The amount of capital banks are required to hold should be determined by the source of funding for their assets, not just by the probability of default by their debtors, according to a report released yesterday.
The International Centre for Monetary and Banking Studies in Geneva and the London-based Centre for Economic Policy Research said existing rules, based on credit quality of assets, are not enough to ensure banks build up enough capital in boom times to withstand the inevitable downturns.
The authors – including Charles Goodhart, a London School of Economics academic and former Bank of England policy-maker, and senior JP Morgan executive Andrew Crockett – proposed several changes.
"If two banks hold the same asset, the one funding assets with term deposits would set aside a lower amount of capital than the one funding assets with overnight borrowing from the money markets," they said. "If funding markets dried up for three months, the short-term funded bank would be in difficulty and would be forced to sell assets that would worsen the liquidity and solvency environment for its competitors," they added.
"The financial system's reliance on short-term funding of long-term assets with potentially low market liquidity has been the main source of instability in this and previous financial crises," the researchers said.