LCR buffers, not levels, enable bank credit during stress
A Federal Reserve paper finds that banks with higher Liquidity Coverage Ratio (LCR) buffers provided more credit to firms during the COVID-19 crisis. Only buffers above the regulatory minimum, not overall LCR levels, proved critical for liquidity provision.
Buffers, not levels, unlock credit
Banks with higher Liquidity Coverage Ratio (LCR) buffers above the regulatory minimum significantly increased credit to firms with undrawn credit lines during the acute phase of the COVID-19 crisis in March 2020.
This Federal Reserve study, using confidential bank-firm credit data, reveals that overall LCR levels alone did not predict credit provision; only the buffer capacity beyond the 100% regulatory minimum proved critical.
The effect was concentrated among high-quality borrowers with clean credit profiles, suggesting selective liquidity insurance.
This support was temporary, disappearing by mid-2020, confirming that LCR buffers provide timely, stress-contingent liquidity rather than reflecting permanent relationship characteristics.
The findings provide direct evidence that the LCR regulation operates as a binding constraint during stress, illustrating the 'last taxi' problem.
The 'last taxi' paradox
The Liquidity Coverage Ratio (LCR), introduced as part of Basel III, mandates large banks hold high-quality liquid assets (HQLA) to cover 30-day net cash outflows.
This regulation aims to mitigate adverse effects of disruptive runs.
However, a fundamental tension exists: buffers designed for use may become frozen when needed most.
This 'last taxi problem' arises because drawing down LCR buffers can bring banks closer to regulatory minimums, potentially signaling weakness to markets.
The paper emphasizes that a bank's LCR *buffer* (e.g., 20% above 100% minimum) is distinct from its overall LCR *level*, and only the former provides true deployment capacity during stress.
Regulation's double-edged sword
This paper critically highlights the inherent tension in liquidity regulation, revealing that buffers, while intended for use, become binding constraints during stress.
The findings suggest that current LCR rules may inadvertently limit credit supply when it is most needed, particularly for less prime borrowers.
Policymakers face the challenge of designing frameworks that encourage buffer utilization without signaling weakness or inviting undue scrutiny.