FPC recommends looser liquidity demands

Posted on June 29, 2012

Rules stipulating how much cash, gilts and other liquid assets banks must hold in case of a crisis are to be relaxed, Britain’s financial authorities pledged on Friday, which could release tens of billions of pounds for lending to households and companies.

The June meeting of the Bank of England’s interim Financial Policy Committee took the decision to clarify and loosen banks’ liquidity buffers after noting that the “outlook for financial stability had deteriorated”.

    With lending to small companies falling and interest rates for companies and households rising, the FPC had become concerned that the perception of rules on liquid assets were standing in the way of credit flows and a sustainable economic recovery.

    But even with lighter liquidity regulations helping to get credit flowing, economists still expect the BoE’s Monetary Policy Committee to pump between £50bn and £75bn additional funds into the economy next Thursday by raising its £325bn tranche of quantitative easing.

    The FPC, now a year old, is an integral part of Britain’s economic and regulatory framework and seeks to eliminate the chance that the financial sector could again derail the wider economy.

    Still meeting in an interim form until the legislation giving the BoE supervisory duties for the financial system is passed, the committee currently oversees the BoE’s twice-yearly financial stability report and recommends regulatory changes for implementation by other bodies, such as the Financial Services Authority.

    The FPC laid the blame for the deteriorating financial stability outlook squarely on the sovereign and banking crisis in continental Europe. It noted that within the eurozone there had been a “sustained redistribution of international capital” reflected in deposits in peripheral banks moving to banks in core nations such as Germany.

    Were the peripheral eurozone crisis to deepen, the FPC worried that “[UK banks’] exposures to non-bank private sector borrowers in many of these countries are significantly larger”, even though their direct exposures to peripheral sovereign debt and banks is low.

    “If contagion spread, significant disruption would be likely through secondary channels, such as counterparty risk, funding market stresses and feedback from macroeconomic weakness,” a report from the FPC’s June meeting warned.

    One consequence of the heightened risks, the committee noted, was rising interest rates on mortgages and corporate loans even though UK banks’ underlying funding shortfalls were on course to be eliminated.

    In a bid to get more lending flowing from banks, Sir Mervyn King, governor of the BoE, made it clear that the authorities did not want banks to sit on their liquid assets, which are thought to be in excess of £500bn. The FPC recommended “that the FSA makes clearer to banks that they are free to use their regulatory liquid asset buffers in the event of a liquidity stress”.

    It added that banks should also use the almost £160bn of pre-positioned collateral available for transfer into cash at the BoE in the calculation of liquidity buffers. Andy Haldane, the BoE’s director of financial stability, insisted a significant amount of additional funding could be freed-up for lending that way.

    “Both of those are chunky numbers and suggest that were an element to be released, it would be enough to make a big impact on real economy lending in the UK,” Mr Haldane said.

    But economists complained about a lack of detail in the announcements and cautioned that banks might not use the additional liquidity buffers for lending.

    Kevin Daly of Goldman Sachs said the impact of the policies would depend on “the extent to which banks are prepared to reduce their liquidity buffers in response to the reduction in the regulatory minimum, and the extent to which banks are prepared to use these funds to lend”.

    Jens Larsen of the Royal Bank of Canada said markets should not fear that banks will dump their gilts holdings and go on a lending spree because the “vagueness of the communications and the lack of detail on quantities of reductions in liquidity buffers” so far prevented any real understanding of the likely effects.

    But even as the FPC pleased banks by loosening their liquidity requirements, the authorities reiterated their tough line that the banks should raise capital levels so that they are in a better position to withstand potential losses that might arise from the eurozone crisis.

    The BoE insists higher bank capital does not prevent lending, while commercial banks complain that it gives them an incentive to reduce the outstanding quantity of loans in order to increase their capital ratios.

    Philip Rush of Nomura said the effect of the consistent exhortation to increase capital “has been excessive and is contributing to the financial sector’s accelerated deleveraging”.

    While strenuously rejecting these charges, Sir Mervyn said the FPC was “born in difficult times” a year ago. It had been successful in limiting distributions of cash to shareholders and employees, but not in persuading banks to increase their capital levels, he added.

    He insisted the FPC was still not established in a statutory form and so was merely making recommendations. “From next year onwards,” he added, “we will have statutory powers and I think that’s bound to lead to quite a significant change.”

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