Liquidity buffer

Regulatory Capital Anatomy™ The JC’s untutored thoughts on how bank capital works. The Jolly Contrarian holds forth™ →Go uptown intro sa Resources and Navigation Capital Requirements Regulation: 575/2013/ (EUR Lex) | BIS publications: BIS capital requirements for bank exposures to central counterparties | leverage ratio | RWA | portfolio risk | systemic risk Index: Click ᐅ to expand: Regulatory Capital Index: Click ᐅ to expand: Essays

Just in case it isn’t obvious from its content and tone, bear in mind this resource is meant to help contract negotiators, legal eagles, and other non-specialists get a basic handle on the drivers and rationale for regulatory capital. It is no technical manual. Think of it more like a bluffer’s guide.

Prudentially regulated financial institutions — banks, dealers and brokers — must follow certain guidelines to make sure they are adequately “capitalised”. These are designed to ensure that the banks remain solvent and stable, having enough cash on hand to meet their obligations even in situations of significant market dislocation or credit stress.

Being “holders of customer money”, during times of significant market stress, banks are unusually susceptible to sudden and unexpected payment demands. This may take the form of a queue of retail customers snaking around the block waiting to withdraw their life savings, a sudden uptick in revolving credit drawdowns, or the studied unwillingness on the part of regular investors to “roll” the bank’s commercial paper, meaning the bank has to pay it back.

This sort of thing does not happen during fair times or normal trading conditions. Only when la merde frappe le ventilateur.

Amongst those are rules requiring banks to hold a “liquidity buffer”: a reserve of “high-quality liquid assets” — government bonds, money-market instruments and currencies: in essence cash, and assets that can quickly and reliably be converted into cash — to meet their payment obligations during times of significant market stress.

High-quality liquid assets tend to be low-yielding, so banks like to minimise this obligation. They can do that by ensuring their contracts do not carelessly give away contingent repayment rights which might be used against them in a crash.

Cross Default is just such a contractual term.

See also

• Cross Default