Liquidity Rules Cover the Failure Mode Capital Ratios Miss
Banks that met every capital requirement still failed in 2008 because they could not fund themselves. The response was a second set of rules about cash rather than equity.
The Gap That 2008 Exposed
Several institutions that failed or required rescue in 2008 were adequately capitalised by the standards then in force.
What killed them was funding. They relied on short term wholesale borrowing that had to be rolled continuously, and when lenders declined to roll it, the institutions could not sell assets fast enough at acceptable prices.
Capital answers whether the assets are worth more than the liabilities. Liquidity answers whether you can pay today. An institution can pass the first test and fail the second, and the second is what kills you first.
The Liquidity Coverage Ratio
The liquidity coverage ratio requires a bank to hold enough high quality liquid assets to survive a defined 30 day stress scenario.
The numerator is assets that can reliably be converted to cash quickly: central bank reserves, high quality government bonds, and a limited allowance for other assets at a discount.
The denominator is projected net outflows over 30 days under stress, calculated by applying assumed runoff rates to each funding source.
| Funding type | Assumed 30 day runoff |
|---|---|
| Insured retail deposits, stable | Low |
| Uninsured retail deposits | Higher |
| Operational corporate deposits | Moderate |
| Non operational wholesale funding | Very high |
| Committed credit lines to clients | Partial drawdown assumed |
The runoff assumptions embed a specific view: insured retail deposits are sticky, wholesale funding is not. That view was correct in 2008.
Where the Assumptions Proved Optimistic
The 2023 failure of Silicon Valley Bank ran considerably faster than any 30 day scenario contemplates. Deposits left in a single day at a pace no liquidity buffer sized to a monthly assumption could absorb.
Two things had changed. Deposits could be moved instantly through digital banking rather than by visiting a branch. And concern spread through social networks and messaging among a concentrated, connected depositor base faster than any previous run.
The episode prompted genuine reconsideration of whether runoff assumptions calibrated on historical experience describe a world where a run can complete before regulators convene.
The Net Stable Funding Ratio
The companion rule addresses structure rather than survival. The net stable funding ratio requires that longer term assets be funded with correspondingly stable funding sources, over a one year horizon.
Its purpose is to limit maturity transformation, the practice of funding long assets with short liabilities. Maturity transformation is the fundamental function of banking, so the rule constrains it rather than eliminating it.
The Cost
Liquidity requirements are not free. Holding large quantities of government bonds and central bank reserves earns less than lending, so the rules reduce profitability.
They also affect market functioning. Requiring many institutions to hold the same category of assets increases demand for those assets and can reduce the liquidity of everything else, since balance sheet devoted to holding the buffer is not available for market making.
The Usability Problem
Buffers exist to be used in stress. In practice institutions are reluctant to draw them down, because falling below a requirement invites regulatory consequences and, more importantly, signals distress to counterparties.
A bank drawing on its liquidity buffer announces that it needs to, which can accelerate the outflow the buffer was meant to absorb. Regulators have acknowledged this and have not fully solved it, since a buffer nobody will use is not functioning as a buffer.
The Bottom Line
Liquidity rules address the failure mode capital ratios miss: an institution that is solvent and cannot pay. The coverage ratio sizes a buffer against 30 days of assumed outflows, and 2023 demonstrated that modern runs can outrun those assumptions. The rules cost profitability, affect market liquidity, and suffer from the problem that using a buffer signals the distress it was meant to contain.