The European Central Bank (ECB) published a working paper aimed at addressing the new risks arising from changes in the regulation of liquidity related issues.

The prudential regulation of banks has changed dramatically since the global financial crisis. While the Basel III reforms of the quantity and quality of bank capital have been the most prominent, a number of other policy initiatives have also been pursued with the aim of making banks safer and avoiding future crises. The paper focuses on one of these initiatives – a new regime of bank liquidity regulation – and examine if and how it can be beneficial for financial stability, at what cost, and how it interacts with other financial policy tools such as capital requirements and the Lender of Last Resort.

An empirical assessment of the benefits of liquidity regulation and a quantification based on macro-financial models and euro area data of its long-run macroeconomic costs is proposed. This allowsto shed light also on the interactions with capital regulation and LOLR, and take these interactions into account in our evaluation of benefits and costs.

The usefulness of liquidity tools in the optimal financial policy mix is determined by three main factors: (1) the size of LOLR distortions, (2) the effectiveness of liquidity policy instruments in alleviating liquidity stress and (3) the cost of liquidity policy instruments themselves. Our empirical work takes as a point of departure that unlimited LOLR interventions are costly and focuses on providing guidance on the quantitative importance of the last two factors.

Among the benefits of liquidity regulation, the beneficial effect of the two main liquidity ratios (the Liquidity Coverage Ratio, (LCR) and the Net Stable Funding Ratio, (NSFR)) in reducing liquidity take-up by European banks is explored. During the 2008-2009 crisis period, European banks in our sample on average used a total of 460 billion euros of public liquidity. The estimates suggest that, had these banks fully complied with the LCR (NSFR) ratio, this would have reduced liquidity take-up by 32 (110) billion euros.

The proposed policy tools therefore had a statistically and economically significant negative impact on liquidity take-up during the most recent crisis. Nevertheless, the evidence also suggests that liquidity regulations (at least as currently specified) would not have prevented the need for large public liquidity assistance for European banks. This stands as a note of caution against expecting the end of LOLR interventions due to the application of the current liquidity policy tools.

The cost for banks of complying with the LCR and NSFR is also explored. These costs turn out to be non-trivial but small, especially when compared with the costs of capital requirements. The analysis therefore suggests that while the LCR and NSFR do not have financial stability benefits on a par with bank capital requirements, they are still useful due to their relatively low cost.