Lehman Brothers' Liquidity Ratio

In my last post, I discussed the irrelevance of the G20 compensation agreement as well as why higher capital requirements are not a panacea for banks. Today I will look at some of the details of new US liquidity regulation. The FT reported last week that US regulators are working on new rules aimed at helping banks avoid the sudden funding withrawals that doomed Bear Stearns and Lehman Brothers. These regulations would require banks to operate under new liquidity ratios as well as capital ratios. Capital requirements wouldn't have saved Lehman, which had 11% tier 1 capital at the time of its bankruptcy, but what about liquidity ratios?

One ratio would compare a bank's assets to its stable sources of funding. Lehman revealed on Sept. 10, 2008 (4 days before bankruptcy) in an accelerated Q3 guidance call that its funding position was "stable." At this point, Lehman had $211bn in secured funding from tri-party repos. Comparing the $211bn in short-term funding to its 600bn of long-term assets (meaning a stable funding to assets ratio of 58%) illustrates Lehman's vulnerable position. But it's not that simple. Of those $211bn, $115bn were in treasuries and agencies, which is very reliable collateral. Of the remaining 96bn, $39bn is central bank eligible and could be used for emergency funds from the Fed. Now the $211bn has been whittled down to $57bn, of which $25bn is investment grade fixed income and liquid equities. So, we are left with a measly $32bn of risky short-term funding, only 16% of total assets. Will regulators demand short-term liquidity must be less than 16% of total assets? Who knows, but it could easily be more. 16% short term funding is not that high. This example merely underscores the drastic effect minor funding gaps can have. That's the thing about liquidity--you either have it or you don't.

This exercise shows the massive difficulties facing regulators in coming up with liquidity ratios. Much like capital ratios, the devil is in the details. Regulators must ensure companies do not find the equivalent of a credit default swap for liquidity ratios, (referring to the role CDS played in keeping bank capital ratios artificially low).