Has the RBA cracked the liquidity code?

The Reserve Bank’s mechanism for providing last-resort liquidity for banks in a crisis has been generating some controversy here but is now drawing attention offshore as a potentially useful approach for regulators as they try to deal with the liquidity risk issues highlighted by the global financial crisis.

There has been a debate about the Reserve Bank’s "Committed Liquidity Facility" in this market, with critics claiming that the CLF makes available liquidity in a crisis that is too cheap and which is actually solvency, rather than liquidity, support because it would only be drawn down in a situation where a bank was unable to meet its debts as and when they fell due.

While that argument is technically true, the existence of the CLF actually means that a bank with access to the Reserve Bank facility would almost always be able to meet its obligations and therefore couldn’t become insolvent purely because of a liquidity "event".

The CLF concept was borne out of necessity. The global regulatory response to the financial crisis has been to significantly toughen minimum capital requirements and to introduce new minimum liquidity standards, including a liquidity coverage ratio that require banks to hold sufficient high-quality liquid assets to withstand at least 30 days of acute liquidity stress.

Under the CLF, from 2015 the banks and the RBA will agree in advance a specified amount of accessible liquidity, supported by a repurchase arrangement for high-quality assets the banks would have to lodge with the RBA if they draw on the facility. The banks would pay an annual fee of 15 basis points for the full amount of the undrawn facility they have negotiated and would pay a 25 basis point premium over the RBA’s cash rate if they actually used the facility.

The arrangement is unusual in a global context because of the relative dearth of other sources of high-quality liquid assets in this market, notably (relative to the US or Europe) a shortage of Australian government debt. Without the CLF the Australian banks would have trouble meeting the new global liquidity rules.

Apart from the debate about whether the CLF represents liquidity or solvency support there has also been criticism that it under-prices taxpayer support for the major banks.

Last Friday a governor of the US Federal Reserve Board, Jeremy Stein, gave a speech on liquidity and central banking in which a key theme was the extent to which access to central bank liquidity should be allowed to count towards satisfying the new liquidity coverage ratio regime.

As he said, the introduction of liquidity regulation after the crisis reflected a desire by regulators to reduce dependence on central banks and taxpayers as lenders of last resort. There was, however, still a question of how the role of lenders of last resort could co-exist with a regime of liquidity regulation.

Stein said that if one were going to make an argument in favour of adding preventative liquidity regulation on top of capital regulation a central premise must be that the use of lender of last resort capacity in a crisis is socially costly so it should be an explicit objective of policy to economise on its use.

He referred to the blurred line between illiquidity and insolvency, the credit risk that would be taken on by central banks and taxpayers in a crisis and the moral hazard problems associated with lenders of last resort.

Which is where Australia’s CLF got a mention. Stein said it was important to distinguish between priced and unpriced access to lenders of last resort and cited the Australian example of an up-front fee for access to what was effectively a loan commitment.

"In contrast to free access to the lender of last resort this approach is not at odds with the goals of liquidity regulation because the up-front fee is effectively a tax that serves to deter reliance on the lender of last resort," he said.

While a price-based mechanism like the CLF might not be immediately necessary in countries where there is no scarcity of high-quality liquid assets, Stein said it was worth keeping an open mind about the more widespread use of CLF-like mechanisms.

He also said they could help protect the integrity of regulation by harmonising costs across countries and that policymakers should aim to strike a balance between reducing reliance on lenders of last resort and moderating the costs created by liquidity shortages.

There has been a lot of talk in this market (mainly from the Greens) about imposing levies on the four majors, deemed to be too big to fail because of the ultimate taxpayer exposure to them. The CLF, in effect, is a tangible example of and conduit for that support.

Stein’s description of the CLF fees as implicit taxes highlights the reality that the banks would pay a premium for the insurance provided by the existence of the CLF and then an excess if they actually drew on it.

While there are those who characterise the CLF as effectively a taxpayer-provided subsidy, it isn’t costless to the banks and the question of whether the facility is adequately priced or not is complicated by the low probability of it actually been drawn down.

It is designed to be activated only in periods of acute stress, like the global crisis, and even then is only available at the discretion of the RBA, which would discourage banks from relying on it and therefore encourage them to maximise the amount of high-quality liquidity that they can accumulate themselves.

It is a more effective and sophisticated way of providing lender-of-last-resort facilities than that which existed pre-crisis and one that Stein’s musings on the merits of the CLF suggests might have international application.