Additional Details on Liquidity Coverage Ratio Changes

Monday’s announcement that the Basel Committee on Banking Supervision (“BCBS”) had made changes to its liquidity coverage rules was largely met with accusations that regulators were softening their stance, “caving” to industry pressure (e.g., see here for a particularly critical example).

At first glance, one can see how these accusations came about. Most changes involved a relaxation of what had been initially proposed. For example, a wider range of securities was included in the definition of High Quality Liquid Assets (“HQLA”) and the deadline for compliance was extended from 2015 to 2019. A complete summary of these changes can be found here (links externally to BIS website). More generally, concerns about regulatory capture and undue industry pressure routinely surface. Hence it is not surprising that such arguments also were prevalent in Monday’s coverage on this topic.

I would instead argue that such modifications are an important part of the policy process. In fact, in the US, modifications are to be expected, as Federal agencies are required to both solicit and address all comments received on their proposals prior to implementation. A good description of the rulemaking process for Federal regulations in the US can be found via these two external websites:

Overview of rulemaking process:
http://www.reginfo.gov/public/jsp/Utilities/faq.jsp
Executive Order 12866 and the comment period:
http://www.reginfo.gov/public/jsp/Utilities/EO_12866.pdf

One of the most important aspects of this process is that it provides for direct public involvement in the regulatory process via an open comment period, generally required to be a minimum of 60 days. Not every country does this.

Note that Federal agencies are not required to incorporate the comments, only to address them. But clearly solicitation of comments without any intent to modify is disingenuous. From what I’ve seen of the rulemaking process, regulators know they are not infallible and genuinely value helpful feedback. The presence of a comment/modification process helps to temper the risk of a “knee-jerk” response to a crisis. And even with legislation that has come about quite quickly (e.g., the Dodd-Frank Act), modifications continue to be part of the process (see Steven Lofchie’s Jan 4 post). There is much to be gained from regulators and those in the industry they regulate engaging in discussion and learning from each other.

The BCBS employed a similar process for its liquidity coverage ratio (LCR) standards (see here for the full document). First published in December 2010, Monday’s revision incorporated feedback received since the initial publication.

An extended transition period is a relatively common regulatory response. The use of a transition period is a helpful and constructive way to articulate a high standard while simultaneously providing a path to achieve it. The tremendous growth-by-acquisition that the banking sector experienced over the past decade has led to increasingly complex IT structures that understandably cannot be modified overnight in response to new regulatory requirements. As a cost center, IT is rarely a top priority for firms rushing to complete a merger; yet is often given as a reason those same firms need a more gradual implementation schedule of proposed regulation. Thus at least some of the frustration regarding the delay to 2019 should be channeled into forcing banks to upgrade their IT infrastructure. This would not only help them to meet regulatory requirements more quickly; it would also improve their ability to identify and mitigate risks.

Two other considerations that are worth mentioning. First, times are still challenging. Regulators need to be careful that they do not make definitions so stringent that firms would need to scramble in order to be in compliance, shedding assets that were not included in the HQLA definition and rushing to gather those that did make the cut. Such activity might further destabilize an already fragile recovery.

In addition, we should keep in mind there is nothing magical about the initially proposed thresholds. Yet it is all too tempting to evaluate each modification via comparison to its initially proposed threshold, an example of a well-documented cognitive bias known as “anchoring” (Tversky and Kahneman, 1974). Which is the more appropriate threshold may be anybody’s guess – but I prefer the one that has the benefit of two more years of experience and feedback from a wide variety of constituents.

Regulators should be applauded for carefully and thoughtfully considering feedback.  If they have gone too far in their response, rest assured more modifications will result.  And thankfully there will be ample opportunity for comment.

See also: Amos Tversky and Daniel Kahneman, “Judgment under Uncertainty: Heuristics and Biases,” Science, September 27, 1974, pp.1124-1131

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