2014 Financial Markets Conference
April 2014
An interview with Franklin Allen, Nippon Life Professor of Finance and Economics, Wharton School, University of Pennsylvania
Larry Wall: Hello, I'm Larry Wall from the Federal Reserve Bank of Atlanta at the Financial Markets Conference, and I'm here to speak with Professor Franklin Allen of the Wharton School at the University of Pennsylvania.
Franklin Allen: Thank you, Larry. It's a pleasure to be here.
Wall: In your presentation you talked a fair amount about the importance of market failures to justify regulation with regards to commercial banks' liquidity. Could you talk some about why it's important that we identify those, and what are some potential failures that might justify liquidity regulation?
Allen: Well, normally, in the U.S. at least, we think markets do a pretty good job of allocating resources. And the way that we usually justify intervention by the government is that the market doesn't work, or in other words, there is market failure. I think it's very important that when we design policies we need to understand what the market failures are. Now with liquidity regulation there are a number of ones that have been suggested—moral hazard is one that's often quoted. Moral hazard isn't the only one, so failure in payment systems, monopoly power, risk taking, these are all other candidates, incomplete markets, and so on.
Wall: You've mentioned the possibility that there might be some downsides of costs to liquidity regulation. What sorts of things do you have in mind?
Allen: Well, I think the discussant Simon Davis [of Royal Bank of Scotland] did a very good job of explaining some of the difficulties that the banks actually face in terms of implementing these rules. They are going to have to expand their balance sheet to make sure they've got the coverage for this, and that is costly for them in many cases.
Long-term assets have higher yields in normal times than short-term assets, so if you make banks hold short-term assets, there's a cost. Now, quite what that cost is, is difficult to estimate. On the other side, we know that the central bank can create liquidity very easily. So there's this balance of whether it's a good idea to rely on the central bank, or whether it's a good idea to try to regulate the commercial banks, and I don't think we have a good understanding yet of this trade-off.
Wall: Basel III sets up both liquidity and capital requirements now for banks, but they really don't coordinate very much between the two of them. How would you see the interrelationship, how should we be thinking about the interrelationship between the two?
Allen: So I think it's very important because the reason that banks usually have liquidity problems is because people who are lending to them are worried about their solvency. And so the more capital you have, the less problem liquidity is likely to be. And I think one way of structuring the regulation might be to take account of that, the more capital you have, the less liquid you have to be because then the market's more willing to lend to you, but also the central bank has a much better chance of lending without problems if you've got a good capital ratio.
Wall: How should we think about the impact of this liquidity regulation on the maturity transformation that might occur outside the banking sector?
Allen: I think this is a risk here because these regulations are probably going to lower yields and that's going to make it more attractive for people to go outside to money market funds and so on. And they also have systemic problems, and I know the Federal Reserve views them that way. And I think that that's a very valid concern, and I think that that's the kind of unexpected, unintended consequence of these things, particularly when we try it for the first time, and that's why at the beginning I was advising caution just because we haven't had time to think this through very carefully yet.
Wall: Can you think of any way we can slowly step into this and learn as we go along, or is it pretty much an "all or nothing" proposition?
Allen: I think it's good to start off with fairly low requirements and then gradually change them so that we find out, "Is it difficult to manage these?" So quite where the 30 days comes from, who knows? Maybe it should be more; maybe it should be less, but maybe we could start with 10 days. You had mentioned that maybe one advantage of liquidity regulation was that the bank could go out and explain its situation and what its business strategy was, and how good its assets are, and so on. Maybe 10 days is enough for that, maybe it's not; maybe we need 30, but 10 would be a starting point.
Wall: Thank you very much, Franklin, for joining me, and thank you for watching.