The UK's financial regulators have urged banks to run down their £500bn liquidity buffers in order to keep lending flowing to households and businesses.
Sir Mervyn King, Governor of the Bank of England, made the announcement alongside Lord Turner, chairman of the Financial Services Authority (FSA), as they unveiled the Bank's twice-yearly Financial Stability Report. The two men sit on the new, incoming City super-regulator, the Financial Policy Committee (FPC).
"It is important that banks are willing to make use of their liquid asset buffers in times of stress, in order to support lending to the real economy," said the Governor. "The [FPC] recommends that the FSA makes clearer to banks that they are free to use their regulatory liquidity buffers in the event of a liquidity stress."
This was backed up by Lord Turner, who said that the FSA would be passing on the message to individual banks in the coming weeks. "They are holding buffers on top of buffers. They are holding in excess of what we require of them," he said.
The Financial Stability Report said the outlook for financial stability had deteriorated due to the eurozone sovereign debt crisis, pushing up the funding costs of private banks. It warned they have, in turn, been passing on these costs to households and businesses creating "an adverse feedback loop" for the UK economy.
The report estimates banks are holding about £500bn in liquidity buffers. Andrew Haldane, executive director for financial stability at the Bank, pointed out that this is more than three times the size of the stock of lending to the UK's small and medium-sized firms. If the UK's banks were to run down these reserves down by 20-30 per cent it would release £100bn to £150bn for additional lending.
Paul Tucker, Deputy Governor of the Bank of England, who is tipped as a successor to Sir Mervyn when he steps down next year, said that allowing the banks to run down their liquidity buffers was appropriate since their present problems stemmed mainly from the eurozone crisis rather than their irresponsibility. "The banks have done many things, but they didn't design the [European] monetary union," he said.
Despite the easing of liquidity requirements, the Governor said banks would need to continue to build up their capital buffers so they can cope with potential losses from their eurozone investments.
Sir Meryvn also reiterated his instruction for banks to restrain their dividends and bonuses to do so.
"Raising capital can increase banks' capacity to lend and, if used to build a bigger cushion, can reduce the cost of debt funding" he said.
The Bank and FSA have been accused of contributing to the credit shortage since the 2008 financial crisis by insisting banks build up their holdings of liquid assets.
Don't the regulators usually want the banks to increase their safety buffers?
That's capital. What the regulators are referring to here is liquidity. There is a difference between the two. Capital is the difference between a bank's assets and liabilities, a gap that banks have been ordered to maintain at a certain level. Liquidity is the amount of safe assets a bank holds in order to sell quickly to meet any unexpected liabilities that might arise.
So isn't it dangerous to run this buffer down?
No, because the Bank is making it cheap and easy for private banks to borrow cash from it. Banks now don't need to keep all these liquid assets on their balance sheets because they can always borrow any short-term cash they might need.