term deposits, thereby making a form of short-term, liquid investments available to households and businesses, while providing longer-term credit to these same entities. This role, however, makes banking firms vulnerable to the potential for rapid, broad-based outflows of their funding (a so-called run), and these institutions must therefore balance the extent of their profitable maturity transformation against the associated liquidity risks. Leading up to the 2007-09 financial crisis, some large firms were overly reliant on certain types of short-term funding and overly confident in their ability to replenish their funding when it came due. Thus, during the crisis, some large banks did not have sufficient liquidity, and liquidity risk management at a broader set of institutions proved inadequate at anticipating and compensating for potential outflows, especially when those outflows occurred on a rapid basis." Quarles continues, "In the wake of the crisis, a combination of regulatory reforms and stronger supervision was needed to promote increased resilience in the financial sector. With regard to liquidity, the prudential regulations and supervisory programs implemented by the U.S. banking agencies have resulted in significant improvements in the liquidity positions and in the risk management of our largest institutions. And, working closely with other jurisdictions, we have also implemented global liquidity standards for the first time. These standards seek to limit the effect of short-term outflows and extended overall funding mismatches, thus improving banks' liquidity resilience. One particular liquidity requirement for large banking organizations is the LCR, which the U.S. federal banking agencies adopted in 2014. The LCR rule requires covered firms to hold sufficient high-quality liquid assets (HQLA) -- in terms of both quantity and quality -- to cover potential outflows over a 30-day period of liquidity stress. The LCR rule allows firms to meet this requirement with a range of cash and securities and does not apply a haircut to reserve balances or Treasury securities based on the estimated liquidity value of those instruments in times of stress. Further, firms are required to demonstrate that they can monetize HQLA in a stress event without adversely affecting the firm's reputation or franchise."
