1. P a g e | 1Basel iii Compliance ProfessionalsAssociation (BiiiCPA)1200G Street NW Suite800Washington, DC 20005-6705USA Tel:202-449-9750Web: www.basel-iii-association.comDear Member,I will leadaBaselIII classin Londoninafewdays (March20-22,2013).Wehaveensuredthat not onlythecourse, butalsothevenue is great: Four SeasonsHotel, Canary Wharf, London.Theview and thefoodthereis fantastic.Yes,this isveryimportant too.I want to spend 3 greatdays, not simply lead aclass.You can call RossFenwick after visiting:http:/ / www.baseliiitraining.com/book_course.php?InstanceID=174I lookforwardto meetingsomeof you.Todaywewill start with themonitoring of theimpact of theBaselframeworks.Yes,westill have Basel iii monitoring withBasel i figuresBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com

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P a g e | 2Basel III monitoringQuestionnaire and instructionsTheBasel Committeeon Banking Supervisionismonitoring the impact of Basel III: Aglobalregulatory framework for moreresilient banksandbankingsystems and Basel III: Internationalframeworkfor liquidityrisk measurement,standardsand monitoringon a sampleof banks.Theexercisewill be repeatedsemi-annuallywithend-December and end-Junereportingdates.Scope of the exerciseParticipationin themonitoring exerciseis voluntary.TheCommitteeexpectsboth largeinternationallyactivebanks andsmallerinstitutionstoparticipatein the study, asall of them will bemateriallyaffectedbysomeorall oftherevisionsof thevariousstandards.Whereapplicableand unlessnoted otherwise,datashouldbereported forconsolidatedgroups.Themonitoring exerciseistargetedat both banksunder the Basel II/ IIIframeworksand at thosestill subject to Basel I.However,asoutlinedin theremainderof theseinstructionssomeparts ofthequestionnaireare only relevant for bankssubject toBasel II or tobanksapplying a particularapproach.If Basel I figuresareused, they should be calculatedbased on thenational implementation, referred to asBasel I in this document.In some countries supervisorsmay have implemented additional rulesbeyond the1988Accord ormay havemademodificationstotheAccord inBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 3. P a g e | 3their national implementation, and theseshould be consideredin thecalculationof BaselI capital requirementsfor thepurposesof thisexercise.If a bank hasimplemented Basel II at a particular reportingdate, itshould calculate capital requirementsbasedon thenationalimplementationoftheBaselII framework, referredtoasBaselII in thisdocument.Unlessstated otherwise,the changestothe risk weightedassetcalculationof the BaselII framework introducedin 2009whicharecollectivelyreferredtoasBasel2.5 (RevisionstotheBasel II marketrisk framework(theRevisions) and Enhancementsto theBasel IIframework(the Enhancements)) and through the Basel III frameworkshould onlybe reflectedif theyarepart of the applicableregulatoryframeworkat thereportingdate.When providingdata on Basel III, banksshould alsotake intoaccountthefrequentlyasked questionson capital, counterparty risk and liquiditypublishedbythe Committee.This data collectionexerciseshould be completed on a best-effortsbasis.Ideally, banksshould includeall their assetsin thisexercise.However, due to data limitations, inclusion of some assets (for examplethe portfolio of a minor subsidiary) may turn out to be an unsurpassablehurdle.In thesecases, banksshould consult their relevant national supervisortodeterminehow to proceed.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 4. P a g e | 4Financeand EconomicsDiscussionSeries, Divisionsof Research& Statisticsand MonetaryAffairs, Federal ReserveBoard, Washington, D.C.Lessonsfrom the Historical Useof Reserve Requirements in theUnited Statesto Promote Bank LiquidityMarkA. CarlsonNOTE: Staff workingpapers in the Financeand Economics DiscussionSeries (FEDS) are preliminarymaterialscirculatedtostimulatediscussion and critical comment.The analysis and conclusionsset forth are those of the authors and do notindicate concurrence by other members of the research staff or the Boardof Governors.Referencesin publicationsto the Financeand Economics DiscussionSeries (other than acknowledgement) should be cleared withtheauthor(s) toprotect thetentativecharacter of thesepapers.***Shortlyafter the Panic of 1837, statesbegan institutingreserverequirementswhichmandatedthat bankshadto hold liquidassetsrepresentingat least someminimum fraction of their liabilities.When Congresspassedthe National Bank Actsin the 1860s,banksreceivingNational Bank chartersalsofaced a minimum reserverequirement.Theseruleswerepart of an effort topromote liquidityand soundnessbyensuringthat eachindividualbank hadapoolofliquidassetsthat it coulddraw on during timesof stress.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 5. P a g e | 5Despitetheseefforts, aswell assomeeffortsfrom within the bankingsectortoprovide liquiditysupport, thebankingsystem remainedvulnerable tobankingpanicsand suspensionsof convertibilityin whichbankstemporarilystoppedor restricted withdrawalsof funds(Calomirisand Gorton 1991,Sprague 1910,Wicker 2000).Thesepanics werequitedisruptive toeconomicactivityanddemonstratedthat the reserve requirementswerenot sufficient toensurethat the financial system remained liquid during periodsof stress(Grossman 1993, James,Weiman, and McAndrews2012).In part toaddresstheseconcerns, CongressestablishedtheFederalReservetocreatean elastic currencythat could add liquidityto thebankingsystem and serve asa lender of last resort.This paper reviewsthe historical experienceof the United Stateswithreserverequirementsto provide insightsfor policymakers todayregardingeffortsto promote individual bank liquidityand the relationofthoseeffortswith a lender of last resort.(Someproposals, such asthe, liquiditycoverage ratio proposed bytheBaselCommitteeonBankingSupervision, arequite similar tothesehistorical reserve requirements.)Theinsightsdiscussedhere draw importantlyon the activediscussionsamongacademics,policymakers, and bankersduring the 1800sand early1900sabout thevalueof reserve requirements.Other lessonsare based on contemporarydiscussionsand some dataanalysisregardingthedynamicswithinthebankingsystem during panicsandtheimpact of reserverequirements.While thispaper reviewsthehistorical experienceof theUnited Stateswith reserverequirementsstartingin the 1830s,there is a bit moreemphasison material from the National BankingEra (1863-1913).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 6. P a g e | 6Theempirical partsof the paper alsodraw on data from thisperiod.Thefocuson theNational BankingEra reflectsthe fact that it wasin this period that use of reserve requirementswasmost prominent andthat the experiencesduring this period ultimately resulted in the creationof the Federal Reserve and a shift awayfrom the useof reserverequirementsto regulate liquidity.Onekeylesson that can be drawn from historicalexperienceisthatcentral banksare important during panicsfor multiplereasons.Onedescription of a panic is a situationwhereextraordinarydemand forliquidassetsexceedsthe availablesupplyof thoseliquid assets(asevidencedby thesuspensionsof convertibility that occurred duringpanics and by the spikes in short-term interest rates).Acentral bank can help easea panic byrapidlyexpanding thesupplyofliquidassets.Relatedly, banks oftendepend on other banksfor liquidity.During a panic, theabilityof other bankstofurnishthat liquiditysupportis likelyto become impaired.Without accessto this usual source of liquidity, and in the absenceof alender of last resort, banksmay faceincreased incentivestohoardliquidityduring stressevents.This dynamic may exacerbatethe severityof thestressepisode.Thus, during a crisis, the liquidityof an individual bank isintricatelyconnected to central bank liquiditypolicyand optimal liquidityregulation should consider these jointly.There areother pertinent lessonsaswell.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 7. P a g e | 7Theliquidityreservesmandatedby reserverequirementsaregenerallyintendedto be used whenliquiditydemand spikes.Nevertheless,banksareoftenreluctant todraw downtheirstoresofliquidassetsduringpanics.Historicalexperiencesuggeststhat if therulesregarding the instanceswhenthe reserveshould be usedare unclear, the lack of clarity mayexacerbatebanksreluctance.On a relatednote, the regulationsand penaltiesassociated withmonitoringand enforcingthe reserve requirement during normal timesthat werein placeduring the late1800sand early1900sdo not appear tohavebeen particularlyeffectivewhichindicatesthe importanceofconsideringtheseaspectsof liquidityrequirementsaswell.Additionally, historicalexperiencesuggeststhat when certain assetsaredesignatedasstoresof liquidity, institutionswill seekto accumulatethoseassetsduring a crisistodemonstrate their strength;Uunlessthepool of liquid assetscan be expandedat thosetimes,there issome riskthat the functioningof the market for thoseassetsexpectedtoprovideliquiditycan deteriorate.This paper isorganizedasfollows.Section 2 describesthe introduction of reserve requirements,reviewstheargumentsfor and against suchrequirementsduring the 19th and early20th centuries, and providessome stylized factson reservesheld bybanks.Section 3 reviewsmechanismswithinthesystem designed toaddressthestressesassociatedwith banking panics and presentssome evidenceonhowholdingsof reserves changedshortly after a panic.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 8. P a g e | 8Section 4 brieflyrecountseventsfrom thePanic of 1907and discussessome reasonswhythe reserverequirementsalonewerenot sufficient tostop banking panics.This section alsoreportson the subsequent debateabout the need for acentral bank toprovide liquiditysupport tothe banking system.Section 5 describesreserve requirementsin the presence of a central bankand the decline in the use of reserve requirements as a tool for regulatingliquidityfollowingtheestablishment of the Federal Reserve.Ageneral review of the lessonsfrom thehistorical experienceandconcludingthoughtsare provided in Section 6.Section 2. Reserve requirements prior to the Federal ReserveThis section brieflyreviewsthehistory of the lawsregardingreserverequirements.It alsodescribessome of the reasonsgivenbypolicymakers for havingreserverequirements,thedifferencesin requirementsacrossstates,andtheenforcement of the reserve requirements.Additionally, this section providessome basicempirical information onthelevelsof reservesheld by individual national banks.Section 2.1 Introduction of reserve requirementsThefirst reserve requirementswereintroducedin the United StatesshortlyfollowingthePanic of 1837bythe states of Virginia, Georgia, andNew York (Rodkey 1934).Theserequirementsweregenerallyintendedtoensure that bankshadready accessto resourcesthat wouldenablethem tomeet their liabilityobligations.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 9. P a g e | 9Theadoption of reserve requirementsbyother statesoccurred slowly;only10 stateshad such lawsby 1860.Although after the Panic of 1857there werea number of journal articlesandpamphletsadvocatingin favor of reserve requirements.When reserve requirementswere first enacted the main bank liability wasbank notes, which were privately issued currency that the bank promisedto redeem for specie (gold or silver coin), and state laws referred to thoseliabilitiesasthe basefor determiningtheappropriatereserve.As the liability baseof banksshiftedtoward deposits,the referencepointfor the reserve requirementsshiftedaswell.In 1842, Louisianapassed a law requiringbankstomaintain a reserveinspecie equal toone-third of itsliabilitiestothepublic, whichincludedboth notesand deposits(White 1893).By 1895, 21stateshad reserverequirementsfor commercial banks;at thistime, all such lawsincluded depositsin liabilitybase(Comptroller 1895).For statesthat enactedreserve requirements,the lawsregarding the ratioof reservesthat had tobe held relativetothe liabilitybaseranged frombetween10 percent and 33 percent.Statelawsalsodifferedwith respecttowhat could be included in thereserve.Somestatesalloweddepositsin other bankstocount aspart of thereserve.This feature likely owedtothefact that many banks in smallercommunitiesmaintainedbalancesat banksin larger citiestoclearpayments.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 10. P a g e | 10As many bank notes, and later checks, were redeemed at these clearingbanks, interbank deposits played an important part in a banks liquidityprofile (James1978, White 1983).Other statesrequired that that theentire reservebe carried asspecie inthebanksvault.Afew statesallowedshort-term loanstocount aspart of the reserve.There weresome further debatesabout thetype of depositsshould beincludedin the basefor the reserve. Some policymakersargued thatbanksought tomaintain a greater reserveagainst more volatiledeposits.As a result, some statesonly required a reserve againstdemand deposits(Comptroller 1895,Welldon 1910).Ahandful of states mandated reservesagainst both demand and timedeposits,but specifiedthat the amount of liquid resourcesthat needed tobeheld against each dollar of timedepositswassmaller than that requiredfor demand deposits.Nevertheless, a majority of statesrequired the reservetobe calculatedagainst all deposits.When the U.S. Congress passed the National Banking Acts in the early1860s and provided for National Bank charters, the legislation includedreserverequirementsfor National Banks.Thesereserve requirementsweretiered dependingon thelocation of thebanks.For much of theNational BankingEra, bankslocatedoutsidemajorcitiesreferredto ascountry bankswererequired to hold reservesequal to 15 percent of deposits, three-fifthsof whichcould beheld asdepositsin banksofreservecitieswhiletherestwasrequiredtobeheldasvault cash.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 11. P a g e | 11Banks in reserve citiesgenerallylarger citieswererequired to holdreservesequal to 25percent of deposits, half of whichcould be carriedasbalancesin central reserve cities.Banks in central reserve citiesat first justNew York but later alsoChicagoand St. Louisheldsignificant amountsof interbank deposits.Thesebankswererequired tomaintain a reserve equal to 25percent ofdepositswhichneededto be held in gold or in Treasurynotes.Onereason that banks in reserve and central reserve citieswereexpectedtoholdahigherportion of their assetsasreserveswasthat theyheldmoreinterbank deposits; thesedepositswereseen asmore volatileand, inparticular, more likelyto be withdrawnduring bankingpanics(FederalReserve1927).Section 2.2 The purpose of the reserveAs noted above, reserve requirementswerea prudential requirementmeant toensure that banksmaintainedtheresourcesto meet theirobligations.This goal is quitebroad and hasaspectsof both solvency and liquidity.Indeedproponentsof reserverequirementsoften blended thetwoorspokeof the benefitsboth in termsof the safetyof thebanksand thepromptnesswithwhichbankscould meet withdrawals, though there wasperhapsa bit more frequent mention of the liquiditybenefits.An exampleof argumentsframing thereserve asa tool for supplyingliquiditycomesfrom the1873report of theComptroller of the Currency(Comptroller)thechief regulator of theNational Bankswhonotedthat thequestionisnot whetherareserveshall beheldwhichshall insurethepayment, merely, of the note, for that is unnecessary, but whatBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 12. P a g e | 12amount of reserve shall be held by thebankstoinsurethe promptpayment of all their liabilities?(p.19)Among the argumentspointingto solvency benefits,Tucker (1858)suggestedthat bank failures, such asduring the Panic of 1857, weretheresult of imprudence asbanks overextendedthemselvesand did notmaintaina reserveof at leastone-third of their liabilities.Most advocatestendedto blend theseextremes.Hooper (1860) providedone of themost interestingblends.He maintained that a bank could reduce its riskiness by adjusting eitheritscapital or its reserve and that for a given level of capital, a bank couldextendmore loansif it held greater reserve.Havingastrongreservemeant that thebank wouldbeabletoavoidbeingforcedtoaccessemergencyfundsfrom other banksorrapidlycall in theirloans(or presumablybe forced to sell assetsin firesales) and thusbestronger overall.While much of the discussionfocused on themicroprudential benefitstothe individual banks of requiring a minimum level of reserves,somecommentatorsdid suggest that there were systemic benefitsof ensuringbanksretained sufficient liquid resourceson hand.Opdyke (1858)arguedthat excessivecredit growthledtoaboomandbustcycle and that a reserve requirement could be useful in restraining creditgrowth.Moreconcretesystemic benefits weredescribedby Hooper (1860) andCoe (1873) whosuggestedthat there werecollectiveaction reasonstomandateminimum reserves,especiallyfor banks in themain moneycenter of New York City.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 13. P a g e | 13Hooper noted that thereserveof banksinNewYork wasacommon goodbenefittingall thebanks in the cityaswell asthe rest of the country andthat the management of thosebanksmight not internalizethesocialbenefit they provided.As a consequence, he arguedthat the law needed to require them toholda larger reservethan thebankswouldotherwisehavechosen.It is out of the question for the banks of the city of New York to hold thatrelation of the entire confidence through the country, solong asthe actionof each bank, in regard to the amount of itsreserve of specie, isdependentupon thepeculiar viewsor character of itsboard of managers.Thelaw must secure theuniform ability of thebanksto meet theirengagementsby making it imperativeupon each one of them tohold therequisiteamount of specie asa condition of their power to discount(p.44).Coe noted that banksin New York City werelinked both through theirgeneraldependenceon thecall loan market for liquidity(describedindetail below) and that interior bankstendedtoreact to troublesat onebank asa signal of troublesat all the banks.Thus, during a panic thestrong banksneeded tosupport theweaktocontain liquiditydrainsand prevent problemsfrom cascading.This linkage, Coe argued, wasa reason that all banks neededtohold astrongreserve and wasa motivation for the New York Clearinghousetoestablisha reserverequirement in 1857.Section 2.3 Enforcing the reserve requirementThedebate about how to ensure that banks met thereserve requirementstartedsoon after therequirementswereintroduced.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 14. P a g e | 14Tucker (1839) advocated enforcingtherequirement using a moderatepenaltyproportional to any deficiency of the reserve.He maintained that the penalty should be high enough to dissuade banksfrom running below the reserve in good times but not so high that bankswereunwillingto use thereserve during a crisis.Opdyke (1858) argued for requiring a minimum reserve somewhat belowwhat was desired as he maintained that banks would hold a buffer stockabovethe requirement and that thebuffer could then be used:A legal minimum of 20per cent will, it is believed, give a practicalminimum of not lessthan 25to30 per cent, for noprudent bank willvoluntarilyoccupya position on the vergeof legal death (p.15-16).In the National Banking Era, the law providedthat in the event theComptroller found that a National bank wasdeficient in itsreserve, thebank could be required toceasemaking loansand stop paying dividendsuntil the amount of the reserve wasrestored.TheComptroller (1893) statedthat in theevent that thebank had loanedout toogreat a portion of its fundsor depositorshad withdrawnasignificant amount of funds, the onlysafeand prudent course for thebank topursue is toceasepaying out money in anydirectionexcept todepositorsuntil either through the collectionof demand or maturing loansontheonehand, orthereceipt ofdepositsontheother,therequiredportionhasbeen restored (p.18).If the reserve wasnot restored within 30 days, the Comptroller could, withthe concurrence of the Secretary of the Treasury, appoint a receiver for thebank.It waswell noted that both the findingby theComptrollerthat the bankwasdeficient and thedecisiontoseek areceiverwerediscretionaryonthepart of theComptroller.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 15. P a g e | 15Moreover,theComptrollerstated that heonlyhad the opportunitytolearnabout the banksbalancesheet from one of thebiannual bankexaminationsor thereport of condition filedfivetimesa year (1893).Theactual abilitytomonitor wasslightlymore complicated.In their examinationreports, examinerswereasked tolook through thebanksbooksand calculate and comment on the adequacyof banksreservefor thepast 30 days(or more if deemed appropriate).Thusthe examinationreportsallowedtheComptroller more just than asingledays observation.Carter Glass(1913) assertedthat this particular penaltyregimewasreportedlynot very successful.In the debatesrelated to Federal ReserveAct, he maintainedthat thepenaltiesfor holdinginadequatereservesfor an extended period weresoseverethat theyhad thenever been applied and that in some casesbankshadbeen allowedby regulatorstohave deficient reservesfor periodsofseveral years.Lookingat examination reportsfor a sampleof banks indicatesthat theexaminerstook noteof theconditionof the banksreservesand used thisinformation, along withother aspectsof thebankscondition, to makerecommendationsabout whetherthebank should be allowedto paydividendsor make other changestoits capital account.This indicatesthat the conditionof the reserve did matter totheexaminers.There werenosuggestionsin thissample of examinationreports that abank ought not make new loansdue toa deficit reserve.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 16. P a g e | 16Information from Welldon (1910) suggeststhat, asof 1909, manystateshad similar, though perhapsslightlylesssevere, penaltiesfor banksfallingshort of their reserve.Out of the 39 statesthat had reserve requirementsat that time, Welldonmentionsa penaltyfor failing tomeet that reservefor 25states.In everycase, that penaltyinvolvedaprohibitionon extendingnewloans.In 15 cases, there wasalsoa prohibitionon issuingdividends.For onlyone state, Arizona, doesWelldon mention an explicit provisionthat failure torestorethereserve could result in a bank beingdeclaredinsolvent.For one other state, Welldonnotesthat it had removed a previousprovision allowinga bank tobe declaredinsolvent if the bank failed torestorethereserve.Section 2.3 Use of interbank deposits in the reserveWhether or not to allowinterbank depositsto count aspart of the reservewasa subject of considerabledebate.TheNational Bank Act allowedcountry and reservecitybanksto countinterbank deposits for up totwo-fifthsand one-half of their reserverespectively.Most statesallowedinterbank deposits tocount aswell;only 3 out of the21statesthat had reserve requirementsin 1895required that all reservesbeheld at thebank.Interbank depositswereallowedpartly asrecognitionof thewaybanksoperated.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 17. P a g e | 17As noted earlier, smaller banks had historically maintained deposits atcorrespondent banks in larger cities to clear payments or facilitate theredemption of their bank notes.As liability holders would seek to redeem the notes in the larger cities, itmade some sense to include part of the balance held there to meet thoseobligationsaspart of the banksliquidityreserve.However,during a panictheseinterbank depositsweregenerallynot aneffectivesource of liquidity.Noyes(1894) notesthat whendemand during a panicwasfor physicalcurrency, reservesheld elsewherewerenot particularlyuseful.Morefundamentally, it wasalsonoted that allowinginterbank depositstocount asreservescreateda pyramid structure.Abank could deposit cash in another bank and count that deposit in itsreservewhile thesecond bank countedthe cash in itsreserve.Thesecond bank could then deposit thecashin a third bank andcompound the process.Awithdrawal of reserves by thebottom of the pyramid during a paniccould thusresult in a rapid depletion of reserveswithin thebankingsystem (BankersMagazine1907, July).The Comptroller noted in 1900 that reservesheld in other banks had beenineffective in protecting depositors during the panicsof 1873and 1893andencouraged Congressto increasethe portion of the reserve that banks hadtocarry asmoney in their vaults(seepages25-27).Section 2.4 Some empirical observations on reserve holdingsLookingat thestatusof reservesfor asampleof 208banksin both reservecities(82banks)andlargercountrytowns(126banks)usingdatafromtheBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 18. P a g e | 18September 1892Call Report providessome further information about thelevel of bank reserves.Most banks appear to have held reserve in excess of the required reserve;the average reserve ratio wasaround 29 percent and quite similar for bothcountry banksand thosein reserve cities.(Theseratiosare similar tothosefound by the Comptroller in 1887.)Moreover,theratio of reservestodepositsexceededthelegalrequirement(15percent for country banks25percent for reservecitybanks) by 10ormore percentagepointsfor three-fifthsof country banksand almostone-fourth of reserve citybanks.Banks may havepreferred tohold reserveratiosin excessof what wasrequiredsimplybecausetheypreferredbeingmore liquid, asissuggestedbythe BankersMagazine(1908, November), or becausetheyviewedtherequiredreserve ratioasa minimum theydid not want tobreach anddesiredtomaintaina buffer.Reservesheld in thebank (asopposed towithreserve agents) accountedfor about half the total reserve.Relativetodeposits, reservesat thebank averaged about 14percent forboth groups;alsowell above the legal requirementsof 6percent forcountry banksand 12.5 percent for reservecity banks.Thefinding that about half the reserve washeld in cashmatchessimilarfindingsby theComptroller a decade or solater (Comptroller1907). Whilemanybanks appear tohavepreferredto hold reserve well in excessofwhat waslegallyrequired, some bankshaddeficienciesin their reserveratios.Of the banks in thesample, 10percent of the country bankshad adeficient reserve and 25 percent of reserve citybanks did.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 19. P a g e | 19That bankshad deficient reservessuggeststhat theydid not see thereserveratio assomething that had to bemet at all times(perhapsespeciallyastheyhad 30days torestoreit upon notice by theComptroller).Nevertheless, most of thesebanksdid not sink toofar below thelegallimitmanyof them being within 3percentagepointsof thelimitperhapsindicatingtherule did have some influenceon their behavior.Section 3. Reserve requirements and liquidity during panicsIt wasunderstoodthat bankingpanicswerestressful periodsin whichtheliquidityof the banking system wouldbe tested.In the absenceof a central bank, there weretwoprimarymechanismsforprovideliquidityduring the panics:usingthe reserve and issuanceofClearinghouseloancertificates.This section considersthesetwomechanisms.Section 3.1 Usability of the reserve during a panicThere aretwoaspectsof the debateabout theusabilityof the bankreserve.Oneiswhetherthelawallowedbankstousetheirreserve, and theotheriswhetherbanks woulduse their reserve tosupport other institutions.Theconcern that legallyrequired reservesheld by bankswouldnot behelpful if thebankshadtomaintain these reserveat all timesand couldnot usethem wasstated clearlyearlyon.In 1848, Kettell argued that This keepingof 15per cent. of specieonhand hasbeen tried in New York, inAlabama, and elsewhere,and itsBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 20. P a g e | 20grossabsurdityalwaysmade manifest. Of what useisit that a bank hasthegold and silver, if the law forbidsit to part withit?Thedebate about whetherbankscould legallyuse their reservescontinued during the National BankingEra.In his annual report for 1894,theSecretaryof the Treasuryarguedagainstthereserverequirement forNationalBanksasthenwrittensayingthat, asthelaw wassilent on whenthe National bankscould usetheirreserves,the law created a situationin whichtheywereunusable:Among thesearethe requirementsthat a fixed reserve, whichcannotbelawfullydiminished, shall be held on account of deposits.Theconsequenceofthislastrequirement isthatwhenabank standsmostin need of all its resourcesit cannot usethem without violatingthe law(reprintedin Rodkey 1934).Proponentsof reserve requirementsrespondedthat thereserve wasestablished withtheintent that it be used during stressperiods.As noted above, thedecision to find a bank deficient in itsreservewasdiscretionaryon thepart of theComptroller.This discretionallowedthe Comptroller to effectively waivetherequirement duringapanic and allowbankstime torebuild their reservessubsequently(Comptroller1893).Othersviewedthevaguenessofthelawregardingtheuseofthereservetobea notableimpediment to bankswillingnessto use the reserve.TheBankersMagazine(1907,August) arguedthat the vaguenessof thelaw regardingwhenthe reservecould be drawnmeant that manybankersfelt that the reservecould not beused during a crisis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 21. P a g e | 21ThePresident of theAmerican BankersAssociation expressedsimilarsentimentsin 1908(seeBankersMagazine1908, November).Providingcertaintyabout when thereserve could be used wasseen asinherentlydifficult.Coe (1873) arguedthat it isvery challengingto prescribe rulesregardingthecircumstancesor timing in whichthereserve should beallowedto beused or rebuilt.Concernsthat the ruleswere preventingbanksfrom runningdown theirreserveweresufficientlygreat that in at least one instance, Congressintroduced legislationin whichone goal tomake the reservemore clearlyusable.In 1897, RepresentativeWalker, Chair of the House CommitteeonBankingand Currency, arguedthat the currencylegislationforbids,under severe penalties,thebanks under anycircumstancestousetheirreservesfor thevery purposefor which thebanksare required tokeepsuch reserves and proposed legislationto allowthe bankstousetheir reservesin anylegitimatewayfor thepurpose for whichtheyarerequiredtokeep a reserve (Committeeon Bankingand Currency, 1897p.28).This claim wasstrenuouslydenied by the Comptroller (Eckels 1897, pp.320and 324).Thereserve and itspotential use alsocreated tension betweenbankssubjecttothereserverequirementsand thosenot subject to them.TheBankersMagazine(1894,April) indicatedthat there wassomeexpectationthat theNational Banks wouldusetheir reservestoprovideliquidityand support to stateand trust companiesnot subject to thereserverequirements,even if this support wasonlyprovided by theNational Banks to protect themselves.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 22. P a g e | 22Thearticleindicatedthat thisexpectationwasthesourceof some tensionamongbankersand resultedin some lack of cooperation duringthepanic.One might alsospeculate that some state banksor trust companiesmayhaveheld lowerreserves than theywouldhave if they had not expectedtheNational Bankstoprovide support.Hooper (1860) suggested that confidenceabout the reservealsolikelyaffected bankswillingnessto use it.In particular, he arguedthat banksin New Orleanswererequired by lawtomaintainahigherreservethanthoseinBostonandthatthepopulaceofNewOrleans,knowingthestrengthofthereserve,hadgreater confidencein their banksand thusthe New Orleans banksweremore ableto usetheir reservetimesof financial trouble.Section 3.2 Evidence on Use of the Reserve During a PanicEvidenceon useof thereserveduring panics situationsprovidesa mixedpicture of whetherbankswerewillingtousetheir reserve.As their reservesweredepleted during bankingpanics, banksin thecentral reserve cityof New York wouldsuspend or curtail shipmentsofcurrencytoother parts of the country.Sprague(1913) argued that theNewYork bankstendedtodo sowellbeforetheyhad exhaustedtheir reserve.In 1907,theWall Street Journal notedthat reserveswerearound21percentof depositsaround the time of suspension, belowthe legal requirementbut still fairly high.It wasnoted in the Journal that use of the reserve during thepanic wasappropriate:[T]hereis a deficit of the bank reserve of $38,838,825. It should beBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 23. P a g e | 23remembered, however,that a reserve is for use.There is no wisdom in locking up immensesums of moneyin bank vaultsunlessthey can be employed in times of emergencyalthough the deficitis very large, yet there is still left in the banks a reserve amounting to over21percent of deposits(Wall Street Journal, Nov. 4, 1907).Detailedinformationonbank balancesheetsand reservesareavailableata timeshortlyafter thepanic from the October 3, 1893call report.Comparing reserves in 1893 for banks in the same citiesas in 1892suggests that reserve rates declined slightly for country banks andincreaseda bit for reserve citybanks.There alsoappearstobea shift towardholdingthereservesin cash at thebank rather than asdepositswithreserve agents.Shiftsin thesizeof thetotal reserveratio appeartoduelargelytoshiftsinwhichbanksare reporting.When thesampleis restricted to banksreporting in both 1892and1893,for the medianbank thetotal reserve ratiosis higher in 1893by lessthan onepercentagepoint higher.By contrast, theshift towardcash is evident even whenlookingat thesamebanks.Again lookingat themedianbank for banks reportingin both 1892 and1893,the ratio of cash to liabilitiessubject to the reserve requirement rosebyover5percentagepoints,whiletheratioofdepositsatreserveagentstoliabilitiessubject toreserverequirementsdecreased by over 5 percentagepoints.This shift wasobservableat both countyand reservecity banks.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 24. P a g e | 24Moreover,thenumber (and share) of banksreportinga reserveratiobelow the legal requirement decreased relative to what wasobserved in1892.Overall, thesefiguresgive the impression that banksnot under suchpressure tended not usetheir reservestosupport the general liquidityofthefinancial system.Given the pyramiding of reservesthat occurredthrough interbankdeposits,the shift towarduseof cash in reserveslikelyhad a detrimentalimpact on overall system liquidity.Looking at how thereservesin 1894compare tothosein 1892providessome information about longer-term changestoreserve holdingsfollowinga panic.Reserveratiosat country bankscontinued to average29percent, but theaveragereserve ratio for reservecitybanks increasedto 33 percent.Consideringonly banks that reported in both years, reserveratiosincreased1percentagepoint for banksin country townsand 2percentagepointsfor banksin reserve cities.(Thechangesare stronglystatisticallysignificant for reservecitybanksandmoderatelysofor country banks.)These changes took place entirely from increases in cash holdings at thebanks as ratios of reserves held with agents relative to depositswere littlechanged.Thesechangessuggest that some of theincreased preference for cashevident in 1893persisted for some time.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 25. P a g e | 25Section 3.3 Private sector mechanisms for promoting liquidityduring banking panicsCommercial banksdid have some mechanismsfor responding to panicsandtrying to expand thesupply of liquid assets.Banks in New York, and other largecities,formed clearinghousestofacilitate the settlement of paymentsbetweenmembers.Theclearinghousesalsoprovided a wayto supplyliquiditytotheirmembersduring a panic.In particular,theclearinghousesestablishedprocedurestoallowbankstodeposit securitieswiththe clearinghouseand receiveclearinghouseloancertificatesthat could beused tomake paymentstoother membersof theclearinghouse.Using clearinghousenotesallowedspecieor other forms of cashtobeused to satisfythe heighteneddemand from others for liquidassets(Comptroller 1873and 1890, Nash 1908).Theclearinghousenotesworked for interbank and sometimeslocaltransactions,but not well for interregional payments.Clearinghousenoteswereissued extensively in thePanic of 1907.In New York these notes continued to belargedenominationnotes,but in many smallercitiessmall denominationnoteswereissuedand circulatedwith other currencyin the general publicmarket.Banks appear tohave been fairlywillingtouse these loan certificateswhenthe need arose.Tallman and Moen(2012) report that themajorityof theloan certificatesissuedby theNewYork ClearinghouseAssociation during the Panic of1907went tothe six largest banks.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 26. P a g e | 26Nevertheless, there appears to have been some concern about thepossibility of a negative reaction to the issuance of clearinghousecertificates.Coincident with theissuanceof clearinghouseloan certificates,theNewYork ClearinghouseAssociation halted itsnormal practice of issuingaweeklystatement that provided information on the balancesheet of eachindividual bank and instead reported only aggregate figures for allclearinghousemembers.This shift wasreportedlydone in part toprotect members receivingtheloancertificatesand whosereservesmight otherwiseappear tobedepleted(BankersMagazine1907, November).Mediareaction totheissuanceof loancertificateswasalsomixed.Shortlyafter the issuanceof the loan certificatesin 1907, the Wall StreetJournal noted:Although the issueof these certificatesis a confession of weaknessneverthelessit isalsoan assuranceof strength, and the situation at theendoftheweekisall thebetterfortheactiontakenbytheClearingHouseAssociation (Oct. 28, 1907, p.1).Section 3.4 DiscussionThetwomechanismsdid providesome additional liquidityduring abankingpanic.Nevertheless, asevidenced by the widespreadsuspension ofconvertibilityduring themajor bankingpanics that occurredbetween1865and 1910,thesemechanismswereclearlyinsufficient toprovidethenecessaryliquidityduring timesof stress.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 27. P a g e | 27Thereservedoesnot appear tohave been usedtothe degreethatproponentsmight havehoped, perhapsbecausethe degreeof regulatordiscretionand rulesfor its use and restoration wereunclear.Clearinghousecertificatesalsohelped, but, asthey could not facilitatedistancetransactions,alsoproved insufficient.Section 4. The Panic of 1907This section very brieflydescribesthe eventsof the Panic of 1907,whichprovidesa useful illustration of thedynamicsof bank liquidityduring acrisis.Thesection alsodiscussesthe lessonsof the crisisand the resultingimpetusfor a central bank.Section 4.1 Brief history of the Panic of 1907Twopiecesof background information are useful for understandingthepanic.First, in the years prior tothepanic, therehad been considerablegrowthin thesize of thetrust companiesof New York City.Theseinstitutionstook depositsand weresimilar tobanksbut the statelawsallowedthem tooperatewithsmaller reserverequirementsandwithout some other restrictionsfaced bybanks.Indeed, these institutionsestablishedthemselvesastrust companiespartly toavoid capital and reserve requirements.Trust companieswerenot membersof the NewYork ClearinghouseAssociation, but relied on membersof theassociationasclearing agentsfor payment processing.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 28. P a g e | 28Asecondpieceof backgroundinformationisthat, at bothbanksandtrustcompanies, a significant portion of liquid assetsconsisted of call loans.Both banksand trustsdependedon thecall loanmarket asa secondarysourceof reserves,and most of the funding for the call loanmarket camefrom the banks and trusts.(Call loanswereshort-term loanstostock brokerstofinancestockpurchasesand werecollateralized by the purchasedstocks.Theseloanscould becalledby the bank whenfundswereneeded and itwasassumed the stock brokerswouldbe easilyabletosell the stocktorepay the loan.)ThePanic of 1907started whenan attempt tocorner the copper marketcollapsed.Anumber of bankswereimplicated, but runson these institutionswerequelledfollowinga statement of support from the ClearinghouseAssociation.Shortlythereafter, a National Bank announced that it wouldnolongerprovideclearingservicesfor theKnickerbockerTrust company.When it became clear that the ClearinghouseAssociation wouldnotsupport the trust companies,a number of trustsexperienced runs.Thecall loan market quicklycame under immensepressureandborrowersin that market that wereunableto find alternativefundingandfaced theprospect of sellingtheir stocksin a firesaleand possiblydefaulting.Consequently, bankswerenot ableto tap the call loanmarket asasecondarysource of liquidityastheymight normally do and thefunctioningof that market deterioratedsignificantly.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 29. P a g e | 29Although the bankshad held reservesin excessof what wasrequired bylaw prior to thecrisis,such reserveswerenot sufficient to prevent theNew York banks from beingforced to restrict paymentsto outoftownbanks.Sincetheyheld largequantitiesof interbank deposits, theserestrictionsaffected bank liquiditythroughout thecountry.Theinterbank market for reservesona national level and at thecitylevel for many regional financial centersbroke down asmany banksfeareddeposit withdrawalsand hoarded cash and maintained reserveswell in excessof what wasrequired (Yates1908).Thepanic endedwhenJ.P. Morganand a consortium of bankers agreedtoserve asa de factolender of last resorttothefinancial sector.Section 4.2 Impetusfrom the Panic of 1907 for establishing acentral bankThere wereseveral lessonsthat policymakers took from thePanic of 1907that prompted them toworktowardestablishinga central bank.One lesson was that when the instrument used as a reserve and primarysource of supply liquidityin this case the supply of gold and Treasurynoteswas fairly inelastic in the short run, demand for that instrumentwouldexceed the availablesupplyduringa panic.Thesubsequent scramblefor liquiditywouldcauseshort-term fundingmarketsto freeze.(Goldcould, and did, flowintothe USfrom abroadin responseto risinginterest rates.Theseinflowsboosted liquidity, but did take some timetoarrive inquantitiessufficient tomeet demand.)Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 30. P a g e | 30As a result, manypolicy makersconcludedthat anelasticcurrencythatcould increasein quantitywasrequired (Vanderlip 1908).The notion that an elastic currency wasneeded was not new; as early as1868, the Comptroller argued in favor of providing some elasticity to thecurrencyfor use during timesof stress.In particular, theComptroller arguedthat The treasuryof the UnitedStatescould hold in reservea certain amount of legal tender notesinexcessof the amount of money in regular circulation, tobe advanced tobankinginstitutionsat a specified rate of interestupon thedeposit ofUnitedStatesbondsascollateral security, a source of relief wouldbeestablished whichwouldeffectuallyprevent a monetary pressurefrom being carried toany ruinousextent (1868,p.27).Similar argumentsin favor of making availableadditional currencybackedbybondstoaddelasticitytothecurrencyandrelieveseasonalandother financial pressureswere madeby the Comptroller in hisAnnualReport in 1899(pp. 11-17)and 1902(pp. 61-63).Variousbankersalsoargued for an elastic currency(Seefor instancePugsley(1902) and Hamilton (1906).White(1983) describesvariousother initiatives.)Nevertheless, followingthe Panic of 1907, legislativeaction seemedconsiderably more likely.Some proposals provided for an emergency currency that could be issuedby a central authority only during a crisis; asa temporary palliative such acurrencywasincludedin theAldrich-VreelandAct of 1908.Under thisAct theSecretary of the Treasury could, during acrisis, authorizetheissuanceofcurrencybackedbyanysecuritiesheldbybanksinstead of the usual requirement that thecurrencybe backedbyU.S.government bonds.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 31. P a g e | 31Ultimately, policymakers choseinsteadtocreatetheFederal Reserveasapermanent solution wherethe discount window could be used to turnbank assetsintocentral bank reservesand wouldthusprovidean elasticcurrencythatcouldbeusedtorespondtochangingstringenciesin moneymarketsmore flexiblyand continuouslythan could the issuanceofemergencycurrency.Acloselyrelatedargument made by advocatesof a central bank wasthatonlycentral bank notesor reservesare certain tobe liquid during afinancial crisis(Sprague1911).Other assetswerearguedtobeliquidonlytotheextent that theycouldbeconverted intocentral bank reserves:In countrieswherethesenotesof thecentralbanksaregenerallyacceptedin settlement of debtsby businessmen and banks, the bankingreservesof the stock banksmay safelyconsist of the central bank currency, or of abalancekept withthecentral bank, convertibleintosuch currency. Theseform the first lineof banking reserves.Thesecond lineconsistsof thoseassetswhich, withcertaintyandpromptness, may be converted intocredit balanceswith thecentral bank(Warburg 1916,p. 9).Central bank reservesalsohave theadvantage of being able tobeexpanded by the central bank during a stressepisode.Moulton(1918) notesthat the expansion of liquidityis essential during acrisisasbanks areexpectedtobe thesource of liquidityfor theirnon-financial customersduring a crisisand if banksare required tobolster their own liquiditytosupport their reservebydemandingrepayment of, or even refusingto renew, loansduring a crisisthenfinancial strainscan be significantlyexacerbated.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 32. P a g e | 32(Moulton alsocautionsthat, at least at that time, securities holdingswereunlikelyto be effectiveasa secondary reserveduring a crisisasbankscould only sell their securitiestoother banks.If all bankswereseekingtoselltheirsecuritiesholdingsat thesametime, thosesecuritieswouldbe not function asa source of liquidity.This impliesthat tofunction asa source of liquidityduring a crisis, asecurity must have readypurchasersfrom outside thebankingsystem.)Another lesson wasthat behavioral dynamicscould be affectedby theabsenceor presenceof a central bank.During a panic, individual bankswouldpull their fundsout of thebanksin thereservecitiesandbolstertheir liquid resources(BankersMagazine1908,November); several observers, such asthe Comptroller (1907) andHerrick (1908), reportedthat declinesin interbank depositscontributedatleast asmuch tothepanic asthe actionsof individual depositors.Banks wereargued tohave acted out of self preservation becausetherewasnoguaranteethat their regular sourceof liquidity, thereservecitybanks, wouldbe able tofurnishliquidityshould thecrisisintensity(Roberts 1908, Sprague1913).Indeed, the banksin New York had suspendedpaymentstoout-oftownbanksduring severalprior banking panics.As a central bank wouldbe able to provide a guaranteed liquiditybackstop, individual bankswould not need to hoard liquidityat the firstsign of stressbecause theywould know that thebackstop wouldstillbeavailable in a crisis; Warburg (1914) goesa bit further and arguesthattoprevent hoardingthe backstop and ability toturn supply cashmusthaveabsolutecredibility whichonly a central bank could provide.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 33. P a g e | 33It wasexpectedthat the existenceof the central bank wouldprompt achangein behavior during a panic and wouldstop minor stressesfromescalatingintofull blowncrises(Warburg 1916).Athird lessonwasthat the liquidityrequirementsthat tried tostrike abalancebetweenensuring that the liquidityof the banking system wasmaintainedyet not hamperingbanksin providing credit werelikely tobeoverwhelmedduring a panic.Even critics of central banks sought waysto allowprivatemarketparticipantsto expand the supplyof liquid assetsduring a panic.Oneother aspect of thepanic that wasnot loston policymakers wasthatinstitutionsoutsidethe normal banking system, in thiscasetheTrustcompanies, could precipitatea run on the banking system.Therealizationthat theseoutsideinstitutionscould threaten thestabilityof the system may haveprompted some largeinfluential ClearinghouseAssociation membersto support a central bank (seeWhite 1983, Moenand Tallman 1999).Section 5. Reserve requirements after the founding of theFederal ReserveWith the establishment of the Federal Reserve, required reserves werereduced asit wasexpected that theliquiditybackstop from thecentralbank provided individual commercial banks witha ready meansofmeetingextraordinary liquiditydemands.As noted by Rodkey (1934):With the advent of the Federal Reserve System in 1914,weentereduponan era of central banking...Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 34. P a g e | 34Thecentral bank is thusplaced in position to make advances,eitherdirectlyor indirectly, to the individual member banksasthereplenishment of their reservesbecomesnecessary...It is clear that the presence of a central bank, prepared to make advanceson eligible assets, places the individual bank in a less vulnerable positionwith respect todemandsof itsdepositors.It tends tolessenthe need for primaryreserves.TheFederal ReserveAct recognizedthisfact by reducingmateriallythepercentageof required reserves(p.64).Westerfield (1921) notedthat thereductionin reserveswasappropriateforseveralreasonsincludingthat thereservebecausetheywereconcentrated(asopposed to dispersedacrossbanksthroughout thesystem), becausethereserveswerelocatedin acentral bank whichfeelsitsresponsibilityandbecausetheir availabilityisnow unquestioned.Lunt (1922), whoprovided instructionstoinsurerson how to assessthequalityof a bank from itsbalancesheet, noted that prior tothefoundingof the Federal Reserve the statement of cashand cashitems wasregarded asextremelyimportant, and banks that habituallycarried largerreservesthan thoserequired by law werethought to be exceptionallysafe(p.217).However,withtheFederal Reserve, the point seemsfar lessimportantnow, sinceanybank that hasa proper loanaccount can replenish itsreserveat will by thesimpleprocessof rediscounting.While reserve requirementscontinuedtobe viewedasa tool topromotebank liquidityfor some time, there wasa gradual shift awayfrom thisview.Indeed, by the late 1930s,reserverequirementswereno longer seen asplaying an important role in providingliquidity.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 35. P a g e | 35Thecommittee [Federal Reserve System Committeeon Bank Reserves]takesthepositionthat it isnolongerthecasethat theprimaryfunctionoflegal reserve requirementsisto assureor preservetheliquidityof theindividual member bank.Themaintenanceof liquidityis necessarilytheresponsibilityof bankmanagement and isachieved by the individual bank whenan adequateproportion of itsportfolio consistsof assetsthat can be readilyconvertedintocash.Sincetheestablishment of theFederal ReserveSystem, theliquidityof anindividual bank is more adequately safeguarded by thepresenceof theFederal Reserve banks, whichwereorganizedfor the purpose, amongothers,of increasingtheliquidityof member banksby providingfor therediscount of their eligiblepaper, than by thepossession of legal reserves(FederalReserve 1938).It is useful tonote that during thisperiod, theFederal Reserve wasimportant asa lender tothe banking system.Burgess(1936)notesthat in a typical month during themid-1920saboutone-third of member banksobtained at least one loanor advancefromtheir Reserve Bank.As a regular lender tothesystem, it wouldbe fairlyeasyfor the FederalReservetoprovideadditional liquiditytoindividual banks.Thediscount window wasseen by Federal Reserve staff asthe primarysourceof emergencyliquidityfor the bankingsystem, especiallyafter therangeof eligiblecollateral wassignificantlyexpanded in 1932.29As theyshiftedawayfrom beingseen aspromotingindividual bankliquidity, reserverequirementswereincreasinglyseenasatool tomanagecredit growthand facilitate theuseof monetary policy.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 36. P a g e | 36This development occurred asthe Federal Reserve began to useopenmarketoperationstoadjustavailablereservesin thebankingsystem asitsprimarymonetary policy tool; it wasseen asimpractical tohavereservesbothserveasasourceofliquidityandbemanipulatedformonetarypolicypurposes.Thetwomain functionsof legal requirementsfor member bank reservesunder our present bankingstructureare, first, to operate in the directionof sound credit conditionsby exertinganinfluenceon changesin thevolume of bank credit, and secondly, toprovidethe Federal Reservebankswith sufficient resources to enablethem topursue an effectivebankingand credit policy (Federal Reserve 1938).Section 6. Lessonsand concluding remarksFrom thelate1830suntil 1913,regulatoryeffortsaimedat promotingbankliquidityconsisted primarily of reserve requirementsthat mandated thatindividual institutionshold liquid assets.However,thesereserves werenot sufficient toprovideliquidityandprevent banks from suspendingdeposit withdrawalsduring bankingpanics.Toprovidefor an elastic currencythat could be expandedtomeet theextraordinaryliquiditydemandsexperiencedduring a crisis, the FederalReservewasestablished.Several lessonsfrom thehistorical reserverequirement experienceareapparent.Oneof themost important lessonsisthat individual bank liquidityisintricatelyconnected to central bank liquiditypolicy.For instance, in the absenceof a lender-of-last-resort backstop, bankshavemore incentiveto hoard liquiditywhichcould exacerbatestressepisodes.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 37. P a g e | 37Second, thehistorical debatespoint out that a knownand understoodregulatoryresponsetoshortfallsin the reserveisan important factor forwhetherthe reservewill be used in timesof stress(and for how bindingthereserve requirement will be during ordinary times).Third, historical experienceindicatesthat whencertain assetsaredesignatedasstoresof liquidity, institutionswill seekto accumulatethoseduring a crisis.Unlessthe pool of designatedassetsislargeor can be expandedat thosetimes,there is some risk that thefunctioningof themarket for thoseassetscan deteriorate.Further, if non-regulated institutions also use the designated assets as asource of liquidity, then problems at those institutions can spill over andaffect theliquidityof the banking sector.Policymakers todayare consideringvariousliquidityrequirementsforbanks.For instance, under the Basel III requirements, bankswill be subject toaliquiditycoverageratio (LCR).Under this requirement, bankswill be required tomaintain a stock ofhigh qualityand liquid assetsasa buffer that issufficient tocoverpotential netcumulativecashoutflowsat all timesduringa30-dayperiod.Toa largedegree, the LCR is similar toa reserve requirement in that iteffectivelyrequiresliquid assetsto be held against certain classesofliabilities(and linesof credit).Thehistorical experiencewith reserve requirementsoffersvaluablelessonsfor policymakers astheyimplement the LCR and other liquidityregulations.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 38. P a g e | 38Bank for International SettlementsInternational financial markets and bankfunding in the euro area: dynamics andparticipantsJaimeCaruana, General ManagerAdrian Van Rixtel, Senior Economist1. IntroductionFinancial marketsare undergoing major and attimesveryrapid changes,mostlyasaresult ofthefinancial crisisthat beganin 2007.It isstill tooearlytosayfor certainwhichof thesechangeswill endure and whichwill disappear andtowhat degree whenanew balanceisreached.However,wemust analyse them in order to beableto design appropriate policies.Among the many forcesdrivingthesemarket developments, wewouldlike to focuson three whichhave their rootsin the crisis.First are changesin market participantsperception and management ofrisk.Counterparty and liquidityrisk, for example, wereundervalued in theyears precedingthecrisisbut are now major concernsfor financialinstitutions.In addition, systemic risk, stemmingfrom the interconnectionsbetweenthefinancial system and the real economy, must be internalised.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 39. P a g e | 39Second, imbalancesaccumulatedon public and privatebalancesheetsover many years must be corrected.Theseimbalancesarereflectedonfinancialinstitutionsbalancesheetsintheform of excessiveleverageand excessivematurityand liquiditytransformation.While deleveragingispart of the adjustment needed to restorethesoundnessof the banking sector, at thesametime it burdensfinancialmarketswithasset salesand contractionsin credit, giving riseto viciouscyclesthat increasesystemic risk.Policies toreduce riskand provideprotection against contagion areleadingtoa renationalisationof financial flowsand tomarketfragmentation.Cross-border lendinghascontracted more rapidlythan domesticlending.In particular, marketsin the euro area have been segmented increasinglyalongnational borders.As theyattempt toprotect themselvesagainst the effectsof thecrisis, somenational authoritiesare building barriers against cross-national liquiditymovementsthat threaten further segmentationalongnational lines.Third are regulatorychanges.Financial marketsare undergoing regulatory changesaimedat makingthem sounder and more stable.Thesechangesseek to applythe lessonslearned from thecrisis whilepreventingcollectivebehaviour from leadingto a watering-downofregulations.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 40. P a g e | 40Much emphasisisbeingplacedon consistencyin the adoption of theregulationsindifferent countriesand onanalysingtheunwantednegativeeffectsthesemeasuresmight have.Thesedriversand their effectson thefinancial system can be clearlyseenin theunfolding crisisin theeuro area, particularlyin the strainsandchangesin bank financing.At the most critical points in the crisis, risk aversion and volatility in euroarea financial markets increased sharply, with severe contagion effects tointernational financial markets.Therecent tensionsin some countriesweredrivenby theincreasinginteraction betweenconcerns about the sustainabilityof publicfinancesandthe fragilityof financial systems in an atmosphere of lowgrowth.Concernsabout government deficitsand debts in variousperipheralEuropean countries,especiallywhenaccompaniedby externalimbalances,spilled over to euro area banks.And financial systems fragility generatedcontingent liabilitiesinpublic finances,thusmaking the fragilitiesof sovereign debt becomeincreasinglyintertwinedwith thefinancial crisis,and creatingdifficultiesfor bank funding.In addition to this vicious circle, lower economic growth and the inabilityto provide stimulusdue to the lack of fiscal space make deleveraging evenmore difficult and weakenbank asset quality.Bank funding had already seen major changesin theyearsprior to theeuroarea crisis.During the past few decades, banks loosened the constraints of depositgrowth and raised funds from institutional investors in global financialmarkets.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 41. P a g e | 41Theytappednew sourcesof funding, such assecuritisation.The business model of investment banks relied on wholesale fundingfrom institutional investors, especially at short maturities (Merck et al(2012)).Financial globalisationallowedbanks totap institutional investorsbeyond national borders, whichexpanded traditional internationalfundingtointernational interbank markets(CGFS (2010a), McGuireandvon Peter (2009), Fender and McGuire(2010)).This greater relianceon fundingprovided through financialmarketsexperienced unprecedenteddislocationsduring the 200709globalfinancial crisis.It set off major adjustmentsin banksbusinessand fundingmodels,whichinmanycaseswerelaterreinforcedbytheeuroareafinancialcrisis.In both crises,somebanksaccesstofundingwaslimited, predominantlybecauseof a deterioration of the qualityof their assets, eg mortgage -relatedfinancialinstrumentsin thecaseof the global crisisand sovereigndebt in theeurocrisis.Thisarticleinvestigateshowbank fundingin theeuroareain recent yearsreflectedthesemarket developments.In fact, bank fundingcan be seen asthearea whereimportant issuesrelatedtothe crisisand financial marketscome together.It should be emphasisedthat this analysissimplifies a very complexreality, with profound differencesamong different financial institutionsand countries.First, adversefeedback effectsbetweentheweaknessesof sovereignsandbanksdisruptedfundingmarketsseverely.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 42. P a g e | 42During episodesof severe sovereign strains, accesstoshort- andlonger-term wholesalefundingmarketsbecameproblematic even foreuroareabankswiththe highest credit ratings, forcing them toresort toalternativefunding sourcesand to shrink the sizeof their balancesheets.Second, BISdata show that international interbank fundingfor euro areabankshascollapsedfrom thehigh levelsobserved in 2008.Thisrenationalisationappliesespeciallytofundingprovidedbyeuroareabanksto other euro area banks.As a result, a bankscountry of origin largely determinesitsaccesstovariousfundinginstrumentsand their costsinstead of itsfinancialstrength.Thesedifficultieshave been most pronounced for banksfrom peripheralcountries,which have suffered themost severelyfrom fiscalimbalances.Third, aparticularclassof internationalinstitutionalinvestors,US moneymarket mutual funds, has on balanceover thepast year withdrawnlargesumsof short-term fundingfrom euro area banks.For theseinstitutional investors,however, it is not somuch a caseof areturn to home biasasa shift from euro area and UK bankstootherforeign banks.Fourth, the crisis hasled to a growingrecourse to fundingsecured bycollateral, such ascovered bonds.This development addsto the alreadygrowingdemand for assetswithhigh liquidityand low credit risk, in theaftermath of the 200709globalfinancial crisis.Meanwhile, changesin regulation are addingtodemand for such assetseven asthe lossof creditworthinessof sovereignsis reducingthenumberof suppliers.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 43. P a g e | 43This hasraised concerns about a potential scarcityof safe assetsthatcan be used ascollateral.In addition, thefact that a larger part of bank assetsis used ascollateralfor covered bonds(BIS(2012)) tends toraisethe riskinessof unsecureddebt, leadinginvestorsall themore todemandthat debt be collateralised.Finally, the renationalisationof bank fundinghasintensified thedependenceon ECB liquidity, whichhassubstituted for lostaccesstoeuroarea cross-borderinterbank and bond funding.In what follows, weanalysesome of these market trends:first wesketchtheadverse feedback betweensovereignsand banks.Thenweconcentrateonthedynamicsof several main sourcesof funding,namely international interbank markets(mostly for loansbut alsoforbond holdings), US money market funds, bond marketsand ECBliquidity.Thefinal section concludes.2. Link between sovereignsand banksSincethe first quarter of 2010,sovereigndebt tensionsand their spillovertobanks in general and their funding in particular havedominated, invariousstagesand todifferent extents, financial and economicdevelopmentsin theeuro area.Thesesovereign debt strainscame beforemany Europeanbanks hadreallycleanedtheir balancesheetsof assetsthat wereimpairedduringtheglobal financial crisis.In theevent, government financesand banksfundinginteractedstrongly(Caruana (2011), Caruana andAvdjiev (2012)).In particular, sovereignrisk affectsbank fundingthrough severalchannels(CGFS(2011)).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 44. P a g e | 44Many bankshold significant amountsof predominantlydomesticsovereignbondson their balancesheets,whichcan leadtovaluationlossesand credit risk concernswhensovereign yields rise sharply.Moreover,sovereign debt servesascollateral for variousfinancialtransactions,includingprivate repos.Sovereigntensionsresult in lowercollateral values, owingto largerhaircutsor margin requirements,whicheffectively reducethe abilityofbanksto obtain funding.In addition, sovereign downgradesspill over tobanks, worseningboththeir cost of and accessto funding, whilereducingthe fundingbenefitstheyderivefrom implicit and explicit government guarantees.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 45. P a g e | 45Signsof the strong link betweensovereignsand banksstarted to becomemore pronounced earlyin 2010.Tensionsin international financial marketsweredriven by growingconcernsabout thesustainabilityof publicfinancesin view of persistentgovernment deficitsandhighlevelsofpublicdebt inperipheralEuropeancountriesin general and in Greece in particular.Specifically, this wasthecasewhenthetensionswerecompounded bycountriesextensiverelianceon foreign fundingand that fundinghadtocompetewith therefinancingof high public debt.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 46. P a g e | 46Theseconcerns spilled over to banksand, in most euro area countriesandmost periods, were reflected in marked increases in bank CDSspreadsinparalleltothe sovereign ones(Graph 1).In this context, interbank funding costs, not only for euro borrowingbutalsofor that in USdollarsand sterling, increasedsharply (Graph 2,left-handpanel).Again, euro area banksexperiencedstrainsin US dollar short-termfundingmarkets(Fender and McGuire(2010)).International spillovers of the euro area financial crisiswere alsovisible inthe frequent and often sharp declinesin stock pricesof US and UK banksin parallel tothoseof euro area banks (Graph 2, right-hand panel).Weak economicgrowthand lossof competitivenesspointedtolowergovernment revenuesand loan losses,and theanticipation of thesefeedback effectspressured banksfurther.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 47. P a g e | 47Thesignificanceof the strong interconnection betweensovereigns andbanksin the euro area financial crisis is shownby the overall increasingtrend in thepredominantly positive 90-daymoving correlationsbetweensovereign and bank CDSspreadsfor most countries(Graph 3).Theco-movement betweenthesespreadsincreasedacrosseuro areacountriesafter thenationalisationofAllied Irish Bank in January2009,whichsubsequentlycontributedtoa more pronounced transmission ofsovereign risksto banks (Modyand Sandri (2011)).It wasparticularlyhigh for most euro area countriesduring crisisperiodsinvolvingvariousperipheral countries,such asGreece, Ireland andPortugal, joinedlater in the crisisby Spain and Italy.At the same time, correlationsbetweensovereignand bank CDSspreadsof thesecountries declined sharply after theyreceivedsupranationalsupport.[Greece, Ireland and Portugal received support through joint EU-IMFprogrammesin May2010/March 2012,November 2010andApril2011, respectively; the ECB re-activateditsSecurities MarketsProgramme (SMP) for Italian and Spanishsovereign debt inAugust2011;Spain receivedlimitedofficial fundingtosupport therecapitalisationof its bankingsector in June2012.]Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 48. P a g e | 48Cross-border holdingsof government debt by bankshave played animportant role in the development of theeuro area financial crisis.Traditionally, domestic banks in keyeuroareacountriesheld a largershareof their respectivegovernmentsdebt than banksin theUS orUK (but a smaller one when compared with Japanesebanks).Theintroductionoftheeuroreducedthishomebiasbyfosteringportfoliodiversification, whichledto a significant increasein cross-border euroarea sovereign bond holdingsamong euroarea countries.In fact, owing to EMU, euro area investors increased the share of theirinvestments in debt securities issued by euro area countries more thaninvestorsfrom all other countries (De Santisand Grard (2009)).Still in 2007, the share of sovereign debt held by domestic banksremainedlarge, particularlyfor theperipheral countries(Greece, Ireland, Italy, Portugal and Spain).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 49. P a g e | 49Moreover,there areindicationsthat during more recent crisisperiodsthehomebiasof banks from peripheral countries increased again (MerlerandPisani-Ferry(2012)).Holdingsby euro area monetary financial institutions(MFIs) of othereuroarea countriessovereign debt asa ratioof their total bond holdingshavebeenonadecliningtrendsince2006andhavenowreturnedtolevelsobserved in 1998(ECB (2012b)).All in all, the euro area crisishasdemonstrated that sovereign debtholdingscan impede bankseffortstoregain the trustof their peersandmarket participantsat large.The high degree of international integration between government debtmarketsand banking systems in the euro area has played an importantrolein thepropagation of the crisis (Bolton and Jeanne(2011)).Exposurestosovereignsin theeuroareasperipheryspreadbank distresstocountries with stronger statefinances.And for many banksheadquarteredin theperiphery countries, exposurestoown governmentsare much higher than common equity.Theyare alsosizeablein the caseof largenational bankingsectorsinother euro area countries.Thus, gettingsovereign financesin order is a necessarycondition for ahealthybankingsystem.3. International interbank lendingSincetheonset ofthefinancialcrisisinAugust 2007,euroareabankshaveseen their accesstointernational interbank fundingreduced, in somecasessubstantially.This hasbeenmainlyconcentratedin intra-euroarea interbank markets:international lendingby euro area banks to other euroarea bankshasBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 50. P a g e | 50declined sharply, asfundingwithin the euro area hasagain becomesegmentedalong national lines.Overall, between end-2008 and end-2011, international interbank lendingfrom one euro area bank to another shrank drastically, thereby reversingan equallydramaticsurgebetween2003and 2008(Graph 4).This withdrawal of international fundsfrom intra-euroarea interbankmarketswasnot offset by an increasein funding providedbynon-euroarea banks.Thedecline in international interbank lendingwithin the euroareawasconcentratedinfundsprovidedthroughboth loansand depositsanddebtsecurities(Graph 5).Debt securitiescontracted most in proportional terms, but internationalloansand depositsalsofell sharply from thehistoric high recordedatend-June2008.Thedynamicsof the movement in international fundsprovidedbetweenbanksin theeuro area followedthedevelopment of the euroarea crisisclosely.For both loansand depositsand debt securities, it fell sharplyduringepisodesof severe market stress, such asthe first half of 2010and thesecond half of 2011, whileit recovered during periodsof subduedtensions,most notablythe first half of 2011.Therecent measurestaken by the ECB, theexpansion of therangeofacceptablecollateral and thenew sovereign bond-buying programme(Outright MonetaryTransactions, OMT) have reduced redenominationrisk, one factor that had increasinglybeen contributingto marketfragmentation.Sustainingthe improvementsachievedwith regard torisk premia willBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 51. P a g e | 51requireswift progressboth at the country level and through institutionaladvancesin the euroarea.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 52. P a g e | 524. The role of US money market fundsSo-calledprime US money market funds(MMFs) are importantparticipantsin international financial markets,astheychannel fundsfrom US householdsand firmsto non-USbanks.Thesefundsinvest in short-term instrumentsand try to offer moreattractivereturnsto retail and corporate investorsthanbank depositsdo.Before the crisis,US MMFs became oneof themain fundingsourcesoftheshadowbankingsystem, by purchasingasset-backedcommercialpaper (ABCP) from structuredfinancevehiclesand other short-term debtissuedby USinvestment banks and non-bank mortgage lenders.Competition to offer investorshigher yieldshaslongled MMFstoholdshort-term debt and certificatesof deposit issued by European and otherbanksheadquartered outsidetheUnited States.US MMFsbecame thelargest singlesupplier of dollar funding tonon-USbanks, providingaround one trillion US dollarsto European banksinmid-2008(Baba et al (2009)).In theaftermathof the200709globalfinancialcrisis,theyincreasedtheirexposurestoeuroareabanksfurther,whilethosetoUSbanksfell strongly(Graph 6, left-handpanel) asUS banksweredowngraded, and changedtheir fundingmodels.Sinceearly2010,followingthe intensificationof the euro area financialcrisis, however,US MMFshave sharply reducedtheir exposurestoeuroarea banks in general and to peripheral countriesbanks in particular(Graph 6, right-hand panel).This hasbeendriven not only by heightedassessment of underlyingrisk,but alsoby managersof MMFsseekingtoreassure uninsuredinvestors.After therun by institutional investorson prime MMFsin SeptemberBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 53. P a g e | 53October 2008and amid ongoing discussion of whetherthesystemicthreat of suchrunshad been removed bysubsequent SecuritiesandExchangeCommission reforms,such fundsappear tohave beenparticularlyquick toreduceexposurestoeuro areabanks.With the intensification of the crisisin thesummer of 2011, thejointexposuresof USMMFstothefive peripheral euro area countries, whichwerenever large, becamenegligible.Strikingly, theyalsoreduced their short-term investmentsin core euroarea banks, which werelarge.This reduction wasthe most pronounced for French banks, driven byconcernsabout their exposurestoperipheralsovereign debt, but alsoaffected German, Dutch and Belgian banks (Graph 6, right-hand panel).In the firsthalf of 2012,euro area exposuresof US MMFs stabilisedbutremainedat very lowlevels.Rather than retreatingfrom international exposures,thesefundsincreasedtheir investment in debt instrumentsissuedby Canadian,Japaneseand Swissbanks, aswell asScandinavian banks (not showninGraph 6).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 54. P a g e | 545. Bond markets: preference for secured funding can lead toscarcity of CollateralInstitutional investorsin bank bondshave reducedholdingsof euro areabank bondsaswell.Theeuro area financial crisishasimpaired accesstothesemarkets, mostnotablyduring episodesof rapidlyincreasingmarket tensionsand forbanksfrom peripheral countries.Banks from Greece, Ireland and Portugal have been virtuallyshut out ofprimarybond markets,while thosefrom Italyand Spainhaveenjoyedonlyintermittent and unreliableaccesstothem (Graph 7).At thesametime, fundingstressfrequentlyaffectedcore countriesbanksaswell.Banks from Germany, France and the Netherlandsissued very modestamountsof bondsin monthsof severemarket turmoil linkedtotheeuroarea crisis.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 55. P a g e | 55Moreover,during theseepisodes, market strainsspilledover tobanksoutsidethe euro area, suchasUK banks(Graph 7).Overall, grossbond issuanceby euro area bankshasdeclined withtheworseningof thecrisis, by 15% in 2011from 2010and by 22% in the firsthalf of 2012from thesameperiod one year earlier.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 56. P a g e | 56Thecrisishasled to major changesin thecomposition of grossbondissuanceby instrument, especiallyfor banksfrom peripheral countries.Theeuro area financial crisishasreinforcedthetrend towardsgreaterrecourseto secured longer-term funding, such ascovered bonds(RomoGonzlez and Van Rixtel (2011), ECB (2012a)).Theshare of covered bondsin total grossbond issuancebyeuro areabankshasincreasedfrom 26% in the first half of 2007to 40% and 45% inthefirst half of 2010and 2012,respectively.For many banks from peripheral countries,most notablyfrom Spain andItaly, thisinstrument hasbecome themain sourceof long-termwholesaleBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 57. P a g e | 57funding, astheir accessto unsecured marketshasbeen partiallyor fullyclosed (Graph 7).Covered bond issuancehasbeen spurred aswell by more structuralfactors,such asfavourable regulatorytreatment, for exampleunder BaselIII and SolvencyII and in variousbail-in proposals, and legislativeinitiativesin several countries.Growingissuanceof covered bondshasaddedtotheconcernsabout thescarcityofcollateral, ormorepreciselyofsafeassetsthat canbeusedascollateral.Covered bond issuanceby banks resultsin a balancesheet in whichasubstantial proportion of their assetsis encumbered, ie pledgedwithpriorityto investorsin covered bonds.Theintensificationof the crisishasled banksto overcollateraliseto alarger degree, whichhas reduced even more the unencumberedassetsavailableto serve ascollateral for new covered bonds.Asset encumbrancealsoreducesaccesstounsecured senior debtissuance,becauseasthepool of encumberedassetsunderlying coveredbondsgrows,holdersof unsecured bank debt have a claim on fewerassetsin the event of thebanksinsolvency.This substantiallyreducestheir attractivenessasinvestments(Oliver-Wyman (2011), BIS (2012), ECBC (2012), ECB (2012a)).Concernsabout collateral scarcityseem tobe an important driver of theincreasingtrend of so-calledretained issuance by peripheral countriesbanks.As the accessof many of these banks toprimary bond marketshasbecome impaired, theyhave started to retain larger partsof their grossbond issuanceinstead.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 58. P a g e | 58Thesebanksmainlyusethispaper ascollateral in ECB liquidityoperations.In the first half of 2012,significantlylarger sharesof grossbondissuance by Italian, Portugueseand Spanish bankswereretained(Graph 7).In contrast, issuanceby German, Frenchand Dutch bankshasremainedtargeted to primary public marketsand therebyto outsideinvestors.This differencein bond issuancepatternsbetweenperipheral and corecountriesagain underscoresthe renationalisationof fundingmarkets.Strained accesstobond financinghasled to a revival of the issuanceofgovernment guaranteedbonds.Theintensificationof the crisisin the second half of 2011propelledthere-activationor prolongationof programmesin all peripheralcountries,aswell asin Germany.Government guaranteed issuancehad become a very important source oflongerterm bank fundingin 2008and 2009at the height of theglobalfinancial crisis,and generallyhasbeen assessed positively, although notasbeing without some costs(CGFS(2011), Mulleret al (2011)).Thereactivationof the programmesin Italyand Spain allowedsolidpositionshad not reducedthe valueof these explicit guaranteessubstantially.6. The provision of ECB liquidityWith thedevelopment ofthecrisis, someeuroareabankshaveresortedtocentral bank fundingon a massivescale.TheECB hasconducted a widerangeof open market operations,amounting toanunprecedented 1.1trillion at theend of June2012.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 59. P a g e | 59This liquiditywasabsorbed predominantlyby banks from countrieseitherunder joint EU-IMF programmesor experiencingseveresovereigntensions,showingthedistinct segmentationofbank fundingaccordingtobank nationality.It wasaugmented by Emergency LiquidityAssistance(ELA) especiallyin Greece and Ireland, wherenational central bankstook on the risk offundinglocal banksthrough their lender of last resort function.All in all, the worseningeuro area financial crisishassubstantiallyincreasedthe dependenceof several national banking systemson centralbank liquidity, asa result of the increasingrenationalisationofmarket-basedbank funding.Thistrend hasbeentheclearest for Greece, withalmost 30% of total bankassetsfinancedby ECB liquidity, while for Ireland and Portugal theproportion hasreachedabout 10% (Graph 8, left-handpanel).Thesharp deterioration of the crisisfrom March2012onwardsthat wasconcentratedonSpain andspilledovertoItalyledtosignificant increasesin thedependenceof their bankingsystems on ECB liquidityaswell(Graph 8, right-hand panel).Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 60. P a g e | 607. Policy implicationsThesevere fundingdislocationsthat wereobserved during the mostintenseepisodesof the euro area crisis led to unprecedentedchallengesforpolicymakersandforcedthemtotakeexceptionalmeasuresonalargescale.Although the dynamics of thecrisis are still evolving, wewouldlike toemphasiseseveral implicationsfor policy.First, recent experiencehasagain demonstrated how quicklyandprofoundlybank fundingcan dry up whenthereis a lackof confidenceinthemarkets.Fundingstructuresthat seem stablein normal timescan turn highlyunstableduring episodesof financial market stress.Financingobtained from foreign sourcestends tobe particularlyunstable,andmaybeespeciallysensitivetoshocksin recipient countries.Acaseinpoint isthesharpreductionininternationalinterbank exposureswithinthe euro areain recent years.This hasdemonstrated again the benefitsof stablefundingstructures,whichfacilitatethe lengtheningof maturities,and ofconsiderablediversification betweendomesticand foreign sourcesbasedmainlyon depositsand equityand lesson short-term wholesalefunding.TheBasel III Frameworkpromotes thelatter shift.It ensuresthat banksrely on their own capacitytobuild liquiditybuffersand raisestablefunding, therebyreducingfunding liquidityrisk.Banks withstrong capital and liquiditybuffersaremuch better equippedtowithstanddisruptionsin funding.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 61. P a g e | 61Second, the strong link betweensovereignsand bankshasunderscoredtheimportanceof fiscalprudenceand, intheEuropean case,theneed forgreater financial integration in the euro area.This is particularlytrue for thosedependent for funding on foreigncapital, whichcan suddenlyleave, shifting the burden to domestic banksand investors.It is easiertobuild up fiscal buffersin good timesthan torestoreconfidencein a crisis.Financial cycles arelonger and more difficult toassessthan normalbusinesscycles, and more room for manoeuvre is required todeal withthem.Third, becauserecourse tosecured fundingencumbersa larger part of abanksassets,in theevent thebank fails fewer assetsare availabletoholdersof thebanksunsecured debt, whichreducesitsattractivenesstoinvestors.Thus, heavier asset encumbrancemay increaseconcernsof collateralscarcityand potentiallymay impair both theaccessto and cost ofunsecured funding.Scarcityof collateral is worsenedif formerlysafeassetsthat could beused ascollateralbecome seen asriskyassets.Quiteapart from theusual macroeconomic reasonsfor appropriatefiscalpolicy, financial marketsrequire sovereignsthat are consideredpracticallyrisk-free.For thisreason, in financial systems that tend to operateon the basisofcollateral, confidencein thesustainabilityof public debt hasan addedvalue.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 62. P a g e | 62Its absenceleadstodifficultiesand higher fundingcostsfor theeconomyasa whole.Finally, theincreasedfragmentation of financial markets, especiallyintheeuro area, and thereliance of peripheral banking systemsin theeuroarea on ECB liquidityrequire action on several fronts.Withineach country, public debt must be made more sustainable,structuralreformsmustfacilitategrowthandthefinancialsystem must berepaired.For theeuro area asa whole, institutional improvementsmust continue,andthere must be greater financial and fiscal integration, mainlywithregard to thethree aspectsof thebankingunion: common supervision,system-widedeposit insuranceand a singleresolution system.Therecent ECB measuresprovidemore time for thesereformsto beimplemented, but theyare not a substitutefor the reforms, soswiftprogressisstill needed.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 63. P a g e | 63Countercyclical loans for themanagement of exogenousshocks insmall vulnerable economies (SVEs)and non traditional sourcesofdevelopment financeOpeningremarksby Mr JwalaRambarran,Governorof the Central Bank of Trinidadand Tobago, at the Joint CommonwealthSecretariat and UnitedNationsDevelopment Program workshoponCountercyclical loansfor themanagement of exogenousshocksin smallvulnerableeconomies(SVEs)and non-traditionalsourcesofdevelopmentfinance,Port of SpainLadies and Gentlemen,I thank the CommonwealthSecretariat and the United NationsDevelopment Program (UNDP) for theinvitationto deliver openingremarks at this joint workshopon what I consider tobe one of the morecritical issuesfacingsmall vulnerable economies, but whichten yearsafter theMonterreyConsensuson Financingfor Development hasbeenlargelyignored by theinternational policycommunity.While developing countries have made much progressin meetingthe8Millennium Development Goals(MDGs) tofree humanity from extremepoverty, hunger, illiteracyand diseaseby2015,substantial challengesstillremain, especiallyin reachingthe most vulnerable.Multiplefinancial, food, energy and economic crises, whichoften respectnoborders, further aggravatematters.As the deadlineapproaches, wehavethe opportunityto design apost-2015frameworkthat builds on successes,learnfrom pastshortcomings,and addressesthe gapsin thecurrent MDGs.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 64. P a g e | 64JeffreySachs, Professorof SustainableDevelopment at ColumbiaUniversity, warnsusin hisJanuary 24th 2013article entitledWritingtheFuture that humanity facesno greater challengethan to ensure a worldof prosperityrather than a worldof ruins.ProfessorSachsstrikesaprescient notewhenhestatesLike anovel withtwopossibleendings,oursis a story yet tobe writtenin thisnew century.There is nothing inevitableabout thespread or the collapse ofprosperity.Morethan weknow (or perhapscaretoadmit), thefuture is amatter of human choice, not mere prediction.I thereforecommend the CommonwealthSecretariat and theUNDP formounting this first of three workshopshere in the Caribbean, withtheother twoto be held in theAfrican and Pacific regions.Perhapsthiswill be the first chapter on the post-2015development storyof new financingarrangementsfor small vulnerable Caribbeaneconomies,whosefuture might be partlybased on the choicesyou makeat this workshop.I certainlylook forwardto the outcomesof all three workshops,and hopethat the shared positionswill help toinfluenceAfrican, Caribbean andPacific governmentsin their advocacyfor innovativesourcesofdevelopment financeto bea front-burner issueon the internationaleconomicagenda.Ladies and Gentlemen, it is no secret that small vulnerable economies inthe Caribbean have grappled with external shocks of varying magnitudesandduration over the past twodecades.Theseshocks includea compression of aid flows, dismantlingofpreferential trade arrangementsfor sugar and bananas,interventionsBasel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 65. P a g e | 65relatedtoanti-moneylaunderingand combating thefinancingofterrorism.Morerecently, the Caribbeanhasbeen graduallyrecoveringfrom theshockof the global financial crisis, whichoriginated in the UnitedStatesand spread to Europe, the regionstwoclosest tradingand investmentpartners.The untold story, however, is that the combined influence of thesemultiple shocks hasled to a dramatic and fundamental shift in thecomposition of external financing flowstothe Caribbean.In my respectful view,themost significant changein theregional patternof external resource flowsstemmed from thesharp compression inOfficial Development Assistance (ODA).Flowsof ODAtomany Caribbean countries beganfallingin the 1990s,asdonorsredirectedtheir aid prioritiestothe newlyemergingCommonwealthof Independent Statesand the Least DevelopedCountries.This is certainlyironic becausethe eighthMDG recognizesthatdeveloping countriesrequire more generousdevelopment aid to have thebest chancesof reducingpoverty and acceleratingdevelopment within thestipulated15 year timeframe.Faced with decliningaid resources, many Caribbean governmentsresortedtomoreexpensivecommercialborrowingtobridge their fundinggaps.This, combined withthe growinginabilityof regional governmentstogeneratehigh enough primary fiscal surplusesfor debt servicing,contributedtoa largepublic debt overhang.Basel iii ComplianceProfessionalsAssociation (BiiiCPA)www.basel-iii-association.com 66. P a g e | 66Grosspublic debt in theCaribbean climbed rapidlyfrom 65percent ofGDPin 1998toapeak of almost 100percent of GDPin2002,beforefallingtoa still elevated 80percent of GDP in 2012.Theaccumulationof publicdebt waseven faster in the EasternCaribbean, moving from just over 60 percent of GDP in 1998toa high ofalmost 120percent of GDP in 2004, beforefallingto 95 percent of GDP in2012.General