Basel III: Optimising the Liquidity Coverage Ratio Strategy

In the aftermath of the GFC, in December 2010, the Basel Committee on Banking Supervision (BCBS) introduced the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), to be put in place by 2015 and 2018 respectively. In January 2013,
the LCR guidelines were softened
, particularly in areas concerning the liquid assets description, and the implementation timeline was also made less stringent. NSFR guidelines are under development.

The LCR is a key element of the Basel Committee’s response to the GFC. The LCR requires banks to hold high quality liquid assets (HQLA) exceeding anticipated net cash outflows for the next 30 days during a period of crisis, the cash flows being considered under stressed conditions.

Net cash outflows are calculated by applying assumed runoff or drawdown rates to each category of liabilities and off balance sheet commitments, and netting with contractual receivables inflow, after applying a specified inflow rate, but capped at 75% of the gross outflows.

Furthermore, the LCR is required to be maintained for each significant currency, espousing non-dependence on the currency swap markets, which can rapidly turn illiquid in times of stress.

Given the policy objective of building bank-wise short-term resilience to liquidity shocks, the LCR internalises the externality caused by bank’s liquidity issues, reduces moral hazards prevalent in the liquidity regime leading to the GFC, and reduces the multiplicity of an entity-specific liquidity problem being transmitted to the banking system, and eventually the central treasury.

At the entity level, the LCR provides disincentives for dependence on short term (being fewer than 30 days) unstable funding sources and incentives for short-term lending tenors. While this implies a change in the relative size, source and maturity of the funding markets, how the funding market will function in the future will strongly depend on the behaviour of major non-banking participants, such as insurance and asset management companies.

LCR provides for the cost of liquidity risk, and aids allocation of such costs in the most economically-efficient manner. LCR does not impose any new costs, and only redistributes such costs from the public to the banking sector.

A Modest Price

With most countries having some regulatory framework on maintaining liquid assets at the local level, the envisaged cost of LCR implementation should not be high, especially in local currency. The December 2013 European Banking Authority (EBA) report on impact assessment for liquidity measures concluded that the long-run cost on European Union (EU) gross domestic product (GDP) is negligibly low, at three basis points, owing to EU banks having an average LCR of 115%.

It further concluded that the imposition of liquidity requirements is not likely to have a detrimental effect on the stability, orderly functioning, and supply of bank lending, particularly for lending to SMEs and trade financing.

Despite criticisms that applying LCR outflow rates of 0-5% on trade finance contingent funding liabilities overstates the facility risks and will add to the liquidity cost in offering such facilities – leading to eventual reduction of credit supply to the real economy – there is little empirical evidence to support this assertion.

While differentiated product dispensation can be one of the strategies, the level of the bank LCR is more strongly driven by the maturity and structure of its liabilities, rather than its asset offerings.

In conforming to the new LCR regime, banks are increasingly looking to restructure their liabilities. This approach is already evidenced in the new liability product offering being introduced in the market – although not always to the regulator’s comfort.

Ongoing liability product development is seeing banks launch call deposit accounts, where the deposit can be withdrawn with more than 31 days’ notice. With a zero percent LCR runoff rate, such accounts provide higher yield.

Cash and trade products being closely interrelated, banks are providing tiered fees such that higher operating cash balances are incentivised by lower fees on trading products.

Strength in Diversification

With regard to the strategy of increasing HQLA, it remains to be seen if banks would show increased investments in central bank reserves and other liquid assets, although differentiating such bank behaviour as a response towards conforming to the new liquidity regime – or towards the flight to quality – may be challenging.

The adjustment strategies of banks in conforming to the LCR regime is also a strong function of the bank’s business model, and closely linked to the way that liquidity has been historically managed.

This was noted in the December 2013 EBA study and, given banking structures and models that are mostly homogeneous, is expected to be observed across geographies.

Diversified banks, which manage liquidity by minimising short term asset and liability maturity mismatches, and which have access to stable and operational deposits, can be argued to be presented with fewer challenges in conforming to LCR.

Securities trading and custodian banks enjoy a strong holding in liquid assets, aiding their compliance with LCR. Private banks, in contrast, have significant short-term liquidity gaps and adopting LCR can see them increasing their stable funding or shortening asset maturities. Auto and consumer credit banks typically have relatively more inflows than outflows within the immediate 30 days, and arguably may be faced with challenges owing to the cap on inflows, if such banks are not holding adequate HQLA.

Besides the bank-specific business model, the interaction between LCR and capital adequacy ratios (CARs), and another introduction in Basel III, the leverage ratio, provides for an important dimension. A higher share of liquid assets implies lower risk weights, and hence higher LCR should correspond to better capital adequacy ratios.

The leverage ratio, being a volume-based capital ratio, does not differentiate between holdings in liquid or non-liquid assets. However, a higher holding in liquid assets would imply a low return on bank equity, to compensate for which banks would decrease the leverage ratio. Higher LCR should correspond to a lower leverage ratio. Maintaining a regulatory minimum leverage ratio thus provides a backstop limit on LCR, provided the banks are deciding rationally.

The interplay between LCR, CAR and leverage ratio depends on limiting factors introduced by local adoption and specification of the ratios by respective national regulators.

Besides, the optimal LCR strategy would depend on market-specific factors such as maturity of interbank and debt markets and bank-specific factors such as product portfolio and liability composition, as discussed.

The optimal LCR strategy incorporates these variables, leading to the most efficient capital allocation and, hopefully improves economic welfare to make the banking system more robust and shock-proof. Where each banking institution places itself on the optimised capital spectrum deserves a close watch.

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