Liquidity Regulation, the 2007-9 Crisis and the Regulatory Response

Clemens Bonner and Paul Hilbers

Bank capital and liquidity are two intrinsically linked concepts and important mitigators of the risks included in banks’ core business. While capital is part of banks’ liabilities and therefore a source of funding, liquid assets appear on the other side as a use of funding. Capital can absorb losses; liquid assets can be used to compensate the risk of other funding sources drying up. Although they are usually considered separately, bank capital and liquidity interact in a number of direct and indirect ways or, as Goodhart (2009) puts it: “An illiquid bank can rapidly become insolvent, and an insolvent bank illiquid”.

It should therefore not come as a surprise that the then chairman of the Basel Committee on Banking Supervision (BCBS), George Blunden, stated at its initial meeting in 1975 that the Committee’s aim is to ensure adequate capital and liquidity levels of the main international banks. Indeed, when the BCBS was in the process of defining the first globally harmonised capital standards, it also attempted to harmonise liquidity regulation. However, while the BCBS succeeded in introducing global capital standards, known as the Basel Accord or Basel I in 1988, it