Yellen weighs in on banks' liquidity risk and capital requirements

Why Yellen says banks can self-insure against liquidity risk

Yellen’s remarks

On April 15, Fed Chair Janet Yellen made the opening remarks (via video conference) at the Federal Reserve Bank of Atlanta’s 19th Annual Financial Markets Conference, held on April 15–16, 2014, in Atlanta. In the last article of this series, we discussed her concerns about liquidity risks for financial institutions. In this article, we’ll discuss the aspects of the Fed Chair’s speech addressing strengthening capital requirements for financial institutions.

Part 2Enlarge Graph

Janet Yellen on the role of the Basel Committee on Banking Supervision

Following the financial crisis of 2007–2008, the Basel Committee on Banking Supervision adopted the Basel III capital accord and implemented the provisions domestically in order to strengthen bank capital requirements, as “strong bank capital rules remain the foundation of bank regulation.” However, as these rules address balance sheet and off–balance sheet risks (primarily market and credit risks), liquidity risks aren’t directly addressed.

To address liquidity risk, the Basel Committee has developed liquidity standards for global banks: the Liquidity Coverage Ratio (or LCR) and the Net Stable Funding Ratio (or NSFR).

The LCR requires that banks maintain sufficient levels of high-quality and liquid assets that would enable them to meet cash outflows over a 30-day period, simulating a high-stress scenario. The NSFR seeks to ensure that banks maintain adequate levels of stable funding to be able to weather a market or firm-specific liquidity crunch.

According to Janet Yellen, “Under the LCR and NSFR, firms that engage in unstable forms of maturity transformation will be required to maintain buffers of highly liquid assets and use stable funding, both of which will impose costs for the firms. Reducing the amount of maturity transformation they engage in will help firms minimize these costs.”

By ensuring adequate liquidity standards as measured by the LCR and the NSFR, banks can self-insure against structural maturity mismatches—that is, using short-term funding sources to lend long-term to corporates and other institutions. These firms would “be less likely” of needing government support in terms of liquidity during stressful times.

For more on what Fed officials have said on assessing capital requirements for banks, please read the Market Realist series Charles Plosser’s take on using simpler metrics for assessing capital requirements for banks. 

In the following parts of this series, we’ll discuss what enhanced liquidity and capital requirements mean for complex financial institutions—for example, Wells Fargo (WFC), JP Morgan (JPM), and Goldman Sachs (GS)—as well as their impact on both fixed income (HYG) and equity ETFs (IVV) like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the iShares Core S&P 500 ETF (IVV). To learn more, please read on to Part 3.