Reconciling bank processing and prudential regulation

The introduction of new liquidity ratios could undermine banking core business

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Prevent future bank liquidity crises from arising should not be achieved at the expense of other instabilities: difficulties in financing the economy and denial of the role of banks

We have disintermediated funding and the role of financial markets. Recall that the first financial market is naturally where should meet the economic agents in need of financing, companies in general, and those with savings capacity such as individuals

The issue is investment maturity. The maturity of those in need of financing is several years (long-term financing of industrial projects), while household savings should be liquid and short term. This difference often blocks trades and here is where we need intermediated financing and banks involvement. These are the only agents that can transform short-term resources (deposit accounts) in medium and long-term loans. Banks set the bridge between households and businesses.

Banking transformation is inevitable and generates ALM risks (interest rate risk and liquidity risk). The introduction of new liquidity ratios such as NSFR (Net Stable Funding Ratio) tends to force banks to finance with stable resources (more than 1 year) a significant portion of their long-term assets in a context of crisis and under one-year stress tests assumptions.

The regulator did eliminate much of banks liquidity risk which led to the collapse of Northern Rock in September 2007 and the cataclysm of September-October 2008 (Lehman bankruptcy and implementation of plans to rescue the banking system around the world)
But it is useless to handle this issue if it generates 3 new ones:

1. Destabilization of bank liabilities with a frantic flight to deposits and a structural and sustainable increase in the cost of raising capital in the markets in all its forms; and therefore a higher cost for the entire economy.

2. Risk of revival of a structured financial engineering with poor supervision and the development of new forms of securitization; all to enable banks to transfer credit risk to other players in the economy, reduce the liquidity and capital consumption... With all the excesses that we have experienced between 2002 and 2007 (because good risks will be transferred but also bad ones)

3. And above all, require the backing of long-term financing by medium-term and long-term credits would merely turn banks into useless institutions (since they will be involved in "reverse processing" which is the opposite of their core business) and would cut credit institutions’ net banking income with a negative net interest margin. Example: A 20-year conventional mortgage set up in early 2010 will have generated on the last financial year a margin of about 2.30%

  • 2.80% of processing margin equals to the difference between customer’s mortgage rate and bank’s cost of refinancing in money market conditions;
  • -0.50% of sales margin equals to the difference between the customer’s mortgage rate and the rate of internal transfer (normative rate which is indicative of the cost of refinancing if the institution had to refinance the loan on the entire period)

Challenging the processing is therefore eliminate the margin and be happy with negative sales margins; margins that would return to positive at the cost of a sharp increase in loan rates as part of a global move of the entire banking industry

It is necessary to strengthen the prudential regulation of banks to avoid systemic financial crises, but this does not mean that we must set up rules that will turn banks into useless institutions and / or heavily penalize the financing of the economy. We shall address, in a future article, rules and processes to implement in order to reconcile system safety and loan development.

Mory Doré , February 2011

Article also available in : English EN | français FR

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