Preparing for Basel IV – Why Liquidity Risks Still Present a Challenge to Regulators in Prudential Supervision

Abstract

This paper considers and assesses various explanations attributed as principal factors of the recent Financial Crisis. In particular, it focuses on two principal regulatory tools which constitute the basis of the framework promulgated by recent Basel Committee's initiatives, that is, Basel III. These two regulatory tools being capital and liquidity requirements.

Various conclusions have been put forward to explain what triggered the recent Financial Crisis. This paper aims to explain why the Basel Committee's liquidity requirements and present proposals aimed at addressing liquidity risks, still represent a very modest milestone in efforts aimed at addressing challenges in prudential regulation and supervision. Even though problems attributed to capital adequacy requirements are considered by many authorities to have triggered the recent Crisis, the paper will highlight how runs on banks are triggered by liquidity crises and that liquidity risks cannot be isolated from systemic risks. In so doing, it will incorporate the roles assumed by information asymmetries and market based regulation - hence elaborate on how market based regulation could serve to address problems which trigger liquidity risks. Imperfect knowledge being a factor which is contributory to liquidity crises and bank runs, and market based regulation being essential in facilitating disclosure - since the Basel Committee's focus on banks and prudential supervision cannot on its own, address the challenges encountered in the present regulatory environment.

Furthermore, it will address measures and proposals which could serve as bases for future regulatory reforms - as well as criticisms and challenges still encountered by recent Basel Committee initiatives.

Keywords: capital, liquidity, Basel III, Basel Committee, lender of last resort, banks, insurance, securities, information asymmetry, market based regulation, bail outs, disclosure, moral hazard, Dodd Frank Act, Financial Crisis