The Basel III Liquidity Coverage Ratio and Financial Stability
Banks and other financial institutions may increase the amount of credit available in the financial system by borrowing for short terms and lending for long terms. Though this “maturity transformation” is a useful and productive function of banks, it gives rise to the possibility that even prudently managed banks could fail due to a lack of liquid assets. The financial crisis of 2007-2008 revealed the extent to which the U.S. financial system is exposed to the risk of a system-wide failure from insufficient liquidity. Financial regulators from economies around the world have responded to the crisis by proposing new, internationally uniform bank liquidity standards, augmenting the existing Basel Capital Accord. This Note argues that a major component of these standards, the Liquidity Coverage Ratio requirement, may work to undermine the goals of effective liquidity regulation and instead contribute to issues of systemic risk.