20.12.2007 00:00 Real Estate
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Ever since it was bailed out by the government in September, Northern Rock has served as a stark reminder of the crucial importance of liquidity in the banking system.
The notion that a large, solvent and well-capitalised bank could run out of money was not a possibility that bankers or regulators had spent much time discussing. Ever since they have talked about little else.
Liquidity has always been a central issue to the banking system. At their core, banks use short-term fundingfrom retail depositors and the money markets to finance longer-term loans. As a result, there is always a possibility that a bank will not be able to raise enough cash to meet its obligations.
Until this summer, however, the assumption was that a bank with sufficient capital would always be able to raise cash if needed. As a result, the emphasis has been on improving measurement of banks' capital through the Basel II framework. But these rules, which come into force in most of the world in January, make little reference to liquidity.
One senior British bank executive describes Basel II as the "Maginot Line" of international banking regulation - a reference to the elaborate French defences along the German border that proved largely useless in repelling the Nazi invasion in 1940.
Thomas Huertas, the FSA's acting managing director of wholesale markets, says, "Banks and building societies need to achieve a higher level of resilience to funding stress."
But recognising the importance of liquidity is only the first step. Working out how to ensure that banks have enough of it is more difficult. The task is made harder because any overhaul of the rules requires agreement between regulators in different parts of the world.
In the past few months, much of the debate has focused on banks' growing dependence on the wholesale markets. Northern Rock, which relied on the markets to fund about three-quarters of its balance sheet, was an extreme example. But, according to analysts at Citigroup, European banks have been progressively lending out more than they hold in the form of deposits. The ratio of loans to deposits has risen to 120 per cent, from about 105 per cent in 1999.
Put another way, the European banking sector has raised aabout EU1,600bn (?1,152bn) in the wholesale markets - equivalent to 10 times net profits. This compares with just EU125bn, or 2.5 times profits, in 1999.
Some have suggested introducing a limit to banks' wholesale funding. But the FSA points out that retail deposits - especially those raised through internet accounts - can prove just as unreliable as short-term money market funding. Meanwhile instruments such as covered bonds used by European banks can provide relatively secure financing.
The regulator suggests tougher rules requiring banks to hold reserves that they can access even in the most difficult conditions, as well as restrictions on the extent of the mis-match between short-term liabilities and long-term assets.
But it also recognises the limits of rules. "One could design a set of rules that will protect us against an exact replay of what has just happened. The question would then arise whether those rules would protect us against a somewhat different replay," says Paul Sharma, the FSA's head of Risk Review.
As a result, the FSA is pressing banks to stress-test their business models, to consider what would happen in extreme circumstances.
In the past, the regulator has found some banks reluctant to consider such situations. But the memory of long queues outside Northern Rock's branches means this should not be a problem for some time. For most banks, such recent experience may prove the most effective way of preventing them from making similar mistakes in the future.
