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Banks Continue to Wriggle Out of New International Standards

Major banks caught a break when federal regulators determined that financial institutions could plunge below international liquidity levels in the event of a financial crisis.

Banks will be allowed go below minimum liquidity levels set by global regulators during financial crises to avoid cash-flow difficulties.

“During a period of stress, banks would be expected to use their pool of liquid assets, thereby temporarily falling below the minimum requirement,” the Basel Committee on Banking Supervision’s governing board said in a statement on its website yesterday, following a meeting in the Swiss city.

The aim of the measure, known as a liquidity coverage ratio, is to ensure that lenders hold enough easy-to-sell assets to survive a 30-day credit squeeze. The requirement, one of several measures from the Basel group designed to prevent a repeat of the 2008 financial crisis, is scheduled to enter into force in 2015.

If this is the only exemption that the Basel Committee allows, I’m a spotted egret. And I’m not sure why this is needed at all. We’ve seen in every recent financial crisis that the one thing central banks can easily and quickly provide is liquidity. I suppose it’s better that banks use their own assets rather than getting shoveled cheap money every time they get in trouble, but I don’t seriously expect that central banks will stop the practice. In the end, the central banks will take up the lender of last resort role. So banks can have it all – they can up their leverage by jettisoning their liquid assets, and they can benefit from central bank lending facilities.

I don’t see this as being about riskiness – the liquidity buffers are reasonably seen as “rainy day funds” that can get used in a crisis – but about how national and international standards get degraded as a response to bank pressure. First it’s the loosening of standards in a crisis. Then the standards get loosened for other particular events. Then nobody bothers to look at the standards anymore. It’s a very familiar pattern.

And let’s be clear about what the banks did last time. They deliberately stuck their worst assets into securities and sold them to get them off their books. These are not institutions that deserve the benefit of the doubt.

For the most part, these were mortgages that had been pooled into bonds, which in turn were repackaged into CDOs.

The process typically resulted in the creation of triple-A rated securities, but also made it difficult for investors to understand what those securities actually contained. Hundreds of billions of dollars in CDOs went bad as of 2007, causing heavy losses for investors and banks and triggering a broader panic that ultimately sent the global economy into recession.

Using a unique database published by the investment firm Pershing Square Capital Management, Faltin-Traeger and Mayer identified the underlying bonds in some 528 ABS CDOs issued between 2005 and 2007, and compared their performance to similar bonds that weren’t included in CDOs.

They found that the bonds in the CDOs performed a lot worse. Even if one holds observable characteristics such as initial ratings and yields constant, the bonds in the CDOs suffered ratings downgrades that were 50 percent to 90 percent more severe. As of June 2010, for example, bonds with initial triple-A ratings had been downgraded by an average 11.84 notches, compared to 5.99 for those not in CDOs. The bonds in the CDOs were also more likely to have been rated by all three major credit-rating firms.

I don’t know whether these CDOs would count as “liquid assets” in the event of a crisis. But you could see a fire-sale mentality forming in that event. And that’s bad news for investors.

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David Dayen

David Dayen