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Despite Lessons from Lehman, Financial Reform Bill Sets No Hard-and-Fast Rules on Liquidity

Getty ImagesMarch 30: This post has been updated.

Following the bankruptcy examiner's report on Lehman Brothers, financial reporters and bloggers pounced on deceptive, off-balance sheet maneuvers such as Repo 105, which Lehman used to hide its risk and illiquidity in order to raise its company's profile for investors. As we've reported here, other banks have come under scrutiny for possibly using similar tactics -- something that the SEC announced today it would begin investigating.

Because of its deceptiveness, Repo 105 has received a great deal of attention, but the manuever itself is not what made Lehman go bankrupt. Lehman used it to give the appearance that the bank was less leveraged than it really was. That begs the question: As Congress considers the financial reform bill proposed by Sen. Chris Dodd, does the bill contain measures that would help prevent banks from running out of cash the way Lehman did?

According to Bloomberg, the answer is no. Both House and Senate financial reform bills "give regulators the authority to come up with liquidity requirements for U.S. banks without spelling out what those might be," according to an article published yesterday.

That's not to say that in the financial world, there are no guidelines for liquidity risk management -- the Federal Reserve, Treasury and FDIC published some (PDF) on March 17 -- but so far, there have been no hard and fast, quantitative rules. Bloomberg again:

The March 17 guidelines ask banks to keep a “liquidity cushion” based on estimates of their cash needs discovered through stress testing. Supervision should focus on cash flow projections, diversified funding sources, stress testing and a contingency plan, the regulators said.    

The guidelines address only the “qualitative” aspects of liquidity management, according to Thomas Pax, head of the regulatory group at law firm Clifford Chance.

“They’re assessing the processes and monitoring of liquidity but not addressing the quantities of liquidity that banks need to hold,” said Pax, who is based in Washington.

It's worth noting that stress-testing and other such "process" guidelines may not be enough given that the bankruptcy examiner also pointed out that Lehman Brothers' stress-testing was flawed and limited in scope. Banks and some politicians say hard-and-fast rules on liquidity levels would undercut potential profit for banks, according to Bloomberg. (The profit argument, of course, is also the sameargument against having any regulation, period.)

Treasury Secretary Timothy Geithner, on the other hand, said in an interview with Andrew Ross Sorkin of The New York Times that liquidity requirements are crucial -- but he's shy on specifics:

Mr. Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.

But try pinning down Mr. Geithner, or anyone else in the Beltway, on how much capital banks should be required to keep, or even how the word “capital” should be defined, and certainties disappear.

“We have not made a judgment yet on the number,” he said, though he allowed, “it will be higher than where the formal regulatory requirements were coming into the crisis.”

Today President Obama, President Nicolas Sarkozy of France and Prime Minister Gordon Brown of Britain issued a letter calling for international cooperation on financial regulations, particularly in regard to rules on liquidity. An international panel -- the Basel Committee on Banking Supervision -- is working on a set of stricter, more quantitative rules, but as Bloomberg's piece and past reports have pointed out, enforcement of Basel rules in the past has been weak.

Update: My colleague Jesse Eisinger points out that Lehman's use of Repo 105 would have gotten around capital requirements even had they been in place. To get around a capital requirement--a rule requiring, say, a certain ratio of liquid assets to total assets--a bank in Lehman's situation could have just moved illiquid assets off its balance sheet for the very purpose of meeting the required capital ratio. Repo 105, he says, is its own issue. The post has been updated with this clarification.

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