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The Liquidity Coverage Ratio (LCR)
The Net Stable Funding Ratio (NSFR)
 
Welcome to the March 2011 edition of the Basel iii Compliance Professionals Association (BiiiCPA) newsletter
 
Dear Members,
 
 This was a very busy month.

We are well into the transition from the Basel II to Basel III in many banks and financial groups.

The OECD has just estimated that Basel III rules will hit economic growth by 0.05 to 0.15 percentage point a year, because of the rise in funding costs, due to higher capital requirements.

Large banks feel that they will need to do way more. Being large becomes a disadvantage after so many years. The G20 have approved the recommendations from the Financial Stability Board, and we expect extra measures such as capital increases and tougher supervision for a list of Systemically Important Financial Institutions (SIFIs).

 Michel Pebereau, the chairman of BNP Paribas has said that the G20's approach of singling out big banks for tougher regulation would distort competition and be ineffective because even smaller banks could spark a crisis.

Major banks in the States discuss the problems with the capital that qualifies as regulatory capital. The news from Canada did not help. Mark White, assistant superintendent at the Office of the Superintendent of Financial Institutions (OSFI) in Canada told reporters that Canada's banks must redeem, replace or let run off more than C$70 billion in non-common capital by 2023. OSFI has also told banks to meet the Tier 1 target early in the transition period that begins in 2013 and avoid any actions that weaken their capital positions.

French ECB governing council member and head of the Bank of France Christian Noyer has discussed another problem: The uncertainties in the definition of liquid assets under Basel III.

And what should we, Basel ii / iii professionals do?

We must (find and) spend time to understand the new Basel III framework.

We will discuss today the two new interesting liquidity ratios.
 
Liquidity Coverage Ratio (LCR)
 
The Basel Committee has developed two standards for supervisors to use in liquidity risk supervision.
 
One standard, the Liquidity Coverage Ratio, addresses the sufficiency of a stock of high quality liquid assets to meet short-term liquidity needs under a specified acute stress scenario.
 
The complementary standard, the Net Stable Funding Ratio, addresses longerterm structural liquidity mismatches.

 To raise the resilience of banks to potential liquidity shocks, the standards should be implemented consistently as part of a global framework.
 
To this end, most of the specific parameters used in these metrics are internationally harmonised, with specific and concrete values.
 
Certain parameters, however, will need to be set by national supervisors to reflect jurisdiction-specific conditions.
 
In these cases, the parameters should be transparent and clearly outlined in the regulations of each jurisdiction.
 
This will provide clarity both within the jurisdiction as well as across borders.

In addition, supervisors may require an individual institution to adopt more stringent standards or parameters to reflect its liquidity risk profile and the supervisor’s assessment of the institution’s compliance with the Committee’s sound principles.

The liquidity coverage ratio identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute short-term stress scenario specified by supervisors.
 
The specified scenario entails both institution-specific and systemic shocks built upon actual circumstances experienced in the global financial crisis.
 
The scenario entails:

• a significant downgrade of the institution’s public credit rating;

 • a partial loss of deposits;

 • a loss of unsecured wholesale funding;

 • a significant increase in secured funding haircuts; and

 • increases in derivative collateral calls and substantial calls on contractual and noncontractual off-balance sheet exposures, including committed credit and liquidity facilities.

 As part of this metric, banks are also required to provide a list of contingent liabilities (both contractual and non-contractual) and their related triggers.
 
Liquidity coverage ratio - Objective
 
This metric aims to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors.
 
At a minimum, the stock of liquid assets should enable the bank to survive until day 30 of the proposed stress scenario, by which time it is assumed that appropriate actions can be taken by management and/or supervisors, and/or the bank can be resolved in an orderly way. The Liquidity Coverage Ratio (LCR) builds on traditional liquidity “coverage ratio” methodologies used internally by banks to assess exposure to contingent liquidity events..

 Net cumulative cash outflows for the scenario are to be calculated for 30 calendar days into the future.
 
The standard would require that the value of the ratio be no lower than 100% (ie the stock of liquid assets should at least equal the estimated net cash outflows).
 
Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high quality assets as a defence against the potential onset of severe liquidity stress.
 
Banks and supervisors are also expected to be aware of any potential mismatches within the 30-day period and ensure that sufficient liquid assets are available to meet any cashflow gaps throughout the month.
 
The scenario proposed for this standard entails a combined idiosyncratic and market-wide shock which would result in:

(a) a three-notch downgrade in the institution’s public credit rating;

 (b) run-off of a proportion of retail deposits;

 (c) a loss of unsecured wholesale funding capacity and reductions of potential sources of secured funding on a term basis;

 (d) loss of secured, short-term financing transactions for all but high quality liquid assets;

 (e) increases in market volatilities that impact the quality of collateral or potential future exposure of derivatives positions and thus requiring larger collateral haircuts or additional collateral;

 (f) unscheduled draws on all of the institution’s committed but unused credit and liquidity facilities; and

 (g) the need for the institution to fund balance sheet growth arising from non-contractual obligations honoured in the interest of mitigating reputational risk.

 In summary, the stress scenario specified incorporates many of the shocks experienced during the current crisis into one acute stress for which sufficient liquidity is needed to survive up to 30 calendar days.

 This stress test should be viewed as a minimum supervisory requirement for banks.

 Banks are still expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct scenarios that could cause difficulties for their specific business activities.
 
Such internal stress tests should incorporate longer time horizons than the ones mandated by this standard. Banks are expected to share these additional stress tests with supervisors.
 
The proposed standard should be a key component of the regulatory approach, but must be supplemented by detailed supervisory assessments of other aspects of the bank’s liquidity risk management framework in line with the
Committee’s Sound Principles.

The LCR consists of two components:

 A. Value of the stock of high quality liquid assets in stressed conditions.

 B. Net cash outflows, calculated according to the scenario parameters set by supervisors.
 
A. Stock of high quality liquid assets

 The numerator of the LCR is the “stock of high quality liquid assets”.
 
Under the proposed standard, banks must hold a stock of unencumbered, high quality liquid assets which is clearly sufficient to cover cumulative net cash outflows (as defined below) over a 30-day period under the prescribed stress scenario.

As supported by the Financial Stability Board in its September 2009 report to the G20, the LCR establishes a harmonised framework to ensure that global banks have sufficient high-quality liquid assets to withstand a stressed scenario (as set out in the LCR).

 In order to qualify as a “high-quality liquid asset”, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible.

Characteristics of high quality liquid assets

 The 2007-2009 crisis reinforced the need to examine carefully the liquidity of asset markets, and relatedly, the characteristics that allow some markets to remain liquid in times of stress.
 
Banks need to be careful not to be misled by the wide range of liquid markets during booms.
 
Assets are considered to be high quality liquid assets if they can be easily and immediately converted into cash at little or no loss of value.
 
The liquidity of an asset depends on the underlying stress scenario, the volume to be monetised and the time-frame
considered.
 
Nevertheless, there are certain assets that are more likely to generate funds without incurring large fire-sales even in times of stress.
 
This section outlines factors which influence whether or not the market for an asset can be relied upon to raise liquidity when considered in the context of possible stresses.

 During the consultative period and quantitative impact study, the Committee will analyse the trade-offs between the severity of the stress scenario and the definition of the stock of liquid assets which will be held to meet the standard.
 
The final calibration of the factors of the outflows and inflows, as well as the composition of the stock of liquid assets,
will be sufficiently conservative to create strong incentives for banks to maintain prudent funding liquidity profiles, while minimising the negative impact of its liquidity standards on the financial system and broader economy.
 
As such, the Committee is assessing the impact of both a narrow definition of liquid assets comprised of cash, central bank reserves and high quality sovereign paper, as well as a somewhat broader definition which could also include a
proportion of high quality corporate bonds and/or covered bonds.
 
The Committee will gather data on this defined range of asset classes to analyse the impact and trade-offs of various
options involved in defining the stock of high quality liquid assets.
 
The text below describes the general characteristics of high quality liquid assets and outlines the specific instruments
for which the Committee will collect data, along with information on haircuts currently associated with these assets in both normal times and periods of stress.

Fundamental characteristics

 • Low credit and market risk: assets which are less risky tend to have higher liquidity.
 
On the credit risk front, high credit standing of the issuer and a low degree of subordination increases an asset’s liquidity.
 
On the market risk front, low duration, low volatility, low inflation risk and being denominated in a convertible
currency with low foreign exchange rate risk all enhance an asset’s liquidity.

 • Ease and certainty of valuation: an asset’s liquidity increases if market participants are more likely to agree on its valuation.
 
A liquid asset’s pricing formula must be easy to calculate and not depend on strong assumptions.
 
The inputs into those pricing formula must also be publicly available. In practice this should rule out the inclusion of any exotic product.

• Low correlation with risky assets: the stock of high quality liquid assets should not be subject to wrong-way risk.
 
Assets issued by financial firms, for instance, are more likely to be illiquid in times of liquidity stress in the banking sector.

 • Listed on a developed and recognised exchange market: being listed increases an asset’s transparency.

Market-related characteristics

 • Active and sizable market: the asset should have active outright sale and repo markets at all times (which means having a large number of market participants and a high trading volume).
 
Market breadth (price impact per unit of liquidity) and market depth (units of the asset can be traded for a given price impact) should be good.

 • Presence of committed market makers: quotes will always be available for buying and/or selling the asset.

 • Low market concentration: diverse group of buyers and sellers in an asset’s market increases the reliability of its liquidity.

 • Flight to quality: historically, the market has shown tendencies to move into some types of assets in a systemic crisis.
As outlined by these characteristics, the test of the “high quality” of assets is that by way of sale or secured borrowing, their liquidity-generating capacity is assumed to remain intact even in periods of severe idiosyncratic and market stress: indeed such assets often benefit from a flight to quality in these circumstances.
 
Lower quality assets fail to meet that test.
 
An attempt by a bank to raise liquidity from lower quality assets under conditions of severe market stress would entail acceptance of a large fire-sale discount or haircut to compensate for high market risk.
 
That may not only erode the market’s confidence in the bank, but would also generate mark-to-market losses for banks holding similar instruments and add to the pressure on their liquidity position, thus encouraging further fire sales and
declines in prices and market liquidity.
 
In these circumstances, private market liquidity for such instruments is likely to evaporate extremely quickly, as evidenced in the current crisis.

 Taking into account the system-wide response, only high quality liquid assets meet the test that they can be readily converted into cash under severe stress in private markets.

 High quality liquid assets should also ideally be eligible at central banks.
 
Central banks provide a further backstop to the supply of banking system liquidity under conditions of severe stress.
 
Central bank eligibility should thus provide additional confidence that banks hold a reserve of high quality liquid assets that could be used in events of severe stress without damaging the broader financial system.
 
That in turn would raise confidence in the safety and soundness of liquidity risk management in the banking system.

Operational requirements

 This stock of high quality liquid assets must be available for the bank’s treasury to convert into cash to fill funding gaps at any time between cash inflows and outflows during the stressed period.
 
These assets must be unencumbered and freely available to the relevant group entities.
 
At the consolidated level, banks may also include in the stock qualifying liquid assets which are held to meet legal entity requirements (where applicable), to the extent that the related risks are also reflected in the consolidated standard.
 
The stock of liquid assets should not be co-mingled with or used as hedges on trading positions, be designated as collateral or be designated as credit enhancements in structured transactions, and should be managed with the clear and sole intent for use as a source of contingent funds.
 
The stock should be under the control of the specific function or functions charged with managing the liquidity risk of the institution.
 
A bank should periodically monetise a proportion of the assets in its liquid assets buffer through repo or outright sale to the market in order to test the usability of the assets.

 While the LCR is expected to be met and reported in a common currency, supervisors and banks should also be aware of the liquidity needs in each significant currency.
 
The bank should be able to use the stock to generate liquidity in the desired currency and in the jurisdiction in which the liquidity will be required.
 
As such, banks are expected to be able to meet their liquidity needs in each currency and maintain high quality
liquid assets consistent with the distribution of their liquidity needs by currency.

Definition of liquid assets

 The stock of high quality liquid assets should be comprised of assets which meet the characteristics outlined above.
 
The following list describes the assets which meet these characteristics and can therefore be used as the stock of liquid assets:

 (a) cash;

 (b) central bank reserves, to the extent that they can be drawn down in times of stress;

 (c) Marketable securities representing claims on or claims guaranteed by sovereigns, central banks, non-central government public sector entities (PSEs), the Bank for International Settlements, the International Monetary Fund, the European Commission, or multilateral development banks as long as all the following criteria are met:

 (i) they are assigned a 0% risk-weight under the Basel II standardised approach, and

 (ii) deep repo-markets exist for these securities, and

 (iii) the securities are not issued by banks or other financial services entities.

 (d) government or central bank debt issued in domestic currencies by the country in which the liquidity risk is being taken or the bank’s home country.
 
B. Net cash outflows

 Net cash outflows are defined as cumulative expected cash outflows minus cumulative expected cash inflows arising in the specified stress scenario in the time period under consideration.
 
This is the net cumulative liquidity mismatch position under the stress scenario measured at the test horizon.
 
Cumulative expected cash outflows are calculated by multiplying outstanding balances of various categories or types of liabilities by assumed percentages that are expected to roll-off, and by multiplying specified draw-down amounts to
various off-balance sheet commitments. Cumulative expected cash inflows are calculated by multiplying amounts receivable by a percentage that reflects expected inflow under the stress scenario.

 While most of these factors will be applied in a harmonised way across jurisdictions, there are a few select parameters for which each supervisory regime will determine the percentages to apply to banks in their jurisdiction.
 
In the latter case, parameters and factors need to be transparent and made publicly available.
 

The Net Stable Funding Ratio (NSFR)

The net stable funding (NSF) ratio measures the amount of longer-term, stable sources of funding employed by an institution relative to the liquidity profiles of the assets funded and the potential for contingent calls on funding liquidity arising from off-balance sheet commitments and obligations.
 
The standard requires a minimum amount of funding that is expected to be stable over a one year time horizon based on liquidity risk factors assigned to assets and off-balance sheet liquidity exposures.
 
The NSF ratio is intended to promote longer-term structural funding of banks’ balance sheets, off-balance sheet
exposures and capital markets activities.
 
Objective

 To promote more medium and long-term funding of the assets and activities of banking organisations, the Committee has developed the Net Stable Funding Ratio (NSFR).

 This metric establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon.
 
This standard is designed to act as a minimum enforcement mechanism to complement the liquidity coverage ratio standard and reinforce other supervisory efforts by incenting structural changes in the liquidity risk profiles of institutions away from short-term funding mismatches and toward more stable, longer-term funding of assets and business activities.

 In particular, the NSFR standard is structured to ensure that investment banking inventories, off-balance sheet exposures, securitisation pipelines and other assets and activities are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles.
 
The NSFR aims to limit over-reliance on wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across all onand off-balance sheet items.
 
In addition, the NSF approach would help to counterbalance the cliff-effects of the liquidity coverage ratio and offset incentives for institutions to fund their stock of liquid assets with short-term funds that mature just outside the supervisory defined horizon for that metric.
 
The NSF measure builds on traditional “net liquid asset” and “cash capital” methodologies used widely by internationally active banking organisations, bank analysts and rating agencies.
 
However, the proposed measure expands general industry conventions of these concepts to account for the potential liquidity risk of off-balance sheet (OBS) exposures and various types of maturity mismatches involved in short-term secured funding of long-dated assets that traditional forms of these measures may ignore.
 
The standard provides a comprehensive measure of liquidity risk exposure that acknowledges recent market difficulties, including the need to fund securities in trading inventories or securitisation pipelines in the face of illiquid markets.
 
In computing the amount of assets that should be backed by stable funding, the proposed methodology includes required amounts of stable funding for all illiquid assets and securities held, regardless of accounting treatment (eg trading versus available-for-sale or held-to-maturity designations) and with constrained assumptions regarding trading and securitisation inventory turnover.
 
In effect, portions of trading assets are required to be funded using stable funding sources based not on assumed execution turnover but on the relative liquidity characteristics of the positions held.
 
Additional resources funded by stable sources are also allocated to support at least a small portion of the potential calls on liquidity arising from OBS commitments and contingencies.

The NSF standard is defined as a ratio of available amount of stable funding to a required amount of stable funding.
 
This ratio must be greater than 100%.
 
“Stable funding” is defined as those types and amounts of equity and liability financing expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress.
 
The amount of such funding required of a specific institution is a function of the liquidity characteristics of various types of assets held, OBS contingent exposures incurred, and/or the activities pursued by the institution.
 
Definition of available stable funding

Available stable funding (ASF) is defined as the total amount of an institution’s:
 
1) capital;
 
2) preferred stock with maturity of equal to or greater than one year;
 
3) liabilities with effective maturities of one year or greater; and
 
4) that portion of “stable” non-maturity deposits and/or term deposits with maturities of less than one year that would be expected to stay with the institution for an extended period in an idiosyncratic stress event.
 
The objective of the standard is to ensure stable funding on an ongoing, viable entity basis, over one year in an extended firm-specific stress scenario where a bank encounters, and investors and customers become aware of:

 • A significant decline in profitability or solvency arising from heighted credit risk, market risk or operational risk and/or other risk exposures;

 • A potential downgrade in a debt, counterparty credit or deposit rating by any nationally recognised credit rating organisation; and/or;

 • A material event which calls into question the reputation or credit quality of the institution.

 For the purposes of this standard, extended borrowing from central bank lending facilities outside regular open market operations are not considered in this ratio, in order not to create a reliance on the central bank as a source of funding.

Definition of required stable funding for assets and off-balance sheet exposures.

 The amount of stable funding required by supervisors is to be measured using supervisory assumptions on the broad characteristics of the liquidity risk profiles of an institution’s assets, off-balance sheet exposures and other selected activities.
 
The required amount of stable funding is calculated as the sum of the value of the assets held and funded by the institution, multiplied by a specific required stable funding (RSF) factor assigned to each particular asset type, added to the amount of OBS activity (or potential liquidity exposure) multiplied by its associated RSF factor.
 
The RSF factor applied to the reported values of each asset or OBS exposure is the amount of that item that supervisors believe should be supported with stable funding.
 
Assets that are more liquid and more readily available to act as a source of extended liquidity in the stressed environment identified above receive lower RSF factors (and require less stable funding) than assets considered less liquid in such circumstances and, therefore, require more stable funding.

 The RSF factors assigned to various types of assets are parameters intended to approximate the amount of a particular asset that could not be monetised through sale or use as collateral in a secured borrowing on an extended basis during a liquidity event lasting one year.
 
Under this standard such amounts are expected to be supported by stable funding.
 
Except for “repo-like” transactions as defined in existing global capital standards issued by the Committee, all encumbered assets would also be expected to be fully supported by stable funding.
 
 
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Dear Member,
 
I invite you to join our Association. Membership is free, and there are many benefits.
 
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Join us.
 
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Best Regards,
 
 
George Lekatis
President of the Basel iii Compliance Professionals Association (BiiiCPA)
General Manager, Compliance LLC
1200 G Street NW Suite 800
Washington DC 20005, USA
Tel: (202) 449-9750
Email: lekatis@basel-iii-association.com
Web: www.basel-iii-association.com
 
   

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