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Big Bank Phobia: Liquidity, Stupid, Not Just Capital

The Federal Reserve's 2013 stress tests included a particularly dire economic scenario, but said nothing about the type of wholesale liquidity lockups that in 2008 pushed Bear Stearns and Lehman Brothers to the brink of failure almost instantly, because of the companies' reliance on overnight funding.

The immediate cause of Washington Mutual's failure in September 2008 was also a liquidity problem, because a retail run on deposits against the bank seemed to be gaining strength. Of course, with so many poorly underwritten mortgage loans, many featuring payment options that allowed loan balances to rise while home prices were crashing, Washington Mutual could have run out of capital if it went on operating.

In a speech in on May 2, Federal Reserve Governor Daniel Tarullo said that during 2007, "liquidity-strained institutions found themselves forced to sell positions, which placed additional downward pressure on asset prices, thereby accelerating margin calls on leveraged actors and amplifying mark-to-market losses for all holders of the assets. The margin calls and booked losses would start another round in the adverse feedback loop."

That "feedback loop" is particularly dangerous for financial companies that lack a deposit base. Since "short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower," during 2007 and 2008, "the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation," Tarullo said.

After describing the Liquidity Coverage Ratio that was negotiated under Basel III, but has not yet been fully implemented by the Federal Reserve, Tarullo went on to say "a more interesting approach would be to tie liquidity and capital standards together by requiring higher levels of capital for large firms unless their liquidity position is substantially stronger than minimum requirements."

"This approach would reflect the fact that the market perception of a given firm's position as counterparty depends upon the combination of its funding position and capital levels. It would also supplement the Basel capital surcharge system, which does not include use of short-term wholesale funding among the factors used to calculate the systemic 'footprint' of each firm, and thus determine its relative surcharge."
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