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15 J. Banking Reg. 1 (2014)

handle is hein.journals/jlbkrg15 and id is 1 raw text is: Original Article The cost of bank liquidity William C. Handorf is a Professor of Finance with the George Washington University's School of Business located in Washington DC. In addition to his academic duties, he is a Director and Vice Chairman of the Board of the Federal Home Loan Bank of Atlanta. He previously served as a Director with the Federal Reserve Bank of Richmond where he chaired the board of directors of the Baltimore Branch. He has worked as a commercial banker, bank regulator, bank accountant, domestic and international consultant, and expert in legal cases applicable to banking. He has published many articles related to banking, real estate and finance. Correspondence: William C. Handorf, Department of Finance, School of Business, The George Washington University, Washington DC 20052, USA. ABSTRACT Many banks are under regulatory pressure from Basel III to improve liquidity by investing in more short-term, low-risk securities and to fund assets by more long-term, stable sources of debt. The relationship between short-term and long-term interest rates is known as the term structure of interest rates long evaluated by financial economists. This article empirically demonstrates the importance of a liquidity premium and a credit risk premium within the term structure and notes the financial consequence of these incremental costs on banks trying to enhance their liquidity coverage ratio or their net stable funding ratio. Liquidity has a cost that will reduce bank profits via a lower net interest spread. If bank liquidity is sufficient to withstand subsequent periods of market stress, the regulatory plan will reduce public expenditures often associated with bank failure. Journal of Banking Regulation (2014) 15, 1-13. doi:10.1057/jbr.2012.14; published online 22 August 2012 Keywords: interest rate term structure; banks; government regulation INTRODUCTION Bank crises typically occur every 10-15 years in some region of the world. The underlying asset class and country or region of the globe experiencing numerous bank failures shifts over time. Countries can and do incur significant fiscal costs to bail out unsuccessful banks and recapitalize or nationalize salvageable institu- tions. Central banks incur considerable mone- tary exposure to banks borrowing from the lender of last resort should collateral posted by failing banks quickly or markedly decline in value. If too many banks fail, the financial sector is unable to intermediate funds from surplus savers to worthwhile deficit borrowers. Economic problems then intensify because consumers and businesses are unable to finance the production or consumption of durable goods, working capital, or plant and equip- ment. The consequence of a failing banking system can be especially severe when domestic institutions fund a sizable portion of govern- ment debt. Banks ultimately fail because of inadequate capital. Capital ratios typically decline to very low or negative values given excessive losses on high-risk loans and, more recently, securities. The loans and the securities were neither supported by adequate levels of loan loss reserves nor priced appropriately for risk. The problems magnify if the bank is not well diversified and has a concentration in a type of loan, security or geographic region experiencing greater than expected losses. © 2014 Macmillan Publishers Ltd. 1745-6452 Journal of Banking Regulation Vol. 15, 1, 1-13 www.palgrave-journals.com/jbr/

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