Liquidity: A Bigger Challenge than Capital

The new liquidity ratios for banks introduced by the Basel Committee could prove too exacting for those dependent on short-term wholesale funding

During the last financial crisis, one major issue affecting banks was inability to roll over short-term financing. Partly addressing this, two new liquidity ratios have been introduced by the Basel Committee on Banking Supervision (Basel Committee) – the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

In introducing these, the Basel Committee aims to strengthen banks against adverse shocks, eliminate structural mismatches between assets and liabilities and encourage more stable sources of funding – medium and long-term as opposed to short-term options.

The Basel III Liquidity Proposals

Banks that rely too heavily on short-term wholesale funding will struggle to meet both ratios. Until recently, the main focus of banks had been on the challenges posed by capital requirements. The liquidity requirements set by the Basel Committee are now likely to prove an even bigger challenge.

Designed to strengthen the ability of banks to withstand adverse shocks, the LCR will require banks to hold sufficient high quality liquid assets to meet severe cash outflows for at least 30 days. Examples of these assets include cash, government bonds and other liquid securities. The stressed cash outflows include the withdrawal of a proportion of retail deposits and the withdrawal of all wholesale funding due to mature in the next 30 days.

Banks can, however, offset part of these outflows by an assumed inflow of funds they have placed with other banks that mature in the next 30 days. This LCR requirement applies on a currency by currency basis, so banks can better survive shocks that may be caused by sharp exchange rate movements or disrupted currency convertibility.

A more structural measure, the NSFR is intended to ensure that banks hold sufficient stable funding (capital and long-term debt instruments, retail deposits and more than one year maturity wholesale funding) to match their medium and long-term lending.

For many banks, addressing these requirements is akin to evaluating an iceberg below the water. The additional standards will necessitate operational, financial and structural changes, while also moving banks away from short-term wholesale funding toward a longer-term funding strategy.

Implementation Timeline

In putting together the changes outlined above, the Basel III implementation timeline allows for an observation period that allows banks to report their positions under the two ratios to their national supervisors before the ratios are finalised and become regulatory requirements.

The LCR observation period runs to 2014 and subsequently will become a minimum standard from 1 January 2015. The NSFR observation period runs longer to the end of 2017, with the NSFR becoming a minimum standard from 1 January 2018.

Impact on banks

The Basel Committee’s recent study also shows that the large, internationally active banks face significant shortfalls against these two liquidity ratios. Adjustment of the balance sheets would be needed by banks which fall short of requirements.

On the asset side, this could take the form of holding more high quality liquid assets and shortening the maturity of some lending. This is so that it falls under the one-year maturity cut-off point that is critical to the NSFR calculation of the quantity of assets that require stable funding.

On the liabilities side, it could take the form of holding more retail deposits and more long-term wholesale funding. These measures will reduce the yield on banks’ assets and increase the cost of their liabilities.

Additional costs may also arise for banks seeking either to improve or simply maintain their liquidity positions, as many will be trying to take similar actions simultaneously. Banks may therefore find the market moving against them as they try to adjust their positions.

Let us consider some of the key issues.

Banks are now likely to compete more aggressively for retail deposits. This is because of the ‘value’ placed on such deposits as a means of meeting both the LCR and NSFR.

The overall result may be to make retail deposits both more expensive and less ‘stable’ as retail depositors chase the best rates.

Historically, the total amount of retail deposits was usually price-inelastic and only responded marginally to changes in interest rates.

Next, an increased demand for longer than one year maturity wholesale funding may also have the effect of making such funding more expensive. This makes it more difficult for smaller banks to obtain longer maturity wholesale funding at any price.

Separate proposals for the ‘resolution’ of failing banks also include giving the authorities powers to ‘bail in’ (write off or convert into equity) unsecured and uninsured liabilities.

If long-term wholesale funding is first in line to be subjected to such ‘bail in’ when a failing bank is put into resolution by the authorities, there will be further adverse impact on the cost and availability of such funding.

Lastly, banks will also have to respond to tougher requirements on establishing credible and effective recovery plans that include restoring liquidity under stressed conditions. This will apply upward pressure to the cost of contingency liquidity arrangements.

Moves by many national supervisors to ‘ring fence’ branches and subsidiaries of foreign banks may also force bank groups to hold more liquidity across the group than would be required under a purely group-wide calculation of the LCR and NSFR.

Taking Action Now

There are a number of actions that banks should implement now to adjust their operations and ensure that they meet the requirements.

One of these is that they should already be reporting their positions under the two new liquidity ratios and be able to assess how far short of the new requirements they are likely to be.

Some banks may also be able to meet the new requirements through relatively modest adjustments to the structure of their liabilities and by switching into high-quality liquid assets.

Other regulatory requirements – for example, to hold more capital and to hold medium-term debt that could be written down in the event of resolution – may also improve their liquidity positions.

However, some banks may need to take more drastic action to change their business models and restructure their balance sheets. This is regardless of whether they are trying to meet the new liquidity requirements or responding to a combination of these requirements and the wider regulatory reform agenda.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG in Singapore.

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