In reforming the financial system, authorities face a basic trade-off: girding institutions against another cataclysmic breakdown through tougher capital and liquidity requirements on the one hand, and helping the flow of credit amid a fragile recovery on the other.
Proposed international guidelines designed in part to position banks to withstand a monthlong liquidity crisis — including a severe run on deposits, an evaporation of short-term funding and heavy draws against credit lines by borrowers — are a stark example of the tension, according to Rajiv Setia, a bond analyst at Barclays Capital.
American banks have become far more liquid recently, but are miles off the mark established by the framework, which could drive them to shed another $600 billion to $1.5 trillion of loans just when portfolios should begin to expand again, he and colleagues reckoned in a report published June 18.
Such an interruption of the customary workings of the credit cycle — banks typically relax standards and open the loan spigots as the economy turns the corner — could shave perhaps a percentage point off annual growth in gross domestic product. Meanwhile, "a grab for deposits" would lift bank funding costs and hit the industry's profitability.
Applying the criteria the Basel Committee set out in December as a way to gauge a bank's ability to weather a one-month storm, Barclays estimated that U.S. banks currently have a deficit of about $850 billion of cash and ultrasafe bonds that could be sold in an emergency.
Under a second standard that would require banks to balance the stability of their funding — core deposits would be weighted at a modest haircut and capital weighted fully, while short-term debt would not count at all — against funding needs — banks would be required to lock in funding for most loans, but only a small fraction of funding for Treasuries — the shortfall is about $1.7 trillion, or 13% of assets.
That's down from a gap of about $3 trillion at the beginning of 2008 as loan portfolios have contracted and securities portfolios have increased; banks have cut credit lines and built up core deposits and capital; and the Federal Reserve has pumped massive amounts of cash into the industry.
To cover the rest of the distance while maximizing income, banks might further increase holdings of securities by 9 percentage points, to 28% of assets, and further decrease loans by 4 percentage points, to 50%. Under additional scenarios that contemplate lower leverage and other possibilities, loans might be reduced to less than 50% of assets. (Barclays assumed that cash would decrease by $600 billion as the Fed withdraws from extraordinary efforts to boost the economy by buying up bonds.)
In view of such large numbers, Setia said he believes that policymakers' concerns about ensuring the flow of credit could lead them to draw out the timetable for implementation beyond the two years prescribed by the Basel Committee.
(In its communique after its June summit in Toronto, the Group of 20 declared that the new Basel framework would "be phased in over a time frame that is consistent with sustained recovery and limits market disruption, with the aim of implementation by end-2012.")
The standards would still impose a drag on growth — curbs on lending are the price of such steps to strengthen the financial system — but it would be less acute, and "hopefully in three to four years the economy is also on more solid footing," he said.
"These regulations are much needed and ultimately make a lot of sense in terms of reducing systemic risk," Setia said. But "people are operating very, very carefully now," and in weighing the case for rapid adoption, the question is: "What is the potential for another near-term event? Are banks already moving in the right direction and is supervision now tight enough?"