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FSA is right to focus on bank liquidity

Allister Heath

FOR perhaps the first time this year, I agree (at least in the main) with a decision by the Financial Services Authority – and disagree with some of the criticisms leveled at it by opponents, reported on page 1. Before you ask, I haven’t suddenly joined the dark side – I have always thought that banks need to hold greater amounts of more liquid capital.

So what exactly are the FSA’s plans? It wants top banks, building societies and investment firms to hold enough assets that can easily be sold and turned into cash (of the right currency) to meet their payment obligations if the financial system were to freeze up again. At the moment, banks own only £280bn or so of these highly liquid assets, primarily cash and government bonds from solvent countries; the “liquidity buffer” will have to be increased by a third and possibly more, while reliance on wholesale funding will have to be cut by a fifth – all in the first 12 months.

Last year, when markets stopped functioning, most institutions found that assets they had wrongly believed to be liquid were in fact unsellable, even at huge discounts, forcing them to tap the Bank of England’s lender of last resort facilities. The aim is to ensure that this doesn’t happen again. Liquidity requirements will be calculated on a case-by-case basis, depending on how much they rely on money markets (rather than on customer deposits) to fund lending. Wholesale markets can break down and banks that rely on them, HBOS and Northern Rock-style, are riskier.

Banks won't have to start reporting holdings – in some cases daily – until June. The quantitative aspects of the regime will be phased in over several years to make sure banks are not forced to slash their lending; the rules will be amended to conform with any new global agreements. Compared with the original proposal, yesterday’s paper included different timetables; a reduction in the number and frequency of items to be reported; some extra leniency; simplified liquidity rules and reporting for 90 smaller banks; and a big shift to how foreign bank branches will be treated. They will have to follow similar rules – and be self-sufficient in liquidity terms – unless their home countries follow “broadly equivalent” liquidity regulations; but the final outcome is better than feared. This is perhaps the riskiest part of the proposals; in theory, it could chase some of these banks away. In practice, most other countries will probably end up adopting reasonably similar rules to the UK.

All of this will cost banks a fortune (holding low-interest gilts is not as fun as investing in high-return CDOs) and will involve compliance costs; the banks will pass these on to the rest of us. But that, I’m afraid, is life. We enjoyed artificially cheap money in recent years thanks to artificially low bank costs. The FSA says its base scenario implies firms would have to hold another £110bn in gilts; the cost would be £2.2bn a year. But actual liquidity targets will be set later.

There is no doubt that under a free-market, deregulated system, where banks were allowed to go bust, they would hold much greater reserves than they did in recent years, when flawed rules gave them the green light to put very little truly-high quality assets aside. Banks would also rely much less on wholesale financing. The FSA’s plan is not as good as a real free-market solution – but it is the best we have. allister.heath@cityam.com