Buffer Bluffing

“Liquidity is essential to a bank's viability and central to the smooth functioning of the financial system.” So says Fed head Ben Bernanke. And Thursday, Fed governors unanimously approved a proposal for the biggest, most internationally influential US banks to maintain higher liquidity ratios than other international standards. The Fed’s stated goal—making the banking sector “safer”—is perfectly benign, but whether these rules accomplish it won’t be clear for a long while. In the meantime, this is yet one more example of the Fed’s hyper focus on boosting bank balance sheets at the expense of keeping money moving through the system—a long-running economic headwind. On the bright side, this latest change is incremental and shouldn’t much ding bank lending or weigh on stocks.

In the five years since the global financial crisis put bank balance sheets in the spotlight, US banks have seriously bulked up their safety buffers, but the Fed would like to see more. Under the proposed rules, banks with $250+ billion in assets or “great international influence” (whatever that means) will need to increase their liquidity buffers to survive 30 hypothetical days of “severe downturn” and deposit flight. Banks with $50+ billion will similarly need to bulk up, but for a 21-day scenario.

Only the most liquid assets will do. Banks can have all the cash, Treasurys and Fed reserves (i.e., QE funny money) they’d like. Other liquid assets are ok, too, as long as they don’t make up more than 40% of a buffer. But they’ll be subject to haircuts: Fannie Mae and Freddie Mac’s debt could see a 15% haircut, investment-grade corporate bonds 15%, other nations’ sovereign debt 20% and publically traded stocks 50%.

As it stands, the Fed believes banks are currently just $200 billion short of its $2 trillion liquidity goal—many already meet these new standards. For those that don’t—assuming the FDIC and the Office of the Comptroller of the Currency approve the measures—banks will have until 2015 before the rules start phasing in and until 2017 before full implementation. Banks can likely fill the shortfall by simply retaining earnings—significant equity issuance (a negative) appears highly unlikely. Similarly, it appears unlikely banks materially decrease lending tied to meeting these capital standards. Hence, this shouldn’t much (or at all) weigh on Financials stocks.

But it also might not be the boon regulators seem to think. A number of sources, including Bernanke himself, assert bigger buffers will make the banking system safer—essentially, prevent another 2008. More cash on hand does add some safety netting, but requiring bigger and bigger buffers won’t foolproof the system—foolproof doesn’t exist. Plus, no one can know what exactly the next crisis will involve until it arrives. What happens if credit is still frozen after 30 days and banks have drawn down buffers? What if deposit flight exceeds whatever the Fed assumes under its arbitrary hypothetical scenario? Will banks be declared insolvent even if they have plenty of less-liquid assets? Or will the Fed step in with enough liquidity to carry them through?

While the small shortfall this time indicates lending won’t be pinched much, this capital boost is illustrative of a broader, longer-running trend. Should that trend continue or intensify, it unnecessarily hinders credit growth. Boosting and contracting the broad money supply—among the Fed’s primary tasks—seems to have taken the backseat to increasing bank balance sheets. QE is exhibit A, disincentivizing lending while rapidly increasing reserves, and higher liquidity ratio rules take it a step further. Notably, should banks not change a thing, another few months of quantitative easing (QE) should get them where they need to be—hey! Maybe that’s why the Fed didn’t taper! Maybe asset purchases will finally stop when bank buffers are complete! One can hope, though the only folks with clarity are those who set the policy.

The Bank of England (BoE) was similarly confused for quite a while. There, too, QE had the secondary effect of boosting bank balance sheets—a long-running obsession of former BoE Governor Mervyn King. Then, King and his deputies forced UK banks to adopt Basel III liquidity standards by this year’s end—six years ahead of Basel III’s schedule. Credit thus remained tight even after QE ended and the yield curve steepened. Thursday, the BoE seemed to have learned its lesson, announcing the UK’s eight major banks and building societies (the UK’s equivalent of a thrift) could reduce their safety buffers by £90 billion, as long as core equity capital meets the 7% minimum. According to new BoE Governor Mark Carney, “Every pound currently held in liquid assets is a pound that could be lent to the real economy.” The same is true of dollars on this side of the pond!

In our view, the US economy would benefit nicely if the Federal Reserve would take a page from Mr. Carney’s playbook. Even if the new Fed rules don’t knock lending looking forward, giving banks more flexibility would be a nice tailwind for loan growth—M2 money supply and velocity would accelerate, and the entire economy would get a boost. Supporting the money supply is one of the Fed’s core roles. At a time when too much QE is already disincentivizing banks from lending—and slow economic growth a hot-button issue—straying from supporting growth to further boosting bank balance sheets seems an unnecessary distraction. Fortunately, stocks are resilient and have already overcome four-plus years of less-than-ideal Fed policy, but looking ahead, a less activist Fed would be a welcome change.