EU banks to face liquidity checks after concerns about crisis-management capabilities
The European Union’s banks will face close scrutiny next year over their plans to survive a major crisis without relying on central bank support, according to the EU’s banking watchdog.
The need for viable alternatives became evident after Credit Suisse was rescued by the Swiss central bank in March, before being taken over by UBS. In response to this, the European Banking Authority (EBA) announced that it will assess whether national regulators are testing banks’ assumptions on how they would obtain liquidity after a collapse. This evaluation will consider factors like the speed of deposit withdrawals, as highlighted in recent crises in the US and Switzerland.
The swift disappearance of liquidity was also evident in the collapse of Silicon Valley Bank in the US, prompting global banking regulators to review liquidity requirements for banks on a day-to-day basis.
The reasons for the scrutiny
The EU resolution rules, particularly the Banking Recovery and Resolution Directive, have come under scrutiny due to concerns regarding bailouts and potential financial instability. The directive stipulates that troubled banks must bail in at least 8 percent of their unweighted balance sheet before any bailout can be considered. However, this poses a challenge for smaller and midsize banks, as they may not have sufficient eligible debt to meet the bail-in requirement without impacting depositors.
In contrast to the US approach, where Silicon Valley Bank received support, such actions would be considered illegal under the current EU rules. This situation raises the risk of financial instability if a banking crisis were to occur today. Addressing these concerns becomes crucial to strike a balance between ensuring the viability of smaller banks and maintaining financial stability, prompting further discussions on the effectiveness and flexibility of the resolution rules in the EU banking system.
Liquidity refers to readily available cash or short-term debt that can be used to fund a bank’s daily operations without selling assets.
The EBA report
The EBA’s report focused on how regulators across the EU apply “resolution” rules introduced after the global financial crisis to prevent taxpayer-funded bailouts of banks. Resolution can involve smoothly shutting down a bank and transferring key activities to a solvent lender, or restructuring the bank to access markets or other sources of liquidity.
According to the report, banks have mainly relied on accessing central bank facilities to support liquidity during resolution, indicating limited and focused strategies. However, relying on private markets for liquidity may be challenging for stressed banks emerging from resolution, and obtaining central bank liquidity might be difficult without sufficient collateral.
Potential liquidity options for banks include selling assets, issuing debt, or drawing on guaranteed lines of credit.
The importance of liquidity for banks
Liquidity is a critical aspect for banks, essential for their day-to-day operations and overall stability. It refers to a bank’s ability to promptly and efficiently meet its financial obligations, such as customer withdrawals, payments, and settlements. Adequate liquidity is crucial as it instills confidence in depositors and investors.
Sufficient liquidity is particularly important during financial crises and economic downturns. It enables banks to withstand sudden shocks like mass withdrawals or market disruptions without resorting to distress asset sales, which could worsen the situation.
Moreover, liquidity plays a significant role in supporting economic growth. Banks with healthy liquidity are better equipped to lend to individuals, businesses, and governments, fostering economic activity, investment, and credit availability.
Regulators closely monitor banks’ liquidity positions to ensure financial stability and protect depositors. Inadequate liquidity can lead to bank failures, systemic risks, and the potential need for taxpayer-funded bailouts, which governments aim to avoid. Prudent liquidity management is, therefore, a fundamental pillar of sound banking practices, safeguarding the entire financial system and contributing to sustainable economic prosperity.