Long before the recent subprime crisis became a global crisis, regulatory authorities, under the influence of the Basel Committee for Banking supervision, spent much effort on designing, harmonizing and implementing quantitative rules for prudential capital adequacy, but spent little effort on doing the same for liquidity. The crisis has changed this and has revived interest in liquidity regulations as a complement to solvency regulations (Rochet 2008), especially since high-capitalized banks may also suffer from funding liquidity strains in times of market turmoil. In a recent paper, the Basel Committee for Banking Supervision has outlined principles for sound liquidity risk management and supervision (Basel Committee 2008a). While in some countries, such as Italy and Spain, the liquidity regulations contain only qualitative requirements, in other countries, such as the United Kingdom and Germany, regulations specifying qualitative as well as quantitative requirements were installed several years ago (Algorithmics 2007).
Qualitative requirements, which are often based on the recommendation of the Basel Committee (2000), focus, inter alia, on the need for adequate information systems, required processes to assess future cash-flows, net funding requirements, and setting of internal limits (Basel Committee 2008b). Quantitative requirements, which specify liquidity relevant positions in simple rules, may be based on a stock approach that requires target holdings of liquid assets that can be drawn down, when needed and/or a cash-flow mapping approach that forces banks to match their cash in- and outflows. Both qualitative and quantitative requirements aim at limiting banks’ exposure to funding risk (i.e., the risk that the counterparties who supplied short-term funding will not roll over that funding and force banks to use other funding sources), and market liquidity risk (i.e., the risk that disruptions in securities markets may turn formerly liquid assets into illiquid assets). Such quantitative requirements are usually designed for normal market conditions, not for times of market turmoil when liquidity in the interbank or securities markets vanishes.
Recent studies have focused on various aspects of banks’ liquidity management, such as the management of reserve requirements (Bartolini et al. 2001, Jallath-Coria et al. 2002), securities holdings, and cash balances (Aspachs et al. 2005, Freedman and Click 2006), and transforming short-term liabilities into illiquid assets (Berger and Bouwman 2009). However, little is known on how banks manage their overall liquidity that is their liquid assets given their bank-specific payment obligations, although several countries have installed quantitative requirements, which can serve as a description of banks’ overall liquidity. This paper contributes to filling this gap. Examining liquidity management based on regulatory data requires admitting that quantitative liquidity requirements are very simplified rules as compared to the complexity that banks face when managing liquidity. Because liquidity management is, by any standard, very complex, as banks have plenty of adjustment strategies, regulatory liquidity data can only serve to identify some of the basic management strategies that banks employ. Nevertheless, inspecting regulatory liquidity data is important, because banks may be initiated to take too excessive liquidity risks not only when central banks act as a lender of last resort (e.g., Ratnovski 2009, Repullo 2005), but also when quantitative liquidity requirements are too lax to limit liquidity risks effectively.
In this paper, I investigate how banks manage the liquidity specified in the Regulation on the Liquidity of Institutions, which formulates quantitative requirements for financial institutions’ liquidity in Germany. The current liquidity regulation requires banks to have a liquidity ratio (LR) at least equal to one. This ratio is obtained from dividing regulatorily specified liquid assets, such as securities holdings and repayments from loans within the next month, by regulatorily specified payment obligations, which contain, inter alia, regulatorily specified percentages of demand and savings deposits and the full amount of liabilities maturing within the next month. Thus, the liquidity regulation in Germany combines a stock approach, since securities traded on regular markets are classified as highly liquid assets, and a cash-flow mapping approach, since cash inflows and outflows from on and off-balance-sheet assets and liabilities are used when calculating regulatory liquidity.
Behind this regulation is the assumption that a solvent and profitable bank can ensure its middle-and long-term refunding (Deutsche Bundesbank 1999, pp 29), but that it may face the risk of liquidity shortages in the short-run (FBSO 1998). While banks have, under normal market conditions, plenty of adjustment strategies at their disposal that they can employ to have higher liquid assets when they are subject to higher payment obligations, I focus on three stylized strategies only. First, they may increase their liquid assets by purchasing additional funds when they are subject to higher payment obligations. Second, they may have higher loan repayments because they match cash flows of their illiquid assets and liabilities long before they are subject to higher payment obligations from maturing liabilities. Third, they may perform an asset-side accounting exchange at the time when they are subject to higher payment obligations. Here fore, banks decrease illiquid assets, such as long-term loans, and synchronously increase liquid assets. Several recent studies demonstrate that liquidity shortages impact on bank lending (e.g., Paravisini 2008, Loutskina and Strahan 2009, Khwaja and Mian 2008). For example, Loutskina and Strahan (2009) find evidence that banks with high costs of funding and low balance-sheet liquidity are less willing to approve mortgages that are hard to sell than banks with low costs of funding and high balance-sheet liquidity. Their evidence indicates that banks are not able to cushion corporate borrowers against bank-specific liquidity shortages.
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Insights on Banks’ Liquidity Management: Evidence from Regulatory Liquidity Data
