U.S. banking regulators on Wednesday took aim at improving liquidity within the financial system in an effort to reduce the likelihood of another credit crunch similar to the one that nearly crippled the economy in 2008.
The U.S. Federal Reserve voted to adopt final rules requiring big banks to hold more assets that could be easily sold should the banks need to raise cash in a hurry to quickly pay off loans.
The new rules require big banks to hold enough liquid assets to meet their cash needs for 30 days. The Federal Deposit Insurance Corp also plans to vote on the final rules on Wednesday.
“As the financial crisis demonstrated, most of our largest and most systemically important financial institutions used excessive amounts of short-term wholesale funds and did not hold a sufficient amount of high-quality liquid assets to independently withstand the stressed market environment,” Fed Chair Janet Yellen said in a statement that accompanied the final rules.
Critics of the stronger regulations say the new rules will cut into banks' profits. If the banks are forced to acquire and hold onto safer assets in order to ensure liquidity during rough patches, those safer assets aren't going to generate the kinds of profits riskier assets would have, the critics say.
Lack of liquid assets to sell-off to pay down debts that were called in as the financial crisis bore down in 2008 brought down investment banks Bear Stearns and Lehman Brothers.
When many of the biggest U.S. banks found themselves loaded up with toxic mortgage-backed securities that couldn’t be sold to generate cash, credit markets around the world froze because banks weren’t paying off their debts, which created a devastating domino effect that rippled through financial markets.
The new regulations are part of the sweeping Dodd-Frank banking regulations passed by Congress in 2010 in response to the financial crisis.
Fed member Dan Tarullo, who oversees new regulations, said in a statement that “liquidity squeezes were the agents of contagion in the financial crisis.”
The new rules “make such squeezes less likely by limiting large banks from taking on excessive liquidity risk in advance of a period of financial stress, during which the distinction between illiquidity and insolvency can be increasingly blurred, as asset values tumble and uncertainty heightens,” he added.
Regulators believe the new rules will reduce the likelihood of that paralysis happening again because the banks will now be required to hold assets such as stocks that can always be easily sold off to generate quick cash.
Since the financial crisis regulators have also required the world’s biggest banks to increase their capital levels so that they can continue to lend money even if the bank were come under extreme financial stress.
Higher capital levels are also intended to ensure high levels of liquidity in the event of another economic downturn.
Regulators and politicians hope the new rules will help avoid another economic meltdown and prevent the government from having to bailout the financial system at a cost of billions of dollars to taxpayers.