Liquidity coverage ratio: Another brick in the wall

October 2013
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Liquidity coverage ratio: Another brick in the wall

At a glance

The US regulators' Liquidity Coverage Ratio forms one of the key components of the Basel III reform package, and came out much tougher than expected.

On October 24, 2013, the Federal Reserve Board of Governors (“Fed”) approved an interagency proposal for the US version of the Basel Committee on Banking Supervision’s (“BCBS”) Liquidity Coverage Ratio (“LCR”). The LCR measures liquidity stress over a short term period, and would apply to US banking organizations and certain other systemically important financial institutions. The comment period for the proposal is scheduled to close by January 31, 2014.

The LCR forms one of the key components of the Basel III reform package, which also includes:

  • Revised capital standards, which have been largely completed in the US. Only the Supplementary Leverage Ratio for larger firms remains in proposed form, but it will likely to be finalized by year-end 2013.
  • The Net Stable Funding Ratio (“NSFR”), a longer-term liquidity measure over a one-year time frame, is designed to measure institutions’ structural funding characteristics and to restrain over-reliance on shorter-term wholesale borrowing. This separate measure remains under review by the BCBS with the possibility of finalization in 2013, followed by a US proposed rule in mid-2014.

The US LCR proposal came out significantly tougher than BCBS’s version, especially for the larger bank holding companies (“Large BHCs”) – likely beyond the 8 US firms identified as G-SIBs. First, the US proposal excludes key items from the definition of high quality liquidity assets (“HQLA”) such as private label mortgage debt (impacting the LCR’s numerator), while treating GSE-issued debt less favorably than expected (rendering GSE debt a “Level 2A” asset rather than “Level 1”) despite their deep and liquid market. The exclusion of these items may result in an approximately 8% reduction in HQLA stock on average for the largest 6 US institutions as compared to BCBS’s version (discussed below).

Second, the US proposal introduced a stricter methodology for calculating net cash outflows for Large BHCs (impacting the LCR’s denominator), by calculating it based on the “peak” net cumulative amount and applying a daily limit to the amount of outflows that can be offset by inflows (both discussed in more detail below). This change is particularly significant for managing potential mismatches caused by intra-month contractual cash outflows (e.g., processing of customer benefit payments).

This Financial Services Regulatory Brief (a) analyzes the key elements of the US’s LCR proposal drawing distinctions relative to the BCBS version, (b) assesses the impact on HQLA stock from BCBS’s LCR to the US’s proposal, (c) explains the LCR in the context of broader US prudential reforms, and (d) suggests actions firms should be taking now.

 

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