A heuristic view of evolving capital and liquidity standards

Capital and liquidity standards for financial institutions historically developed along different lines for banking and securities firms prior to the 1990s.  As boundaries between banking and securities activities eroded substantially in the 1980s, the efficacy of U.S. legislation separating banking and securities activities also eroded.  Banking rules focused on credit risk and on capital as a loss-absorbing buffer; liquidity guidelines played at most a supporting role.  Securities firm's capital requirements focused largely on the market liquidity of assets; while not explicitly taking credit risk into account, they relied on the historical illiquidity of instruments with significant credit risk to restrain credit-risk taking.  Over time, market liquidity for instruments with substantial credit and/or market risk improved dramatically, relaxing the previous (implicit) constraint.  Finally, given both the vast size of financial markets and the size of funding needs at the largest financial institutions, funding liquidity became a much greater vulnerability than expected in the 2007-09 financial crisis.  Under Basel III, a more comprehensive framework of capital and liquidity requirements has been put in place.  The new framework aligns well with the existing framework for banks, while raising both the quality and the quantity of required capital, especially for large institutions, and requiring compliance with funding liquidity standards.  A major contributor to Basel III’s complexity is the treatment of capital market businesses, where it has proven difficult to distill the capital and liquidity needs into a relatively straightforward framework.  As the Basel III framework has been applied to capital markets activities, evidence from 2015 year-end balance sheets suggests that nonetheless both capital and funding liquidity requirements appear to have constrained those activities.