The Global Financial Crisis (GFC), originated in 2007 from United States (US) subprime mortgage loans, brought to the attention of regulators the issue of bank liquidity and its efficient management in ensuring bank stability. Until then, liquidity risk was underestimated by prudential regulation, since it was thought that illiquidity problems did not jeopardize bank stability and consequently the financial system as a whole. Both with Basel I (1988) and with Basel II (2004) Accords, regulators required banks only to comply with international capital requirements. Liquidity risk was managed by non-harmonized and very different procedures between countries, based on rigid rules that were partly inadequate given the degree of market sophistication.
However, between 2007 and 2009, many banks, particularly large institutions in nodal positions in the network of interbank and inter-financial relations, not only American, but also European banks, through accentuated market integration, suffered liquidity shocks due to the difficulty of finding alternative sources of funding, the lack of creditor confidence and the immediate need to rebuild liquidity reserves. In relation to the latter, their actions further aggravated financial instability and systemic liquidity strains. They sought to obtain liquidity by selling financial assets, with significant decreases in their value, revoking credit positions on both the interbank market and with other financial institutions (wholesale funding). This had two serious effects: on the one hand, the impact of the losses on bank equity (demonstrating the connection between liquidity risk and capital equilibrium) and, on the other, the interruption of trading on the interbank market, which ceased to function as a liquidity exchange. In this context, the failure of Lehman Brothers (in September 2008), set off a systemic liquidity crisis throughout 2009, followed by extraordinary and urgent interventions from central banks all over the world aimed at stabilizing and preventing banking crises through significant capital and liquidity injections.
In this context, in 2010, the Basel Committee on Banking Supervision (BCBS) proposed a revision of the regulatory framework at international level to strengthen banks and banking systems. The new regulation, the Basel III Accord, introduced two liquidity indicators for banks: the Liquidity Coverage Ratio (LCR), which came into effect gradually after 2015 and set out to ensure the survival of banks for one month in even acute stress; and the Net Stable Funding Ratio (NSFR), which came into effect in 2018 and aims to avoid structural imbalances in the maturity composition of liabilities and assets over a period of one year.
Although Basel III liquidity rules are geared to ensuring greater banking system stability, they may change the functioning of banks, their profitability, their capacity to lend to the real economy, and so their relationship with the market. In view of this, the aim of this book is to provide a comprehensive understanding of the bank liquidity crisis during the GFC, of the liquidity regulatory reform introduced by Basel III, and its micro and macroeconomic implications.
The book is organised as follow. Chapter 2 provides a discussion of the concept of bank liquidity and its related risk, distinguishing between three different liquidity (risk) types: central bank liquidity (risk), funding and market liquidity (risk). This chapter continues with an analysis of liquidity (risk) interconnections and their impact on financial stability in various scenarios: periods of normality or turbulence, underlining the role of central banks as an immediate, but temporary instrument in managing a liquidity crisis. In light of the strong interlinking of financial and capital equilibrium (underestimated as the GFC of 2007ā2009 made clear), the chapter clarifies the linkage between liquidity and solvency, two related but non interchangeable concepts. The difference between the two terms is fundamental because policy actions to address an insolvency or liquidity crisis vary dramatically and assessing the underlying problems of banks is therefore crucial.
This chapter then gives on an overview of the bidirectional relationships of liquidity risk with other risks and the circular pattern of cause-effect. It ends with the description of the factors that over time aggravated the liquidity risk and its management.
Chapter 3 focuses on the banking liquidity crisis of 2007ā2009, investigating the origin and causes of the crisis originating with US subprime mortgage loans. It moves on to discuss the emergence of bank liquidity problems during the GFC, analyzing the characteristics of the banks most affected by the liquidity crisis and the type of liquidity problems they faced. It explains how the liquidity crisis turned into a solvency crisis for financial institutions, undermining banking stability. It points to the lessons that can be learned from the GFC, particularly with regard to liquidity risk.
The third chapter ends with an overview of leading studies into the nature of liquidity crises and the policies designed to prevent and manage them, including the importance of the role of central banks and the interbank market in bank liquidity management.
Chapter 4 therefore analyses the link between monetary policy and the management of bank liquidity, firstly focusing on the operating framework of the three main central banks involved in the crisis (the European Central BankāECB, the Federal ReserveāFED, and the Bank of England) and the adoption of exceptional instruments put in place to deal with the crisis. Then the chapter reviews the main theoretical contributions related to the role of the interbank market in the transmission of financial crises, examining the functioning of this market during the GFC.
Chapters 5 and 6 shift the focus to bank liquidity regulation. The GFC demonstrated how regulators at the international level had failed to set up homogeneous rules of conduct for banks in terms of liquidity risk management, left to the broad discretion of individual national supervisory authorities. The two chapters examine bank liquidity regulations before and after the GFC. Specifically, Chapter 5 focuses on the Basel I Accord (1988) and the failure of the BCBS to envisage banking liquidity risk. Only in 1992 did the BCBS address the problem of ensuring minimum standards for managing liquidity risk in international banks; however, it limited itself to a report setting out the best practices to measure and manage this risk. The Basel II Accord (2004), and in particular its second pillar, introduced a qualitative supervisory model, but left individual national regulators to consider further measures to monitor and prevent banking illiquidity. The third pillar, relating to disclosure, is also discussed; here, Basel II gave broad discretion to national supervisors in relation to the need to oblige banks to disclose their exposure to, and management of, liquidity risk. Chapter 5 gives ample space to both the aims pursued by liquidity risk management and its main components. It concludes with an analysis of the supervisorsā role in liquidity risk management.
Providing a thorough analysis of the new liquidity regulation, Chapter 6 initially focuses on the principles for sound liquidity management and supervision (the so-called Sound Principles) defined by the Basel Committee in September 2008 and then on the content of the Basel III Accord of 2010 (and its subsequent amendments). With reference to the latter, the chapter describes the two minimum liquidity standards for banks, the LCR and NSFR, and then gives an overview of liquidity and monitoring tools designed to strengthen and further promote global consistency in the supervision of liquidity risk.
The seventh chapter reviews the results of the existing empirical studies and analyses the implications of the Basel III liquidity requirements both at the individual bank (microeconomic) level and market (macroeconomic) level. It also looks at the results of Quantitative Impact Studies (QIS) carried out by the BCBS on a representative sample of banks in order to draw some preliminary considerations on the ability of banks to adapt to the new Basel III liquidity ratios and the strategies adopted to comply with the LCR and the NSFR, highlighting the potential differences between the geographical areas considered.
Finally, Chapter 8 concludes the book underlining the importance of keeping the liquidity risk well monitored in the future.