On 14 July 2022, the Bank of England (BoE) published a speech by Victoria Saporta entitled ‘Capital and (for change) liquidity buffers’.
The speech notes that there is evidence that banks are reluctant to use liquidity buffers and explores the reasons why. The speech also covers what the PRA could do it make it easier for banks to use them.
Key points in the speech include:
- If banks are unwilling to use their liquid buffers when facing liquidity pressures, this could have a negative impact on markets and the real economy, and this means that central banks may need to intervene faster and to a greater extent than is desirable.
- Capital buffers are only one available instrument to support the banking system during periods of stress, there is also the vital liquidity buffer framework.
- In the current Basel framework, only the Countercyclical Capital Buffer (CCyB) is releasable. All other buffers that sit above minima are in theory usable but not releasable. And the evidence suggests that firms would rather deleverage than use non-releasable buffers.
- The impediments to usability of non-releasable buffers indicate that it is desirable to have a larger portion of releasable buffers to mitigate the impact of deep recessions.
- A possible option is to make the buffer placed just below the CCyB in the capital stack – the Capital Conservation Buffer – releasable.
- Evidence suggests that a way needs to be found to preserve the intended effect of Maximum Distributable Amounts (MDAs) and get rid of the market stigma inducing firms to deleverage. One way to do so might be to consider a broader form of capital conservation that applies distribution restrictions to firms irrespective of their capital ratios during the stress.
- The liquidity framework has been designed from the start to facilitate the usability of those liquid asset buffers when banks face liquidity pressures.
- During the early stages of the COVID-19 pandemic, there was evidence which suggested banks were overly reluctant to use their high quality liquid assets, reinforcing similar evidence gathered from the BoE’s exploratory liquidity stress test.
- The results of the Liquidity Biennial Exploratory Scenario (LBES) stress-testing exercise conducted by the BoE suggested that banks would be unwilling to allow their Liquidity Coverage Ratio (LCR) to fall below the 100% level, even in a severe stress.
- The question of how to prudently manage liquid assets in a given stress is no doubt a difficult one, and there are fundamental reasons why banks may be cautious. But the evidence suggests that the way the prudential framework itself is working may be inhibiting banks in appropriately using their liquidity when facing stress.
- One solution could be the releasability of LCR in stress, through a counter-cyclical liquidity buffer that could operate in a similar vein with the CCyB. Releasing the liquidity standard in times of stress could communicate authorities’ views on banks’ forward-looking liquidity resilience and appropriate usage of liquidity buffers, supporting financial stability and market confidence. But while the principle may be similar, in practice there may be bespoke challenges to releasing liquidity standards via the LCR.