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Bank liquidity: Liquidity buffers need rebuilding

Risk-free nature of government bonds in doubt; Regulators’ continuing trust in his paper under challenge.

The panic over possible sovereign defaults seemed to have receded over the summer as investors focused instead on governments’ debt-reduction plans. Regulators did their best to assuage secondary concerns over banks stuffed full of sovereign bonds by pushing through their stress tests, and banks regained access to market funding. But big questions remain.

One reason why banks had gorged on government bonds was to build up so-called liquidity buffers of high-quality assets that could easily be turned into cash in the event that another system-wide crisis or bank-specific problem should scare off bondholders and depositors.

Over the past few months bank managements have been boasting about the size of their liquidity buffers, rather as they once boasted about their reported earnings or returns on equity.

Sadly, rather like those reported returns, it might turn out that the liquidity buffers have provided a largely illusory comfort to investors. Sovereigns have stayed current on their debt service, albeit with assistance in the case of Greece. But the illusion that developed-country government bonds are genuinely risk-free has been shaken and the notion of their guaranteed liquidity has been shattered.

If regulators are to perform their duty to ensure the soundness of the system, if bank management teams are to fulfil their obligations to investors, customers and employees, then what properly qualifies for inclusion in their liquidity buffers will have to be reconsidered.

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