Liquidity risk received little attention prior to the recent financial crisis. Since then, however, banks have improved their understanding of the challenges they face in this area. The crisis also led to heightened regulatory requirements for bank liquidity risk management. On September 3, 2014, U.S. regulators released the final rule for the Liquidity Coverage Ratio (“LCR”). On October 31, 2014, the Basel Committee on Banking Supervision updated its standard for the Net Stable Funding Ratio (“NSFR”).

Together, these regulatory requirements, once they are fully adopted in the U.S., will increase holdings of liquid assets at regulated financial institutions. But will they really achieve the broader objective of helping create a more stable financial system?

Clearly, some banks and other market participants were under-prepared for the liquidity challenges of the crisis and a heightened focus on liquidity is justified. However, liquidity risk is created by maturity transformation, which is a fundamental risk of banking. Holding additional liquidity is always easy to justify. The question is: where’s the limit?

While the LCR and NSFR are not at risk of putting banks out of business, are we squeezing on a balloon? Could we be forcing banks to have “too much” liquidity—not too much in the sense that banks are not better protected from liquidity crises than they were in the past, but in the fact that maturity transformation and other fundamental tenets of the banking sector could move away from the regulated financial sector?

Some of the post-crisis reforms could be shifting us towards a regime where liquidity risk is pushed to those without the traditional liquidity backstop. We have seen this in limited cases so far (e.g., selling mortgage servicing rights to nonbanks, adding call provisions on debt, and adding notice periods on certain withdrawals), but expect more as banks comply with LCR requirements.

We should expect that banks, which are now faced with an explicit cost of providing liquidity to customers, will push such liquidity risks to their customers and counterparties, where possible. This is a rational microeconomic decision. However, in the end, will we have created a financial system that is less able to withstand liquidity shocks, as liquidity will increasingly be provided by individuals and companies that do not have access to Federal Reserve, Federal Home Loan Bank system, and other forms of government-supported backstop liquidity?

Liquidity crises are driven by a loss of confidence on the part of counterparties, customers, and others who have connections to a financial institution. Government intervention during the crisis supported the liquidity needs of individual firms and the system, but it also served an extremely valuable role of helping restore public confidence in banks and other financial intermediaries. Unfortunately, public (and policymakers’) concerns about “too big to fail” have left a persistent desire to avoid a repeat of the government’s support measures. But without similar government support in future crises—even with banks that have more capital and liquidity, might the outcome be worse? The government must be in a position to provide such market confidence in the future.

While there is no “right answer” to how much liquidity to hold (or force banks to hold), a recent Fed comparison of banks’ most severe internal 30-day liquidity stress tests and their LCR calculations showed that the LCR requirement exceeded banks’ most severe internal stress test for two thirds of these banks.1

We should seek broader approaches to liquidity management that take into account other factors, such as capital, risk management, and business mix—and also be cautious of unintended consequences. Liquidity regulation also needs greater customization. The LCR does not have any adjustment for banks’ internal strength in risk management, crisis planning, or other such factors in Pillar I liquidity requirements (which currently include holding enough “High Quality Liquid Assets” to cover net outflows in a regulator-prescribed stress environment). As part of Enhanced Prudential Standards requirements, regulators expect firms to create and manage to idiosyncratic liquidity stress measures, but the LCR is the constraint for most. Internal stress tests are meant to complement and supplement the LCR buffer, but when LCR factors are immovable, regardless of individual firm history/behavior, and the LCR ratios are lower than internal stress tests, the LCR becomes the de facto constraint on liquidity.

A key concern is that banks’ internal risk management departments will become more focused on managing regulatory constraints and requirements than on managing the risks of the bank (regardless of regulation). Such a response is unavoidable when complying with new regulatory requirements is overwhelming internal risk departments. Bank boards of directors have also felt this strain. During KPMG’s recent governance survey2, numerous directors cited the strain compliance efforts had on their boards and how such requirements necessarily reduced the strategic input that these directors felt they could provide.

The challenge is that such a dramatic short-term increase in compliance efforts will by necessity reduce the focus of second- and third-line-of-defense personnel on looking for risks outside of regulatory mandates. We will be well prepared to fight the last crisis, but banks’ internal risk groups, and the diversity of their detection and mitigation techniques, will be weaker relative to an unanticipated crisis. A wise goal would be to balance regulation with the historical “collaborative challenge” between firms and supervisors.

There is still much to do in the area of liquidity risk management. While supervisors have moved toward macroprudential supervision for capital and liquidity risk, they are still early in incorporating interconnectedness between firms into supervision. And, to some extent, supervisory and financial institution focus is currently bifurcated between capital and liquidity risk management. However, it is important for both regulators and financial institutions to consider the relationships between these two crucial aspects of financial resiliency. True, elements of liquidity risk are captured in CCAR and capital planning, but Pillar I requirements should have a stronger connection between capital and liquidity, as banks with strong capital positions have been much less susceptible to liquidity crises (likely due to their stronger inherent financial resiliency as well as the higher perception of financial strength).

There are also opportunities to derive and define alternative liquidity risk measures. We should consider new approaches to help us avert future shocks in addition to capital-liquidity connections. For example, probabilistic approaches, assumptions that take into account multiple and idiosyncratic risk considerations, and approaches that consider different liquidity buffer levels based on risk levels all may have potential. This is both a regulatory and individual firm challenge: to develop better risk identification and early warning systems to monitor idiosyncratic and systemic risks and proactively address them.

Looking forward, the industry and regulators should work together to improve liquidity risk management in several areas:

Risk Identification: Liquidity issues and challenges should be specifically identified and inventoried as part of the capital planning exercise to make certain that all risks are integrated and assessed in the capital plan.

Governance: Specific interrelationships in oversight, policies, and measurement should be considered, including connections in committees, memberships, communication of actions, consistency in policies and consideration of risk measures.

Contingency planning: Capital and liquidity should be considered in a related way (e.g., governance, early warning signals, etc.). Both are important elements in recovery planning.

Risk measurement and management: As we transition closer to Basel III implementation, there are multiple liquidity and capital risk measures that a firm needs to manage. These measures should be considered in an integrated way.

Regulators and financial institutions need to keep liquidity risk management moving forward in a way that balances safety and soundness with economic growth. We need to ensure that risk managers have adequate time to actually manage risk.