Reform in Congress Lacking Cash Clause to Stop Lehman-Like Runs

March 29 (Bloomberg) -- In 2,615 pages of financial reform legislation introduced in the U.S. Congress, there are no rules to ensure that banks keep enough cash-like assets when credit disappears.

Guidelines on liquidity risk management, which were published March 17 by the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corp., also avoided spelling out how much banks need to hold, and in what form, to make sure they don’t collapse if short-term lending dries up. International efforts to do that for the global banking system could take years to implement.

Citigroup Inc., which came close to a funding shortfall in 2008 and received a $45 billion government infusion, is among U.S. lenders that have hoarded cash since credit markets seized up two years ago. Even so, the banks continue to rely on overnight borrowing for their funding needs. While down from its peak in 2007, the U.S. repo market, which provides banks with short-term lending backed by collateral, is still $2 trillion.

“The temptation always is to lower liquidity levels when times are good,” said Baylor Lancaster, an analyst at CreditSights Inc. in Miami. “That’s why we need rules. In three years’ time, are people really going to care about liquidity as much as they do now?”

U.S. banks have increased cash reserves and raised $519 billion of capital since 2007 at the urging of regulators. Citigroup’s excess liquidity -- which CreditSights calculates by adding cash on deposit at the Fed and unencumbered securities such as Treasuries that can be sold easily -- is up 58 percent from a year ago, and Goldman Sachs Group Inc.’s has jumped by 72 percent. As the crisis ebbs and global markets recover, those stashes will likely decline, Lancaster said.

Bear Stearns, Lehman

Running out of cash was behind the collapse of Bear Stearns Cos., Lehman Brothers Holdings Inc., Washington Mutual Inc., Wachovia Corp. and other banks in 2008.

After two of its hedge funds blew up in June 2007, Bear Stearns started to lose long-term funding and had to replace the loans coming due with shorter-term debt, according to two former executives who had knowledge of the firm’s finances. Regulators were informed of the company’s liquidity position in weekly meetings as conditions worsened, those executives said.

There were no rules to force Bear Stearns to maintain a fixed level of cash-like assets or to cap its use of overnight funds. Until the day before the Wall Street firm was sold to JPMorgan Chase & Co. in March 2008, regulators said it had a sufficient capital buffer. When overnight creditors refused to accept even U.S. Treasury bonds held by Bear Stearns as collateral, that buffer proved inadequate, the executives said.

Selling Assets

If there had been rules, Bear Stearns would have had to sell some of its $30 billion in mortgage-related assets early on, a move that might have saved the firm, the executives said.

“Requiring a firm to keep a certain level of very liquid assets like Treasuries will help prevent the sort of liquidity crisis Bear Stearns faced,” said Charles Whitehead, a finance law professor at Cornell University in Ithaca, New York. “It will at least give the firm some time to work out its problems. And that might mean selling the company, getting investors to inject capital or some other solution.”

Lehman was funding as much as half of its $800 billion balance sheet through overnight or other short-term loans, according to two former executives with knowledge of its operations. That accounted for about one-seventh of the U.S. repo market. Asset-backed securities were used as collateral for one-third of the firm’s overnight borrowing, one of the executives said. Those became increasingly difficult to sell when the mortgage market collapsed.

Collateral Demands

While regulators knew of the risk that this collateral could become illiquid, they never pushed Lehman to sell assets or to find other ways of funding, one of the executives said.

The firm’s demise was speeded up by demands for more collateral from JPMorgan, its repo clearing bank, according to a March 11 bankruptcy examiner’s report. Months before Lehman’s collapse in September 2008, Moody’s Investors Service Inc. and Standard & Poor’s LLC, the largest credit rating firms, published reports labeling the company’s liquidity profile “solid” and “very strong.”

“Why is setting liquidity rules not a priority even though regulators keep talking about it as the source of the crisis?” said Mark Williams, a former Fed examiner who’s now a professor of finance at Boston University and whose book on the lessons of Lehman’s failure, “Uncontrolled Risk,” is being published this week. “We need more specific rules on liquidity risk.”

‘Liquidity Cushion’

The March 17 guidelines ask banks to keep a “liquidity cushion” based on estimates of their cash needs discovered through stress testing. Supervision should focus on cash flow projections, diversified funding sources, stress testing and a contingency plan, the regulators said.

The guidelines address only the “qualitative” aspects of liquidity management, according to Thomas Pax, head of the regulatory group at law firm Clifford Chance.

“They’re assessing the processes and monitoring of liquidity but not addressing the quantities of liquidity that banks need to hold,” said Pax, who is based in Washington.

Joseph Longino, a principal at Sandler O’Neill & Partners LP, said the lack of specificity is intentional.

“There’s an attempt by supervisors not to impose one-size- fits-all on financial institutions that are very different,” said Longino, whose New York-based investment bank focuses on financial-services firms. “Most of this guidance is already in existence anyway. This just brings the different regulators’ practices together.”

‘Less Profitable’

One reason regulators and legislators may have avoided making hard-and-fast rules is that the cost to banks would be high, said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission and a Bear Stearns executive from 1999 to 2006.

“Regulations could cap Wall Street banks’ funding by overnight loans to a certain percentage of total funding,” said Lindsey. “That would reduce liquidity risk but raise the cost of capital for the firms and make them less profitable.”

Looming over discussions about liquidity are rules proposed in December by the Basel Committee on Banking Supervision, a 35- year-old panel that sets international capital guidelines. The new framework would require banks worldwide to hold enough unencumbered assets to meet all of their liabilities coming due within 30 days. That amount, called the liquidity coverage ratio, could be used to offset cash outflows during a panic.

Basel Rules

Banks would also have to maintain a “net stable funding ratio” of 100 percent, meaning they would need an amount of longer-term loans or deposits equal to their financing needs for 12 months, including off-balance-sheet commitments and anticipated securitizations.

The Basel committee, which is collecting comments on the proposed rules through April 16, would establish clear definitions of liquid assets and funding needs, rather than leave those determinations to the banks. It would also set new capital requirements. The committee expects to complete its work by the end of the year and implement the regulations by the end of 2012.

The liquidity rules would reduce the annual profit of Bank of America Corp. by $1.5 billion and of Citigroup by $1.2 billion, JPMorgan estimated in a Feb. 17 report.

Bank analysts and executives say the proposals won’t be implemented in their current form.

‘Overly Ambitious’

The rules are “too restrictive and we believe they could ultimately be watered down,” Barclays Plc said in a Feb. 8 report. Societe Generale SA’s Severin Cabannes has been telling investors the Basel regulations will likely be weakened, according to investors who have met with him.

“Full implementation by 2012 is overly ambitious,” said Chris Bates, who follows European regulations at Clifford Chance’s London office.

Bates also said he expects opposition to the rules in the U.S. and the possibility they won’t be adopted in full.

While the U.S. signed on to the Basel II capital framework established in 2004, those rules were never enforced and banks didn’t comply.

The current political climate may make it easier to adopt the new Basel rules in the U.S., according to two people familiar with regulators’ discussions of the matter. They said U.S. officials haven’t established quantitative liquidity rules because they don’t want to front-run the Basel committee.

Bank of New York

The House of Representatives passed a 1,279-page financial reform bill in December. A 1,336-page version was approved by the Senate Banking Committee earlier this month and may be voted on next month. Both bills give regulators the authority to come up with liquidity requirements for U.S. banks without spelling out what those might be.

The Federal Reserve Bank of New York set up a task force in September to recommend changes to the way the overnight lending market operates. The two clearing banks, JPMorgan and Bank of New York Mellon Corp., want to avoid future losses in case of a borrower’s collapse, according to three people who attended task force meetings in February. Among the proposals being drafted are ones requiring better recording of transactions by the clearing banks and establishing standards for collateral valuation, the participants said.

The task force’s efforts don’t address how to ensure that banks have enough cash to meet obligations when financial markets panic, the people said.

Liquidity is not a new issue. Continental Illinois National Bank & Trust Co. failed in 1984 because its overnight lending grew costlier as lenders worried about its viability, according to Allan Meltzer, a professor of political economy at Carnegie Mellon University in Pittsburgh and author of a three-volume book on the Fed.

“Banks should have learned by now it’s dangerous to rely on overnight lending,” Meltzer said. “You’d think they’d learn.”

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net