Special edition on the Liquidity Coverage Ratio

On 6 January 2013, the Basel Committee finalised new, less onerous liquidity rules, for global banks and large investment firms. In unanimously endorsing minimum standards on the Liquidity Coverage Ratio (LCR), regulators have taken a significant step forward in implementing the Basel III framework. The LCR is the ratio of available liquid assets to the estimated net cash outflow over a 30-day period. It is designed to ensure short-term resilience against liquidity disruptions and reduce the need for banks’ to seek outside liquidity support during a crisis.

Key changes

The Basel Committee have delayed the implementation of LCR from 2015 to 2019. Banks will only need to meet 60% of the requirements by 2015—the previous start date—after which requirements will increase 10% each year until 2019.

The new rules expand the range of corporate debt securities that qualify as liquid to BBB-; a big change from its previous stance. As late as September the Basel Committee said that nothing less than AA- should be eligible. Some retail mortgage-backed securities (RMBS) will also count as being “high-quality liquid assets” (HQLAs) under the new regime. Previously, qualifying assets were mostly limited to cash, government debt, central bank reserves and high quality corporate bonds.

The ratio will be smaller under new rules. The new inflow/outflow rules assume a less pronounced withdrawal of bank deposits and a slower loss of income over the 30-day crisis period.

Not so watered-down

Some commentators expressed chagrin about the new rules, believing that it undermines the chief purpose of the LCR—to avoid the necessity of a public injection of liquidity during a crisis. Valid questions come to mind about the expansion of eligible assets, such as: how liquid were RMBS during the sub-prime crisis? How will the recent ramp-up in the supply and demand of corporate debt have on the long-term health and sustainability of this market?

But the new rules do not represent a capitulation by regulators and reading into the technical details of the new rules should appease most sceptics.

Additional assets will only be allowed to be counted as HQLAs subject to higher haircuts. These include corporate debt securities rated A+ to BBB- (50% haircut), unencumbered equities (50% haircut), some RMBS rated AA or higher (25% haircut). These assets won't be able to account for more than 15% of HQLAs after haircuts.

To those who argue that RMBS will be useless during a liquidity crisis, securities must meet the following characteristics to be eligible:

  • not issued, and the underlying assets have not been originated, by the bank itself or any of its affiliated entities
  • long-term credit rating of AA or higher
  • traded in large, deep and active repo or cash markets characterised by a low level of concentration
  • proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions
  • the underlying asset pool is restricted to residential mortgages and cannot contain structured products
  • the underlying mortgages are “full recourse’’ loans and have a maximum loan-to-value ratio of 80% on average at issuance
  • the securitisations are subject to “risk retention” regulations which require issuers to retain an interest in the assets they securitise.

Other asset classes on the margins have similar eligibility criteria. Essentially, the Basel Committee want to ensure that only assets which are likely to be tradable in periods of distress qualify as being liquid. This move is a brave one and should support the development of these markets. But it does open the door to gaming; a blanket ban would have certainly have been easier to patrol.

Inflows/Outflows

In addition to timelines and eligible assets, the Basel Committee made the following changes to the LCR inflows/outflows provisions:

  • reduction in outflow rates for some insured deposits and non-financial corporate deposits (from 5% to 3% and 40% to 20% respectively)
  • clarification of the definition of liquidity facilities and reduction of outflows for committed liquidity facilities to non-financial corporates from 100% to 30%
  • distinction between interbank and inter-financial credit and liquidity facilities and reduction of the outflow rate on the former from 100% to 40%
  • guidance to indicate low outflow rate for trade finance related activities
  • additional derivatives risks included in the LCR with 100% outflow
  • clarification of treatment of activities related to client servicing brokerage (generally leading to an increase in net outflows).

All about the economy

Broadening qualifying assets means the “vast majority” of banks already meet the new requirement—a point that was acknowledged by Bank of England Governor Mervyn King, the chairman of the LCR rule-setting committee. Stefan Ingves, chairman of the Basel Committee, indicated that the average bank already had about 125% of assets requirement under the new rules.

This doesn’t mean banks are getting off lightly, as some have indicated. We are living in very unusual times. Central Banks and governments have been pumping money in the financial system since the crisis, either through special liquidity measures, favourable monetary policy or direct injection of public funds. These interventions cannot (and won’t) continue indefinitely.

Banks will need to stand on their own feet soon and will have to get smaller through deleveraging in the medium term. This means fewer loans in the future but the new rules will give them some leeway to support an economic recovery in the short term (and other sources of finance, such as the venture capital industry and securitisation, time to grow). Bank credit is important, particularly in Europe, where banks provide upward to 60% of all business loans.

The old LCR was expected to put a significant dent in banks’ ability to supply credit. The European Banking Authority’s (EBA) Stakeholder Group estimated that EU banks would have needed an additional €1.15 trillion worth of liquid assets to comply with the old LCR. In the US, the Clearing House estimated a liquidity shortfall of $840 billion for its banks.

And we were already seeing banks preparing for the LCR. Currently over €650 million worth of deposits from large EU banks are sitting in central banks and thus playing “no role in financing the real economy”. The EBA Stakeholder Group was concerned that the old LCR would crowd out further productive investments and sterilise €1.15 trillion of liquidity from the EU economy.

The Basel Committee took these prognostications seriously. Mervyn King said “it does not make sense to impose a requirement on banks that might damage the recovery”. Clearly regulators don’t want to be blamed for holding back the recovery. Sandboxing banks by implementing overly-rigid regulations to ensure their stability could damage the wider economy.

Impact on banks

In general, banks should welcome this announcement because it will allows a wider range of liquid assets to count as HQLAs, which will make the ratio less onerous to maintain. Also, the outflow rate has decreased for several types of liabilities and commitments, which will mechanically increase the ratio.

The new rules provide welcomed clarification in uncertain areas (e.g. definition of liquidity facilities, introduction of a standardised approach to calculate market value changes in derivatives positions) which should promote consistent application and result in fewer arbitrage opportunities. Also, the phase-in arrangements will give more time to complete any required balance sheet / activities restructuring necessary to meet the 100% minimum requirements.

However, outflows related to derivatives and prime brokerage could increase. Also, there were no changes related to secured financing, an area which is typically heavily impacted by the LCR requirements (especially equity financing).

The LCR is not just a ratio. It is also a complex report which requires bespoke infrastructure / processes that still have to be in place from 2015 in spite of the phase-in arrangements. For firms that are in the process of implementing the LCR, these changes may prompt them to revise their existing plans and possibly revisit certain parts of systems / definitions that they had already finalised and signed off. Those firms that have not started or are in the early days of design / implementation will feel pressure to catch-up.

Additionally, the Committee has reaffirmed that in periods of stress it would be entirely appropriate for banks to use their stock of HQLAs, thereby falling below the minimum requirements. Although the circumstances for banks to use their HQLAs still need to be defined, this as well as certain alleviations for banks in countries receiving financial support for macroeconomic and structural reform purposes, shows that the rules aim at establishing liquidity buffers for crisis prevention.

Finally, the way the standards will be adopted in various jurisdictions remains to be seen. There are still some concerns around the consistency with some clear national discretion areas such as the inclusion of central banks reserves and several areas left to local regulators (such as triggers and actions associated with LCR depletion). In the EU, the EBA said in December it expected firms to submit monthly liquidity and leverage data in Q1 2014 but the exact requirements are still to be defined in the final Capital Requirements Regulation.