Bankers say that in the past few months the Federal Reserve has asked them to put balance sheets through a battery of tests to see how they would fare in a major liquidity shortage or sudden downturn in capital markets.
Closer regulatory scrutiny of liquidity reserves could diminish investment banks’ ability to reap profits through aggressive use of their balance sheet by forcing them to be more prudent with funding and capital.
After the tests, which simulated financial disruptions from mild to catastrophic, the regulators advised investment banks how to improve liquidity and urged them to review frequently.
“The regulators asked us to run a comprehensive series of stress tests unlike anything we have done before and then they told us how we were doing in terms of liquidity management,” a senior banker said.
Investment banks and the Fed and declined to comment but people familiar with the situation said the tests were carried out at all big Wall Street firms.
It could be a harbinger of a new regulatory regime if policymakers extend the Fed’s interim powers and let it take over from the Securities and Exchange Commission as the industry’s main regulator.
Senior Wall Street figures welcomed the move by the Fed, which has provided credit lines to investment banks since March. It was helpful to have more clarity on their liquidity position and capital requirements, they said.
Regulators have always looked at banks’ liquidity positions but long-term capital reserves have been regarded as a more valuable indicator of financial health.
Bear’s implosion in March, which led to a cut-price takeover by JPMorgan Chase, highlighted the role of liquidity sources.
The Fed and the SEC singled out liquidity monitoring as one of the main issues in a co-operation agreement on investment banking regulation last month.
Bankers with knowledge of the recent tests said some focused on sources of funding seen as particularly volatile such as the balances held in their prime brokerage business, which lends money to hedge funds.