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The Perils of drawing too much comfort from the Liquidity Coverage Ratio

January 28, 2013

Basel III requires banks to have a certain amount of liquid assets linked to their short-term liabilities.  This liquid asset cover is supposed to provide liquidity to a bank in a crisis when market liquidity disappears.  We opine that things will turn out quite different in a crisis.  All the banks will be selling the same assets which qualify as liquid assets.  This in itself will cause those liquid assets to lose value sharply and become illiquid.  Whenever there is a systemic liquidity crisis, there is no alternative to central bank action.  Liquidity Coverage could only be useful when problems are confined to few institutions (say during the Bear Stearns crisis).  It is less useful during a systemic event such as the Lehman bankruptcy.  But liquidity issues at a single institution, as we have argued elsewhere (https://crediteye.wordpress.com/2011/07/07/is-liquidity-of-assets-relevant-to-a-bank-creditor/ ) are due to deep doubts about the institution’s solvency.  One moment Bear Stearns was drowning in liquidity.  The next moment, when there were doubt’s about Bear’s solvency, Bear Stearns was just drowning.

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From → Credit Analysis

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