Yellen weighs in on banks’ liquidity risk and capital requirements

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Yellen weighs in on banks' liquidity risk and capital requirements (Part 1 of 4)

Janet Yellen’s speech

On April 15, Fed Chair Janet Yellen made the opening remarks at the Federal Reserve Bank of Atlanta’s 19th Annual Financial Markets Conference, held on April 15–16, 2014, in Atlanta. Speaking via a pre-recorded video, she addressed the importance of liquidity for financial institutions and strengthening banks’ capital requirements.

About the Federal Reserve Bank of Atlanta’s Annual Financial Markets Conference

The FRB of Atlanta’s 19th Financial Markets Conference agenda this year included discussions on policies designed to ensure safe and efficient financial markets. The conference focused on how to promote recovery in the economy after the fallout of the financial crisis and how to reduce the risks arising from future crises. The conference discussed the outcomes from experiments such as quantitative easing (or QE) and regulators’ efforts to improve the “information environment” prevalent in markets, which could prevent future crises.

Janet Yellen on liquidity risk

Janet Yellen, in her opening remarks, spoke about the need to strengthen minimum capital requirements, keeping in mind the liquidity risk financial intermediaries face. She said that currently, capital requirements address risks posed by the assets side of the balance sheet (credit and market risks) and off-balance sheet items and “do not directly address liquidity risks.”

Maturity transformation (or the use of short-term deposits held by banks to finance loans that are longer-term) leads to liquidity risk, Yellen said. She cited the examples of Northern Rock, Bear Stearns, and Lehman Brothers during the financial crisis of 2007–2008, when short-term creditors ran from these firms and from money market mutual funds (or MMMFs) and asset-backed commercial paper (or ABCP). These runs, she said, “were the primary engine of a financial crisis from which the United States and the global economy have yet to fully recover.”

Financial intermediaries like Citigroup (C) and JP Morgan (JPM) take deposits from depositors that are short-term and can be withdrawn at any time and disburse these as loans to investment-grade companies like Microsoft (MSFT) as well as through leveraged loans (BKLN) to higher-risk borrowers, for example Hilton Worldwide (HLT).

Leveraged loans are usually secured and carry floating interest rates. Originated by banks, these loans are disbursed to higher-risk corporates like Caesar’s Entertainment (CZR). Leveraged loan ETFs like the Invesco PowerShares Senior Loan Portfolio (BKLN) and the Pyxis/iBoxx Senior Loan ETF (SNLN) provide exposure to leveraged loans. HJ Heinz, recently acquired by Berkshire Hathaway (BRK-B), is the largest issuer in the leveraged loan index that BKLN uses, with a yield of 3.25%.

The next part of this series covers Janet Yellen’s speech addressing stronger capital requirements for banks. To find out more, please read on to Part 2.

Continue to Part 2

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