IntroductionDue to the nature of the financial crisis, there is a greater emphasis on liquidity risk. As outlined by (Principles for Sound Liquidity Risk Management and Supervision, 2008) “Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses”.
There are several tools which can be used to ensure sufficient cover is in place, the one which will be discussed in this report is The Liquity Coverage Ratio (LCR), the limitations will be outlined and supporting metrics to aid in correct calculation will be discussed.Why the LCR was implementedAs outlined in the Basel report Principles for sound liquidity risk management and supervision (2008), the financial crisis which began in 2007, once more emphasized how important liquidity for banks and the financial sector is to function successfully. Prior to this, funding was readily available at limited cost. However, when the crisis hit, it highlighted how certain stock may become illiquid in a stressed environment over a prolonged period, this is what led to the Central Bank having to step in to assist.
It was a common feeling across financial institutions, that as liquidity were readily available that banks had failed to adhere to basic principles of the management of liquidity risk. As a direct result banks failed to implement sufficient frameworks to account for the liquidity of different products and business lines, so as the overall risk tolerance was misaligned. Also banks failed to conduct stress tests as had the view that liquidity would be plentiful and that the chance of a prolonged liquidity disruption occurring was minimum.Similarly, in Basel report titled Basel III: the net stable funding ratio (2014), outlined that with the previous requirements, banks who had set aside the correct capital requirements, they still experienced difficulties due to failing to correctly manage their liquidity. A key learning from the crisis is that previously funding was too readily available and when the financial crisis hit, that it emphasised how quickly liquidity could run out and it can take a prolonged time to return. As a result, the Committee developed 2 standards for assisting with funding and liquidity which would be used to aid in strengthening the liquidity framework; these are the LCR for maintaining short-term liquidity for 30 days and the NSFR for maintaining a longer-term liquidity of one year.LCRAs outlined by the CBOI (2011), “the LCR is a measure of short-term contingent liquidity risk”. It is used to calculate how much banks need to set aside in the short-term to ensure they have suffic2ient ‘high quality liquid assets’ (HQLA), which can be sold in the event of trouble in a stressed environment from exposures both on and off the balance sheet.
The aim of the ratio is to ensure that banks can sustain themselves in a 30-day stress scenario.When the need to use the LCR was first implemented in 2015 all the financial banks internationally was given time to fully implement meeting 100% liquidity as advised by the formula. A target minimum percentage was set out each year which needed to be adhered too, as you can see below, the minimum LCR requirements required by the 1st January 2019 is set at a minimum of 100% of the equation, so the onus is on ourselves to ensure we are setting aside the correct requirements or HQLA stock.
(Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013)The need for liquid stock to be held as outlined in Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, (2013) outline that if certain scenarios where to occur, banks would require easily accessible liquid stock to stay afloat, these factors include:The surplus of a proportion of retail deposits;A fractional loss of unsecured wholesale funding capacity;A fractional loss of short-term secured financing with certain collateral and counterparties;If the banks public credit rating downgraded by up to three notches due to additional contractual outflows;If the banks reputation was on the line they may buy back debt or honour non-contractual obligations to counteract the risk;Unscheduled draws on committed but not used liquidity and credit facilities that the bank provided to its clients;The increase in market volatilities that have an impact on the quality of collateral or the potential of future exposure of derivative positions and therefore require larger collateral haircuts or additional collateral or lead to additional liquidity needs.As set out in the report titled Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, (2013) advise that there are 2 necessary components to the formula:In stressed conditions, the value of the HQLA stock held, andThe total of net cash outflows- (see below for how calculated) (Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013)HQLAThe below information is taken from Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, (2013) who outline that a sufficient unencumbered HQLA needs to be retained to counteract the total cash outflows over a 30-day period, these need to meet certain standards to be classed as liquid with a minimum loss to value when converted to cash. Certain assets will retain their resale value better than others, even in times of poor economic downturn. The following will outline if the asset is likely to raise liquidity in times of stress:Fundamental characteristics Low riskEase and certainty of valuation Low correlation with risky assets.Listed on a developed and recognised exchangeMarket-related characteristicsActive and sizable marketLow volatilityFlight to qualityThere are 2 classes of assets that may be included as HQLA stock, these being ‘level 1’ assets which have no limit on value included and ‘level 2’ assets which can be included up to 40% of the value of stock. Level 2B assets can also be made up of up to 15% of the 40% level 2 assets.
Refer to Appendix 1 and Appendix 2 for examples of each type of ‘level’ asset and their associated percentages and the formula for the calculation of stock of HQLA.Total net cash outflowsThe denominator factor of the LCR formula is total net cash outflows, this is calculated by subtracting the total expected cash inflows from the total expected cash outflows in a specified stress scenario for the following 30 calendar days. Outflows are calculated by multiplying the businesses outstanding balances at the time of calculation by the rates they are expected to be charged based on the type of liability. Similarly, the inflows are calculated by multiplying the outstanding balances due to the business by the rates they are expected to be received under- however, there is an aggregate cap of 75% on the total expected cash outflows.However, to note, if an asset is included as part of the ‘Stock of HQLA’ the associated cash inflows from the asset cannot be counted as cash inflows to calculate the total net cash outflows i.
e. the denominator. An example of cash inflows which could be included would be:Secured lending, including reverse repos and securities borrowingCommitted facilitiesOther inflows by counterpartyAn example of cash outflows which could be included would be:Retail deposit run-offUnsecured wholesale funding run-offSecured funding run-offLimitations of LCRAs advised by Basel- Principles for Sound Liquidity Risk Management and Supervision (2008), no one metric can ‘comprehensively quantify liquidity risk.
‘ Therefore on its own LCR will not provide a comprehensive view of how much HQLA to set aside so other metrics would need to be used in conjunction with the LCR to give a true reflection. As outlined by Konig et al (2016), if minimum liquid assets are set aside as compulsory they may in fact become illiquid, this is known as the “Goodhart Critque”. It outlines that if HQLA cannot be considered liquid if they are bound by requirements.Because of being bound by regulation and fear of penalty, some banks might hoard liquid assets in stressful environments to ensure they are meeting the threshold requirements and therefore they may lose market value if held onto for too long.
NSFR ‘Net Stable Funding Ratio’Like the LCR, the NSFR is used to ensure there is sufficient funding in place to support banks if the stressed timeframe lasted for a period of one year. As set out in the CBOI (2011) discussion paper, they advise that ‘haircuts’ need to be applied to specific asset types depending on the characteristics of their liquidity. The part of the asset deemed to be illiquid must be made up of stable funding. Certain liquid assets are deemed as not requiring stable funding to reinforce them, these include cash, securities and loans to financial institutions due to expire within the subsequent year. All remaining assets will need a buffer of stable funding as part of them would be considered as illiquid. Stable funding can be made up of equity and/ or debt financing which are considered as a reliable source of funding of more than one year an example would be unsecured bank bonds with a maturity date of more than a year from date of inclusion.The formula for the NSFR is outlined below:(Basel III: The net stable funding ration, 2014)Available stable funding (ASF) is calculated based on characteristics of the stability of a banks source of funding, including its maturing contracts of liabilities. The value of ASF is calculated by assigning the value of the bank’s capital and liabilities to one of five categories called out in Appendix 3 below.
The corresponding amount assigned is multiplied by the ASF factor and the total is the sum of weighted amounts.Required stable funding (RSF) on the other hand is determined by the characteristics of the liquidity risk profile of assets and off-balance sheet exposures. It is calculated by associating the value of the assed to a category called out in Appendix 4 below. Like the ASF, the RSF is calculated by multiplying the amount assigned to the category by its associated RSF factor and adding it to the the sum of the weighted amounts of OBS activity multiplied by its associated RSF factor- refer to Appendix 5.Concentration of fundingAlthough there are several metrics discussed in Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools (2013), that can be used; these are called out below. For the purpose of this report it will outline the second one ‘Concentration of funding’. All have their own pros and cons, however, from review, this one appears the most beneficial to what we are trying to achieve.Contractual maturity mismatchConcentration of fundingAvailable unencumbered assetsLCR by significant currencyMarket-related monitoring toolsThe objective of the ‘concentration of funding’ metric is to identify and highlight the sources of wholesale funding that may cause liquidity problems if they were withdrawn from and to promote the correct diversification of funding sources.
The ‘Definition and application of the metric’ is below: (Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013)Significant counterparties – calculated by combining the total of all types of liabilities to a single/ group of connected or affiliated counterparty which account for more than 1% of banks total balance sheet when combined.Significant instruments/ products – single or group instrument/ product that combined account for more than 1% of total balance sheet. Significant currencies- if total combined liabilities in that currency accounts for 5% or more of total liabilities.Time buckets- should be reported separately in periods of less than one month, 1-3 months, 6-12 months and more than 12 months.
This metric is to be used as an average as in some cases it is difficult for certain types of debt to identify the actual funding counterparty, therefor, the concentration of funding sources might be greater than outlined by the metric. This metric should be used to highlight further discussions with the bank rather than outlining a snippet of the potential risks.How all interactAs outlined in Basel III: The net stable funding ration (2014), the LCR and NSFR was developed as minimum standards for funding and liquidity, which were created to achieve two different but complementary goals.
Further to this, the committee also created a set of monitoring tools to measure liquidity in other areas of the banks liquidity and funding risk profile. These monitoring tools such as the ‘concentration of funding’ metric as discussed above are supplementary to not only the LCR but also the NSFR. All three metrics aim to achieve the same thing; to ensure banks have sufficient liquidity in times of financial crisis.ConclusionIn conclusion, the LCR is now a regulatory requirement and must be adhered to or face penalty, it does have limitations, some of which are outlined above, however, these can be minimised, and a more accurate picture calculated with the use of additional metrics such as but not limited to the NSFR and concentration of funding metric. From research for this report, these are the metrics I propose the bank to be use simultaneously going forward to ensure at a minimum the regulations for setting aside HQLA is met.
AppendixAppendix 1Summary of LCR asset inclusion (Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013)Appendix 2The formula for the calculation of the stock (Level 1, Level 2 and Level 2B) of HQLA is as follows:(Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, 2013)Appendix 3The below table is a summary of the components off each ASF category and the associated maximum ASF factor to be applied when calculating an institutions total amount of ASF under the standard.(Basel III: The net stable funding ratio, 2014)Appendix 4 Appendix 5Bibliographyyeshttps://www.bis.org/publ/bcbs238.pdfBasel Committee on Banking SupervisionBasel III: The Liquidity Coverage Ratio and liquidity risk monitoring toolsJanuary 2013https://www.centralbank.ie/docs/default-source/publications/discussion-paper-1/review-of-the-requirements-for-the-management-of-liquidity-risk.pdf?sfvrsn=4 Central bank of IrelandReview of the Requirements for the Management of Liquidity RiskOctober 2011https://www.diw.de/documents/publikationen/73/diw_01.c.534668.de/diw_econ_bull_2016-21-3.pdf Design and pitfalls of Basel’s new liquidity rulesPhilipp König, and David Pothier2016Pg 255 and 256https://www.eba.europa.eu/regulation-and-policy/liquidity-risk/defining-liquid-assets-in-the-liquidity-coverage-ratio EBA European banking authorityhttps://www.eba.europa.eu/documents/10180/807776/20121002_BSG_Liquidity_Paper_incl_amendment.pdf A Position Paper by EBA’s Banking Stakeholder GroupNew Bank Liquidity Rules: Dangers Aheadhttps://ems.iob.ie/EMS-API/utility/file/3117382/0eeb917dd0e26de28b404ac505cd6abd Basel Committee on Banking SupervisionBasel III: the net stable funding ratioOctober 2014https://ems.iob.ie/EMS-API/utility/file/3117379/6ffbe5bdd59fa5b72ef3b128e6768096 Basel Committee on Banking SupervisionPrinciples for Sound Liquidity Risk Management and SupervisionSeptember 2008https://ems.iob.ie/EMS-API/utility/file/3117380/8cb7c841f570972706012f158ac0cae6 CRR The Liquidity Delegated Act Oct 2014https://ems.iob.ie/EMS-API/utility/file/3492864/37c9757847cbe765a33b72e6925d268a MOORAD CHOUDHRYStrategic ALM and Integrated Balance Sheet Management: The Future of Bank Risk Managementhttps://ems.iob.ie/EMS-API/utility/file/3117388/d2aed96987dc7209eca174f2114ac5fe Central Bank of Ireland MARCH 2011 The Financial Measures Programme ReportMarch 2011