Basel III extension is a pointless tonic to a deeper disease

Andrew Lilico
WHAT should discipline how much cash a business keeps aside to service its debts – what we might call its “liquidity buffer”? The answer’s pretty obvious: how much the debts are; how often they fall due; to what extent they can be called up early; how secure are the inflows from a business’s cash-generating activities and so on.

The key discipline is these “market” factors. Obviously, it’s undesirable if firms operate fraudulently, and taking on additional debts when you are already bust is akin to fraud. So all firms are subject to certain regulatory obligations about their liquidity and solvency. But regulatory requirements, of the sort announced on Sunday by the Basel Committee on Banking Supervision, should only be a backstop – the main source of discipline must always be market factors.

What is true of other businesses is also true of banks. There is nothing magical about a bank that means it shouldn’t have to repay its debts, or that it should not be mainly market factors that discipline its activities.

What is unusual about a bank, and intrinsic to its business, is that a relatively high proportion of its debts are subject to early recall – in particular the loans to the bank we call “deposits”. Banks need to keep adequate liquidity available, or have available credit lines, to pay ordinary and unusual withdrawals by depositors. If it does not maintain adequate liquidity for that purpose, the bank should fail, as other businesses fail. And as with other business failures, that might mean that not all creditors are made whole. In the case of a bank, that means depositors may lose money. That’s not improper or some epic failure of the economic system. It’s just what a “business failure” is.

In a fractional reserve banking system, the central bank may be a source of at-a-pinch liquidity – “last resort lending” – for an otherwise-solvent and otherwise-liquid bank. Such a central bank should not provide last resort lending to a bank that does not manage its own liquidity properly. So it is perfectly proper for the central bank to tell banks that they will only receive last resort lending if they hold a certain amount of liquidity in normal times. The Basel rules are an example of this. But, fundamentally, liquidity requirements cannot be set by a committee in Switzerland for the whole world. They must be determined in a supervisory relationship by the last-resort lender, the central bank.

The Basel Committee is increasing liquidity requirements, but now not phasing them in until 2019. If they were not set excessively high, the timing would be irrelevant, since the Bank of England should only grant a banking license to banks with adequate liquidity now, not in 2019. But unfortunately, the banking community sees regulation as the key discipline of liquidity, because it is yet to face up to the need to expose depositors to genuine risk of loss, and hence use market disciplines properly.

Only when depositors are credibly exposed to losses will the banking system become more healthy. We’re a long way from politicians and regulators accepting that.

Andrew Lilico is chairman of Europe Economics.