Bowman urges liquidity framework reform for banking system resilience

The current prudential liquidity framework, comprising the Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR), internal liquidity stress testing, and resolution planning, was designed post-GFC to ensure banks withstand sudden withdrawals and market disruptions.

However, Bowman argues it creates two practical problems.

Firstly, banks over-allocate to High-Quality Liquid Assets (HQLAs) in normal times to meet balance sheet requirements, reducing their capacity to lend.

Secondly, traditional Federal Reserve liquidity sources like the discount window are stigmatized, discouraging use.

During stress, this framework becomes pro-cyclical, as banks are reluctant to use their HQLA buffers for fear of falling below minimum LCRs, exacerbating stress and forcing conversion of less liquid assets into cash.

This leads to 'liquidity hoarding' in excess of what is necessary, imposing unnecessary costs on the banking system and the U.S. economy.

Bowman highlighted the Federal Reserve's discount window as a critical but underutilized tool.

Banks avoid it, even in times of stress, due to the stigma associated with disclosure and higher borrowing costs, which markets interpret as a sign of fragility.

This discourages use precisely when it is most needed.

Furthermore, the discount window's fragmentation, with each of the 12 Reserve Banks having independent rules and processes, creates uncertainty for borrowers and can exacerbate systemic fragilities.

Bowman called for fundamental reform to ensure the discount window functions as a reliable liquidity backstop with consistent rules.

She noted that liquidity hoarding, a consequence of these flaws, reduces credit availability to the economy and requires the Fed to maintain a larger balance sheet.

Bowman believes monetary policy implementation tools and regulatory objectives should be compatible through a modernized discount window.