WASHINGTON — Federal Reserve Gov. Jeremy Stein Friday said an important but little known regulatory anti-crisis mechanism is the kind of rule still being developed that enforces a liquidity requirement on banks so that they can raise a lot of cash fast if necessary without unnecessary ripple effects.

What is known as the Liquidity Coverage Ratio ensures "that banks have an adequate stock of unencumbered high-quality liquid assets that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar-day liquidity stress scenario," he said.

The Fed is expected to propose a U.S. version for large banks later this year. The Basel Committee on Banking Supervision is developing an international liquidity standard to be phased in through 2019.

Stein, speaking at a Richmond Fed bank credit markets symposium, said questions that are still outstanding include how much of what a large bank can draw from its central bank be counted among the 30-day's worth of liquid assets.

Ideally banks would be ready to use their most liquid assets in an emergency rather than conducting a fire sale of less liquid assets during periods of stress. But Stein conceded there might be a stigma attached to using an emergency facility "for fear that a decline in the (liquidity) ratio could be interpreted as a sign of weakness."

Since fire sales can have "spillover effects to other financial institutions and to the economy as a whole," he said, it takes policy rules to define what should be done and under what circumstances.

"While banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because -- although they bear all the costs of this buffer stocking -- they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure."

In the U.S., he said, "when the economy is in a bad state, assuming that a particular bank is not insolvent, the central bank can lend against illiquid assets that would otherwise be fire-sold." That could dampen one of the ingredients that could trigger a run on the bank and help "reduce the incidence of bank failure."

Stein cautioned that "the line between illiquidity and insolvency is far blurrier in real life than it is sometimes assumed to be in theory."

So a central bank, in aiding a troubled bank's liquidity, could be taking on risks that would "ultimately fall on the shoulders of taxpayers." Therefore "it makes no sense to allow unpriced access" to the central bank.

In Australia, the use of the central bank for this purpose involves a fee and "this approach is not at odds with the goals of liquidity regulation because the up-front fee is effectively a tax that serves to deter reliance" on the central bank.

While simple in concept the liquidity requirements being considered by the Fed are nuanced and complicated in practice. In addition, segregating those assets considered to be highly liquid made have other implications, given a Basel Committee estimate is that it would take an accumulation of perhaps $3 trillion dollars worth worldwide of such assets to safeguard the largest banks. In the U.S., Stein said it would be about $1 trillion.

The premium to be charged on the central bank provision of highly liquid assets to banks under stress "will depend on market equilibrium considerations that are hard to fully fathom in advance."

Said Stein, "The recognition that liquidity regulation involves more uncertainty about costs than capital regulation suggests that even a policymaker with a very strict attitude toward capital might find it sensible to be somewhat more moderate and flexible."

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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