Last night, Bloomberg reported that the Basel Committee was considering revising Basel III's new Liquidity Coverage Ratio (LCR) to allow banks to use equities in their liquidity pools. This would be a relatively major change, and one which I consider ill-advised. (For background, I've written about the LCR several times before.) From Bloomberg:

"The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private."
At a Senate Banking hearing today, Fed Governor Dan Tarullo confirmed this report. He also indicated that the Fed would support expanding the list of assets that are eligible for the LCR's liquidity pool. Here's Tarullo after being asked about the Bloomberg report (from the CQ transcript of the hearing):
We — which is to say the Federal Reserve — was one of the entities which asked internationally to take another look at liquidity coverage ratio.
And one of the — one of the precepts, I think, for the — for the renewed look was just the point that you were making, that if you're worried about the liquidity of a firm, what you're really asking is, how well is the liabilities and the assets of that firm matched so that in a period of stress it can cover its needs in a — over some period of time so that it has a plan for — it can develop a plan for longer run survival.

And what I have thought was that the 2008 period gave us a very good real life experiment to test what kinds of instruments actually do remain liquid even during a period of stress like that. For example, highly traded equities of large companies.

So that is in fact one of the motivations for the rethink, and I believe that once the international group at the Basel Committee that's looking at the LCR has finished its evaluation next year, that you will see some changes in things like what qualifies in assumed run rates and the like, to try to conform the requirements somewhat more closely to the experience we actually had in late [2008].
Tarullo, therefore, seems to be willing to allow banks to use certain large-cap equities in their liquidity pools. (Basel III's LCR requires banks to maintain large liquidity pools, which must be made up of "high quality liquid assets," so technically what Tarullo is saying is that certain large-cap equities should be included in the definition of "high quality liquid assets.")

Two points here. First, there's a reason that most banks don't currently include equities in their liquidity pools, and that the Fed applies higher haircuts to equities in its emergency lending operations. The reason is that equities are typically more volatile than other instruments (e.g., fixed-income). Allowing banks to use equities in their liquidity pools increases the risk that a bank will have a large shortfall in its liquidity pool on a given day. Presumably, if the Basel Committee makes this change, equities would be categorized as "Level 2" high quality liquid assets (which I explained here), which means a 15% haircut would be applied. But does anyone honestly believe that a 15% haircut is enough for equities — especially given the wild swings in the equity markets that we witnessed even in 2008? I'm not at all convinced that there's a large class of equities that would be truly liquid in a crisis, and certainly not a large enough class to justify the inclusion of equities in banks' liquidity pools.

Second, I'm disappointed to see Tarullo endorse the argument that we can determine which assets are truly liquid by looking at how they fared in the 2008 crisis. As I've noted before, this is a really stupid argument. It may be true that certain large-cap equities maintained their liquidity throughout the 2008 crisis, but there were also massive government bailouts in 2008 — not to mention the extraordinary amounts of liquidity that the Fed pumped into the financial system.

How much did those large-cap equities that Tarullo refers to rely on the Fed's extraordinary lending programs (directly and indirectly) to maintain their liquidity? The point of the LCR is to ensure that banks can survive a funding crisis without massive government bailouts. Contra Tarullo, 2008 is NOT a very good — or even an appropriate — guide. Regulators will simply have to accept that determining which assets are likely to remain liquid in a TARP-free crisis will require the application of judgment on their part.

This is a development worth watching.