Liquidity Risk and Bank Regulation: Basel III and Beyond

Abstract

Liquidity transformation is a pre-eminent function of the banking system. By utilising at-call deposits to fund long-term and illiquid loans, and by making funds available to depositors and borrowers upon demand, banks contribute to economic welfare. However, liquidity transformation exposes banks to significant risks. As banks do not choose to hold socially optimal liquidity exposures on their own, bank regulations are an important tool for enhancing the safety of individual banks and improving the stability of the financial system. This thesis sheds new light on the causes of liquidity risk by examining the supervisory liquidity risk ratings of Australian deposit-taking institutions. It is shown that liquidity risk ratings are predictable and that the Basel III liquidity regulations are likely to reduce risk in the banking system. By conducting the first microeconomic cost-benefit analysis of the Basel III liquidity standards, this thesis also illustrates that the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) have net social benefits under a range of reasonable assumptions. This is particularly important as past macroeconomic cost-benefit analyses of Basel III liquidity standards are shown to be misspecified and potentially spurious. JEL Classification: G28, G21