A significant problem that banks faced a year ago (and continue to face, though to a lesser degree) was reduced access to capital. In banking terms, there was a liquidity crisis. Whether the "crisis" was avoidable or necessary to clear the market is a debate for a different point, the short point is that banks struggled to get cash on a short-term basis and this limited their ability to do business. This is one reason why loans stopped. This is a prime reason that Bear Stearns teetered on the edge of bankruptcy in March 2008 while Lehman eventually did fall off the cliff.
So, what to do about it.
The Financial Times reports today that the Office of the Comptroller of the Currency (OCC), housed in Treasury, is promoting new ratios for the types of funding that banks can use to conduct business day to day:
regulators are considering proposals to prevent banks from growing overly dependent on short-term borrowings – as was the case with Bear and Lehman. The idea behind the discussions is that capital alone is not enough to prevent a run on a bank that depends on the overnight markets for funding.
“Capital is critical, but liquidity enhancement is a necessary piece of the puzzle,” said Kevin Bailey, deputy comptroller for regulatory policy at the Office of the Comptroller of the Currency, which regulates national banks. The proposals being discussed would require banks to operate under new measures – or ratios – gauging their dependence on short-term funding and their susceptibility to market shocks.
One ratio would compare a bank’s assets to its stable sources of funding, such as deposits or longer-term unsecured debt. This would help regulators determine whether a bank is too dependent on short-term borrowings.
Another ratio would compare borrowings to easily sold assets – measuring, in other words, how quickly a bank could unwind its positions were it to lose its access to short-term market funding. The ratios would come on top of guidance on liquidity issues proposed by banking regulators in July. Those proposals were part of a global effort to address bank liquidity.
Essentially, the OCC idea to to require banks to reserve more stable cash in case liquidity takes a sudden downturn. There might be some merit to the OCC laws, but they ultimately are unnecessary. If banks have the "too big or interconnected to fail" support system removed from under them, of all financial institutions see the safety net of bailouts disappear, if the government makes clear to the industry that taxpayer money isn't going to support their failures anymore, then financial institutions will make corrections to their ratios on their own.
We need to give financial institutions the right incentives to be more prudential risk takers, while allowing them to continue to take risks at their own peril, reaping the positive and negative results.