The buffers gone missing under Basel

FT.com

Can regulation make banks less safe? What has happened in the past week certainly seems to suggest so. Three large European banks – Barclays, Deutsche Bank and Société Générale – moved to partly dismantle one of their main bulwarks against another liquidity crisis: their massive cash reserves.

Barclays last week said it would shrink its “liquidity pool” of cash and government bonds by £15 billion to £20 billion over the next year, after it had already fallen 8 per cent to £138 billion in the past 12 months. At the same time, it emerged that Deutsche Bank had shrunk its amount of cash and deposits with banks by €33 billion to €117 billion within a mere three months. It plans to cut its cash holdings even further, words echoed by French rival SocGen.

The bosses of all three banks sung the same refrain to explain the wind-down of cash and safe assets: It will help them boost their leverage ratios, a gauge of financial soundness that measures a bank’s equity against its overall assets.

Regulators and investors across both sides of the Atlantic have stepped up pressure on lenders to reach a leverage ratio threshold of 3 per cent much earlier than the 2018 deadline agreed on by the Basel Committee on Banking Supervision.

Depleting cash levels, government bond portfolios and holdings of other easy-to-liquidate assets is a handy shortcut for weaker capitalised banks such as Barclays and Deutsche to reach the ratio faster. Even though both banks also sought to boost leverage ratios from the other direction – by raising fresh equity – the amount of new capital required was kept down by cutting assets, too.

Banks’ drive to reduce their liquid holdings reverses a trend that started after the collapse of Lehman Brothers in 2008. Since then, banks have tended to hoard large reserves of easy-to-sell assets. The French banks alone have doubled their gross cash stacks to €324.5 billion – more than the gross domestic product of Austria – in the past five years, according to data from the European Central Bank.

Regulators have pushed banks to do this as part of the lessons learnt from the global liquidity crunch of 2007-09. The first-ever global liquidity standards – an early element of the Basel III rule book called the liquidity coverage ratio – require banks to stockpile enough liquid assets to sustain their operations for 30 days if faced with another crisis. After a brief period of Pavlovian opposition, bankers have long since embraced the new rules. They realised that a higher liquidity buffer gives them more credit with rating agencies, clients and investors.

However, the recent downward trend at Barclays, Deutsche Bank and SocGen points to what one senior European bank executive calls a “frightening prospect”: bankers, prompted by the need to comply with the leverage ratio rules, are becoming complacent about liquidity buffers.

Of course, there are other reasons why banks would eat into their cash positions. The initial 2015 deadline to fully comply with the liquidity coverage ratio has been extended by four more years. Some, such as the Bank of England, have even encouraged banks to use some of their liquidity “war chests” to boost lending.

Meanwhile in the US, banks including Goldman Sachs and Morgan Stanley have kept their liquidity pools untouched, calling them “sacrosanct”. European bank executives might thus simply be using a reduction in their cash pools as a neat lobbying tool, trying to shock regulators into moderating leverage requirements.

But even if that is the case, their key argument is worth listening to: leverage ratios do not make a distinction between liquid, non-risky assets, such as cash, on one side and high-risk, illiquid instruments, such as complex securitisation products, on the other. For leverage purposes, an asset is an asset. The main reason for Lehman Brothers’ downfall was its imprudent lack of liquidity, according to Anton Valukas, its bankruptcy examiner. If banks voluntarily exceed liquidity ratios well before they are even enforced, this should thus be welcomed. Conversely, alarm bells should ring if banks reverse this course due to apparently contradictory regulation.

There is certainly a rationale for a leverage ratio threshold that will make banks safer by forcing them to hold more equity in relation to their assets. But it makes no sense to persist with definitions of leverage that clash with the objectives of liquidity rules. Policy makers should overhaul leverage definitions to exclude or at least apply discounts to any assets that count towards liquidity ratios. Without change, banks will continue depleting liquidity safety buffers – with potentially dangerous consequences.

Daniel Schäfer is the Financial Times’ investment banking correspondent

Copyright The Financial Times Limited 2013