Edited by Thorsten Beck - Vox

VOX Research-based policy analysis and commentary from leading economists
on more stable funding (retail deposits and informed, long-term investors) would also
promote a focus on local business credit opportunities, moving away from the oversized
carry trades, investing in risky global assets and funding it with unstable global liquidity.
Prudential control of liquidity risk under Basel III
In the ongoing regulatory reform, attention has focused on raising capital ratios. Under
Basel II, capital charges were inadequate, relying excessively on credit ratings and
industry modelling. The new proposals are a large improvement, and a broad agreement
has now been reached.
Basel III also seeks to address liquidity risk, recognized as the biggest gap in Basel II.
Understanding bank equity is, unfortunately, much easier than understanding liquidity
risk. After all, even a bank with a 10% adjusted-capital ratio usually has a 95/96% debtto-assets
ratio, after removing capital discounts for safe assets (such as all Eurozone
sovereign debt!). So the key question is – how can we control refinancing risk for 95%
of bank funding, given that banks are tempted to raise cheap, short-term funding and
rely on central bank rescues should a run occur?
Academic opinion agrees that unstable funding imposes a negative risk externality.
Both risk charges and mandatory ratios have been proposed to contain liquidity risk
buildup (Perotti and Suarez 2009; Acharya, Khrishnamurti and Perotti 2011). However,
the Basel III proposals have been cast solely in terms of ratios.
Two standards have been introduced:
• Liquidity coverage ratios: buffers of liquid assets as a fraction of less stable funding.
• Net funding ratios: quantitative limits to short-term funding.
While very tight levels of such ratios can ensure stability, this approach is too narrow.
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