Basel III has garnered a great deal of attention lately. With the latest delay in implementation for US regulators, one wonders if the liquidity portion of the accord – which went missing from the latest NPR (notice of proposed rulemaking) – will ever surface as a set of US regulatory ratios. And, what form will the liquidity requirements take?
Basel III introduces new ratios to serve as preventative monitoring tools for liquidity risk. Two important issues addressed by the new ratios include insufficient short-term liquidity reserves for protection in the event of a liquidity squeeze; and the tendency to pursue aggressive strategies in growth periods that skew the bank’s funding structure in favor of more short-term funding.
Start at the beginning
In June 2008, the first draft1 of liquidity guidance was released for consultation by the Basel Committee on Banking Supervision (BCBS). Numerous revisions were released between 2008 and 2010, but Basel III: International framework for liquidity risk measurement, standards and monitoring,2 the 2010 release, is the formal guidance for
- Liquidity Coverage Ratio3 – The LCR ensures that banks always have a 30–day liquidity reserve.
- Net Stable Funding Ratio4 – To ensure stable funding over a one–year horizon, the BCBS mandates that the liquidity characteristics of a bank’s asset and liability matching structure be controlled through the Net Stable Funding Ratio (NSFR)
These ratios must be computed using the current-state balance sheet. In other words, you must use a static view of the balance sheet. (The quantitative liquidity guidance released to date may appear counter–intuitive given its focus on a static balance sheet.)
Additionally, the Committee developed five common metrics5 that should be considered as the minimum information supervisors should use:
- Contractual maturity mismatch – useful in comparing liquidity risk profiles across institutions. It will also highlight to banks and supervisors when potential liquidity needs could arise.
- Concentration of funding – assists supervisors in assessing the extent to which liquidity risks could occur in the event that one or more of the funding sources are withdrawn (e.g. select counterparties, instruments and currencies).
- Available unencumbered assets – provides a view into the potential capacity to raise additional secured funds. Keep in mind that a stressed environment may significantly impact the value of the collateral.
- LCR by currency – an assessment of the LCR in each significant currency allows monitoring and management of the overall level and trend of currency exposure at a bank.
- Market–related monitoring – useful data to monitor includes market-wide data on asset prices and liquidity, institution-related information such as credit default swap spreads, equity prices and the institution’s ability to fund itself in various wholesale funding markets and the price at which it can do so.
One of the first notable signs of change was in March 2010, when the Office of the Comptroller of the Currency (OCC), Federal Reserve, Federal Deposit Insurance Corporation, Office of Thrift Supervision and the National Credit Union Association released Phase 1 guidance6 on liquidity. This guidance represents the qualitative side of the liquidity framework discussed in the 2008 Principles of Sound Liquidity Risk Management and Supervision.
It was followed in June 2012 by the OCC’s update of the Liquidity: Comptroller’s Handbook7. This booklet aggregated the disparate liquidity guidance into one streamlined document that supersedes all previous guidance.
A key statement in the introductory paragraph says, “A well-managed bank, regardless of size and complexity, must be able to identify, measure, monitor and control its exposure to liquidity risk in a timely and comprehensive manner.”
The OCC liquidity handbook stops short of mandating the computation of the two liquidity ratios but does detail the fundamentals, namely the diversification of funding sources and the need for banks to maintain a cushion of highly liquid assets. Phase two of the liquidity risk guidance will include some form of calculated ratios and monitoring of key variables similar to Basel III guidelines on liquidity risk.
US take on Basel III liquidity guidance
Regulatory bodies have gone to great lengths to devise a capital planning exercise for evolving the balance sheet over a nine-quarter period while looking at the impact of stress scenarios on the bank’s ability to navigate under extreme stress. With that in mind, does it make sense to apply these ratios on a static balance sheet? Shouldn’t we add liquidity metrics based on the same forward-looking assumptions to maintain consistency in the way banks are supervised?
The CCAR (Comprehensive Capital Allowances Review) and CapPR (Capital Plan Review) exercises are quarterly and yearly. Can we expect these exercises to be expanded to include the calculation of liquidity risk ratios? Of course, adding a cash-flow dimension complicates things8. Some of the operational constraints show how difficult it might be to project asset balances according to Basel III classification rather than by product type as required in CCAR and CAPPR. These issues will have to be addressed, but the valuable information that could be garnered from the process may make it worthwhile since it would promote the harmonization of scenarios across all risk types without introducing a new set of scenarios.
So, even if liquidity risk is different from other risk types, shouldn’t liquidity be computed on a forward–looking basis? With a forward-looking approach, we can evaluate the potential effect of the bank’s liquidity strategy on a quarter-by-quarter basis. This would also provide a view into the likelihood that the bank would run out of cash in given scenarios. Those scenarios should rely on the same growth assumptions that the capital planning team uses: baseline, stress and severely stressed scenarios. This strategy will better inform so that contingency plans can be made before signs of a crisis.
Regulators need to define metrics for assessing liquidity risk, a methodology to arrive at those metrics and a mechanism to periodically monitor them. The US liquidity NPR may or may not address the fact that the computation of liquidity ratios will diverge in philosophy from the capital planning exercise.
For banks to be successful in meeting these evolving requirements they must use a holistic approach to managing risk and learn ways to use these systems to run their business.9 And, regulators must provide an incentive for them to think this way – a consistent approach should help achieve this.
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