The liquidity coverage and net stable funding ratios are intended to ensure that Basel III fills the gaps left by the previous Basel accord. But defining suitable liquid assets is proving difficult.
What is it?
The liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) are two new measurements created for Basel III, to provide regulators for the first time with internationally comparable standards for bank liquidity.
What’s behind it?
At the peak of the financial crisis, banks could neither finance themselves in wholesale markets, nor sell existing assets to raise cash. Now regulators want every management board to know their liquidity position as intimately as their capital position.
Who’s been doing what?
The Basel Committee on Banking Supervision (BCBS) published a consultation paper in December 2009 that introduced the LCR and NSFR. There were more than 270 responses worldwide to the combined consultation on Basel III, with several global banking groups writing separate submissions on liquidity.
An amended liquidity proposal was published in December 2010. Regulators are due to begin measuring the LCR and NSFR in 2013, but banks will not need to comply with the minimum ratios until 2018.
The UK Financial Services Authority (FSA) has moved ahead of Basel to implement its own liquidity standards, set out in a letter to bank CEOs in January 2010. FSA and Bank of England staff had a large hand in drafting the liquidity provisions of Basel III.
What are the main provisions?
The LCR is the stock of high-quality liquid assets divided by the total net cash outflows over 30 days, and this must be at least 100%. This one-month stress scenario also assumes a 5% deposit outflow, which is fine if the liquidity problem is extraneous to the bank, but very optimistic if fears about the bank itself have triggered the liquidity squeeze.
The NSFR, which must also be at least 100%, is the ratio of required stable funding to available stable funding. Stable funding is defined as capital, plus preferred stock and liabilities with a maturity of one year or more, plus any deposits or wholesale funds of less than one year’s maturity deemed “expected to stay with the institution for an extended period in an idiosyncratic stress event” – a term subjective enough to leave plenty of room for argument between banks and supervisors.
The major change between the first and second drafts of the Basel proposals was the widened definition of what qualified as liquid assets for the purposes of a bank’s reserves. The first draft included only cash, central bank reserves and sovereign and supranational agency bonds.
This prompted howls of protest from banks claiming there was an inherent conflict of interests – the governments whose regulators control the BCBS have large financing needs right now, which makes a captive bank investor base rather enticing. Bank bonds and the interbank market may have been the focus of the 2007-08 crisis, but today’s threat is sovereign paper.
So the second draft has added corporate and covered bonds with a minimum 15% haircut to allow for market volatility. This has prompted something of a free-for-all, with banks now urging the inclusion of just about any on-exchange asset from senior unsecured bank debt to equity to gold.
A more diverse definition of liquid reserves might avoid a stress scenario where all banks were trying to sell the same pool of liquid assets at the same time. But Selwyn Blair-Ford, head of global regulatory policy at consultant FRSGlobal, questions whether assets that have to be treated with a large discount for market volatility should really qualify as liquid at all.
“As we saw during the crisis, the liquidity calculation is really a binary one – you can either sell the asset in a stress scenario or you cannot,” he says.
What does the industry say?
Banks have warned that excessively tight regulation will undermine their fundamental role in the economy – maturity transformation of short-term funds into long-term investment. The BCBS estimates that the average LCR and NSFR for its 94 'Group 1' largest banks worldwide are currently 83% and 93%, respectively.
But one senior European financial institutions investment banker thinks the one-year threshold for stable funding is rather generous for banks that have a preponderance of long-term project or public finance assets in their portfolio.
“If you look at the spread between three-month and one-year funding right now, it is about 30 basis points. That is not a big deal, and perhaps not big enough to impose discipline in funding strategies, so the start
ing position of the regulator is not so harsh,” he says.
Barbara Ridpath, chief executive of the International Centre for Financial Regulation, believes the toughest challenge may be deciding the level of public disclosure for the liquidity ratios. “If banks face liquidity pressures, supervisors want the latitude to act before the market knows. But the market wants to know as soon as the supervisor knows. How you get the right balance between transparency and the supervisors’ latitude to do their job properly is an almost insurmountable problem,” she says.
Could we live without it?
Just ask the former management of Northern Rock. The LCR and NSFR will not kill the banks, but poor liquidity management can. The more opportunist bankers are already talking about liquidity as the new hot financial product in which to gain a competitive edge.
