Dealing with new liquidity rules

The new Basel III liquidity requirements have been criticised in some quarters. Understanding them, and the framework that has been put in place to ensure stability, requires a little new understanding

Author: Enrique Núñez-Escudero, Chairman, Shirebrook Commodities; Victor Fenton Navarro, Independent Analyst
November 5, 2012

Liquidity risk has been studied for a long time. Gap analysis, for example, goes back more than 50 years. Many different ratios and indices have also been used in time, without any of them having been set as an industry standard. Liquidity is one of the most difficult risks to measure because of its complexity. Almost three years ago, in December 2009, the Basel III international framework for liquidity risk measurement was introduced, including new liquidity and leverage ratios meant to become standard benchmarks. Although during this period much of the implied disaggregation has been completed by banks and regulators of many countries, there is still a long way to go, and many problems yet to solve.

The inclusion of two new liquidity ratios within Basel III has been the cause of some criticism, that ranges from arguing that banks are the natural transformation agents of terms and that liquidity gaps cannot be fully matched, to questioning the credit constrains that these measures could imply, or the economic impact of making long-term financing more difficult to concede, and rising the price of it. This might increase capital requirements, and restrict loans to some economic sectors, changing the role that banks play in the economy and passing some of the risks they take on to their respective nations.

Safety net
The Liquidity Coverage Ratio (LCR) is designed to ensure banks have enough high-quality, liquid assets to survive a 30-day period under stressed conditions. This ratio is scheduled to be computed with a regulatory minimum level in 2015. The main difficulty has been to reach a consensus on what is liquid and to what extent. Very specific and disaggregated information about incoming and outgoing flows of cash is required to compute this new ratio, forcing banks to implement new processes and costly systems. The possible sanctions for those banks that cannot or will not meet the requirements are up for discussion soon.

There are two categories of liquid assets, Level 1 and Level 2 assets, which qualify for the numerator of the ratio. Despite concerns that the definition of liquid assets, even including the new Level 2 category, was overly restrictive and may create unintended risks as a result of the market effects of demand for qualifying assets, and resulting asset concentrations, the Basel Committee on Banking Supervision (BCBS) has not made significant changes to the types of assets that qualify. There is little evidence that the BCBS has taken either market-focused comments or the current discussions about government bond markets into account. The BCBS has also addressed the concern about banks holding a heavy concentration of these narrowly defined liquid assets; moreover, it has stipulated additional criteria that may narrow applicable assets.

The second liquidity measure proposed by Basel III is the Net Stable Funding Ratio (NSFR), scheduled for January 2018, meant to eliminate mismatches between funding and lending by establishing a minimum acceptable amount of stable funding based on the liquidity characteristics of a firm’s assets and activities over a one-year horizon. This latter quotient is some distance away from being ready for implementation. It is defined as the available amount of stable funding divided by the required amount of stable funding, with a mandatory minimum of one. Some illiquidity factors, or risk weights, are assigned to each asset type, with those assets deemed to be more liquid receiving a lower factor and therefore requiring less stable funding.

Some preliminary considerations have already been made to assign these weights or factors, some of them are hypothesis that make sense to regulators but that have not been fully tested. For example, the assumption that clients of the banks will bring more stable deposits the more tied they are with the financial institution, measured in the number of products that they use, is an unfounded conclusion since these clients do not necessarily leave their funds for larger periods of time.

The same goes for supposing that the lower interest rate paid in the deposits, the longer they last. More in-depth studies have yet to be made, based on statistically well proven arguments. For example, just looking at the series of differences of portfolio balances at two established periods of time (for example one year apart) helps to see the largest decrements and simply, to count the number of days that the deposits have not been smaller than some thresholds. Something a little bit more elaborate would be to adjust a probability density to these series, useful to estimate the maximum reasonable loss of resources, and also, a small quantity of these densities would be a better basis for estimating the illiquidity factors of each portfolio.

Filling in the gaps
Since the appearance of the liquidity proposals, the Basel committee has applied studies called Quantitative Impact Studies (QIS), with evolving weights or factors that have shown that too many banks in the world are still far away from reaching the required liquidity levels. These factors still have to be refined in time.

The Basel Group of Governors and Heads of Supervision (GHOS), said in their meeting back in January that, “the aim of the Liquidity Coverage Ratio is to ensure that banks, in normal times, have a sound funding structure and hold sufficient liquid assets such that central banks are asked to perform only as lenders of last resort and not as lenders of first resort. While the Liquidity Coverage Ratio may represent a significant challenge for some banks, the benefits of a strong liquidity regime outweigh the associated implementation costs.”

Better liquidity undoubtedly can make a bank last longer in times of trouble, but enhancing the liquidity of banks might only make them slightly stronger at a high cost, not enough to resist the mayor liquidity problems produced by macroeconomic disturbances.

Having to match gaps between assets and liabilities tends to be expensive, because issuing long-term debt is costly, and the worst is that the increase in price would probably become permanent. The new regulations will increase capital requirements and drive up capital as well as liquidity costs increasing pressure on banks. Generally, banks will experience increased pressure on their Return on Equity (RoE) due to increased capital and liquidity costs, and higher Risk Weighted Assets (RWA). Some banks might find ways to increase their efficiency and profitability, but others won’t, and if their profitability goes too low there would be no interest in running them or they would need to increase their credit prices, becoming less competent or closing with them opportunities for many companies and countries, with no guarantee that those measures would at the end benefit the financial systems.

Trying to protect banks and their financial systems from the consequences of illiquidity sounds reasonable, but this has to be done carefully and taking into account some practical considerations like seeing that normal fluctuations in liquidity to some extent do not need to be hedged because natural systematic corrections happen. Not doing so might cause some undesirable economic impacts and produce more illiquidity problems by themselves.

The potential impact of Basel III on the banking system is significant, so BCBS and regulators of countries around the world have to be very cautious in setting these new rules, based on well-tested arguments, that allow a balance between stronger financial systems and reasonable profitable banking institutions able to provide the services that society needs.