Basel III Liquidity Coverage Ratio: key component of the framework for liquidity risk
The 2007-2008 financial crisis underlined the weakness of the regulatory framework guaranteeing the stability of the financial system. Indeed, while regulations such as Basel II ensured that banks had sufficient capital to absorb potential losses, no strict rule existed to prevent liquidity crises.
The Basel committee addressed this issue in 2010 by introducing liquidity requirements via its Basel III regulatory framework for liquidity. In this regard, the LCR was one of the components newly introduced. The idea behind the LCR is simple: it guarantees that banks have sufficient High Quality Liquid Assets (HQLA) to meet their liquidity needs during a 30-day stress scenario. This stress scenario gathers a series of shocks that impact negatively the liquidity of a bank and which potentially arise during crises such as massive withdrawals by customers, difficulty to roll-over financing, etc.
The LCR is defined as "The Stock of HQLA" divided by "The total net cash outflows" over a 30-day stress period and should equal or exceed 100% under the third Basel accord:
High Quality Liquidity Assets
An HQLA is defined as an asset which can be easily transformed into cash at little or no loss of value. Basel III distinguishes different levels of assets:
- Level 1 assets are considered the most liquid and can be included in the stock of HQLA without restriction. They include cash, certain central bank reserves and other securities issued or guaranteed by sovereigns or other international organizations and qualify for a 0% risk-weight under Basel II standardized approach for credit risk.
- Level 2A and Level 2B assets consist in riskier and less liquid securities issued by public sector entities and certain private sector entities. They can only represent 40% of the total stock of HQLA. Level 2A is subject to a 15% haircut. Level 2B assets are limited to only 15% of the stock and can be included only at the discretion of the national supervisor.
In addition, these assets must be unencumbered and readily convertible into cash which means these assets are free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer or assign the asset at any time.
Total net cash outflows
The total net cash outflows is the difference of the expected cash outflows and the expected cash inflows. It is a measure of the cash that a bank would need during 30 days of a stress scenario.
The expected cash outflows are calculated by multiplying the outstanding balance of certain liabilities (e.g. Retail deposits) and off-balance sheet commitments by their run-off rates which depict the proportion of these accounts that would be drawn away in case of crisis.
These run-off rates are calibrated according to the assumed stability of the source of funding. This stability considers factors such as:
- The protection offered by government or public guarantee schemes
- The length of client or other relationships with the bank
- Purpose of the account (e.g. transactional or savings, operational relationship or not)
The run-off rates are ranging from 3% to 100%.
The expected cash inflows are calculated by multiplying the outstanding balances of several categories of contractual receivables by the rates at which counterparties are assumed to make payments to the bank during the 30-day stress period. The Basel III accord requires the total expected cash inflows to be limited to a maximum of 75% of the total expected cash outflows. Therefore, a bank's stock of HQLA will always exceed 25% of its total expected cash outflows.
The Basel Committee monitors every 6 months the progress done by banks in order to comply with the Basel III principles. They have regrouped banks into Group 1 banks and Group 2 banks. Group 1 banks group together banks which have Tier 1 capital in excess of €3 billion and which are internationally active. All other banks are considered Group 2 banks.
In their last report using data from December 2012, Group 1 banks had an average LCR of 119% while Group 2 banks had an average LCR of 126%. Besides, 68% of the banks already meet or exceed the 100% minimum requirement and 90% of them meet or exceed the 60% minimum requirement.
The aggregate LCR shortfall at a minimum requirement of 100% (60%) was €563bn (248bn), which represents approximately 0.9% (0.4%) of the €63.1 trillion total assets of the aggregate sample.
The report also shows that Group 1 banks have higher cash outflows, in percentage of balance sheet liabilities, than Group 2 banks (19.3% vs 13.4%). This trend may be partially explained by the greater reliance of Group 1 banks on wholesale funding activities and commitments which are considered less stable.
In conclusion, the LCR will measure the short-term resilience of the liquidity risk profile of banks by ensuring that banks have sufficient liquid assets during stress period. Therefore, it could improve the banking sector's ability to absorb shocks arising from financial and economic stress and prevent from crises. A large part of the banks monitored have reached the necessary stock of HQLA to be in line with the 60% requirement which will be established as of the 1st of January 2015.
Different actors fear that the LCR will lead to market distortions due to a change in banks' demand for specific assets. In Europe, discussions are led by the European Banking Authority to prevent these potential distortions, especially when it comes to the definition of an HQLA. Further refinements in the specifications of the LCR could thus be expected in the future.