The Federal Reserve has taken a number of recent actions to support the flow of credit to households and businesses during the COVID-19 crisis. In addition to providing liquidity as the lender-of-last-resort, they are encouraging banks to draw on their capital and liquidity buffers to support credit flows if lending and other actions are taken in a safe and sound manner. In its statement, the Fed emphasized that U.S. bank holding companies currently hold capital and liquidity in excess of regulatory minimum requirements.
The Fed now needs to make clear to banks how they can use their buffers without risking questions later about whether a bank was operating in a safe and sound manner. That would be better than an alternative suggested by some that the Fed should go further and temporarily relax regulatory requirements. (For a Fed FAQ on its guidance to banks, click here.)
Macroprudential policy actions to encourage banks to use buffers to support the economy can work only if the financial sector starts from a position of financial strength. Fortunately, that’s where the system is now, thanks to the stricter regulatory regime put in place after the financial crisis, which requires more and better-quality capital, stress tests, and liquidity buffers, as well as better risk management practices on the part of financial institutions themselves. Tier 1 common equity ratios average over 12 percent for the largest banks, above the regulatory and stress test requirements. Liquidity coverage ratios are above 100 percent, determined by bank internal stress tests. That means banks have more than enough liquid assets—cash, reserves deposited at the Fed, U.S. Treasury securities, etc.—to meet demand for 30 days in a stressful situation.
On the use of liquidity buffers, there are no clear lines on what banks are permitted to do. Here, the Fed should provide guidance to banks and can be aggressive, given banks can access the discount window. The Basel III liquidity requirement did not define a minimum or a buffer. If the LCR buffer was entirely a buffer, then, in principle, it could be drawn down to zero without falling below a minimum requirement. But that is unrealistic—neither the bank nor regulator would think that a safe and sound practice. But it’s unclear to banks how much they can safely draw on their liquidity buffers. The Fed should provide clarity on that consistent with the intent of the liquidity buffer as a safeguard. Banks conduct their own liquidity stress tests, and they could modify their scenarios to include greater use of the discount window to define a buffer that is defensible. Another idea is to allow banks to add to the amount of their liquid assets some fraction of their assets that are eligible collateral for the discount window; that could make sense if liquidity risk managers are concerned that a buffer…