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WorldNovember 24 2014

EU’s relaxed approach opens transatlantic liquidity gap

The EU has introduced a liquidity coverage ratio for banks that is noticeably weaker than its US equivalent.
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EU’s relaxed approach opens transatlantic liquidity gap

What’s happening?

In October 2014, one of Michel Barnier’s last acts as European commissioner for the internal market and services was to finalise the delegated acts implementing the liquidity coverage ratio (LCR) for EU banks. Under this rule, a bank must hold a buffer of high quality liquid assets (HQLA) that could be sold down to cover 100% of outflows during a 30-day stress scenario in which the bank was unable to raise fresh wholesale funding.

In the accompanying press release, Mr Barnier’s focus was not so much on liquidity management, but on encouraging credit growth in the EU. In an earlier draft, the only form of asset-backed securities (ABS) eligible as HQLA were residential mortgage-backed securities (RMBS). This has now been extended to include car loans, consumer loans and lending to small and midsized enterprises.

“These detailed rules show that Europe is serious about creating a framework to support investment in the economy, particularly through promoting safe and transparent securitisation,” said Mr Barnier.

What’s the problem?

The European Commission had based its earlier view that only RMBS should be eligible on hard evidence – studies concluded that most other ABS are illiquid, and many deals do not even trade daily. Stefan Schmitz, a liquidity expert at the Austrian National Bank, believes sophisticated banks have already invested heavily in liquidity risk management and are unlikely to migrate their liquidity buffers down to the lowest possible classes of HQLA.

But smaller banks whose profitability is under pressure might be tempted. At the moment, the spread between covered bonds, ABS and government bonds is probably not high enough to justify the risks, but that could change as interest rates rise.

“In the end, what we have is a relatively complicated result that is not genuinely risk sensitive and may not be economically binding, because the market is likely to demand a higher liquidity standard than the regulation,” says Mr Schmitz.

This is not his only concern. The EU will apply the LCR at both the group level and among about 8500 individual bank subsidiaries across the region. This is clearly a compromise designed to satisfy host countries that want to monitor the liquidity of the local subsidiary of a cross-border group. It has legal ramifications, however, because the delegated acts deviate from Basel III on the treatment of intra-group commitments.

“Between or even within countries, the question of lending to other parts of a group in distress is a significant issue under insolvency law because it effectively means redistributing money from one set of creditors to another. By allowing intra-group commitments, there is a risk of overestimating the available flows of liquidity,” says Mr Schmitz.

What do the banks say?

Unsurprisingly, the banks welcomed the broader eligibility for HQLA. The industry had formed the prime collateralised securities (PCS) initiative in 2012 to create a benchmark label for securitisation deals based on their credit quality and structural integrity – such as reporting transparency, whether the deal is wholly distributed or partly retained by the bank, and how far it engages in resecuritisation of securitised assets or maturity transformation. Ian Bell, head of the PCS secretariat, says that once a high quality securitisation is defined in this way, it justifies changing the approach to including ABS in HQLA.

“When you are looking at liquidity data for 2007 and 2008, that reflects a totally different ABS product, as the definition of high quality securitisation did not exist then. Now that it does, the backward-looking approach is not a good indication of how the high quality product will perform in the future,” says Mr Bell.

What’s the alternative?

The US approach is markedly tougher. ABS are excluded from HQLA (unless guaranteed by state agencies Fannie Mae and Freddie Mac), and the LCR is applied to 33 banks at consolidated group level, not to subsidiaries. Another notable strength of the US LCR is the use of a peak outflow measure during the 30 days. The EU averages the flows over the whole 30-day period.

“If a bank has most of its inflows on day 29, there is a risk it will run out of liquidity well before then,” Mr Schmitz points out.

New European Commission president Jean-Claude Juncker has pledged to review EU regulations to see if they are effective, and financial services commissioner Jonathan Hill embraced that plan enthusiastically at his approval hearings. But it seems unlikely that a tightening of the LCR will be on his agenda.

In fact, the industry is pushing the other way. Currently, only senior tranches of ABS can count toward HQLA. The PCS is arguing that the creation of a high quality securitisation category could even allow for mezzanine tranches to be included as well.

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