Basel III Liquidity Standards: Restructuring on the Way
In the aftermath of the financial crisis, the Basel Committee for Banking Supervision (BCBS) introduced two new standards to strengthen the resilience of the financial industry against liquidity shocks. We look in this article at the challenges revealed by the last BCBS monitoring report and the significant business and operational adjustments that a number of banks have made -- or have yet to complete -- to meet the regulatory targets effective in 18 months.
Highlights of the last BCBS monitoring exercise
BCBS has been monitoring the effect of their revised liquidity rules semi-annually from December 2012 for the LCR and December 2013 for the NSFR, using confidential and voluntary reporting from individual banks.
An overall positive outlook
The last monitoring report, based on data as of June 2015 and published in March 2016, provides an overall positive outlook:
- All banks complied with the 2015 LCR target of 60%.
- More than 80% of the banks complied with the 100% target, for both ratios.
- The aggregate industry LCR and NSFR reached 122% and 112% respectively.
- The average ratios of large international banks stood comfortably above the 100% target.
However, a comparative look at the LCR and NSFR improvement trends reveals a more nuanced picture.
NSFR: a bigger challenge
Four metrics, presented below, point to a sluggish improvement of the NSFR. While banks seem to be cruising steadily towards “LCR-compliance”, their NSFR progression appears less significant and potentially at a stagnation point for a number of banks.
The NSFR challenge
The slower pace of improvement of the NSFR is not surprising.
First, as a structural ratio looking at the matching between assets and liabilities -- i.e. uses and sources of funding, the NSFR is by design more complex to manage than the LCR.
Second, the NSFR calculation rules set by Basel structurally penalise certain business models:
- Capital markets activities generating derivatives/non-HQLA exposures financed by short-term market-based funding -- such as repos, the most popular source of liquidity before the crisis
- Long-term lending financed by short-term funding
The most obvious improvement lever is to replace short-term funding by equity and/or longer term debt. However, this does not come cheap:
- The end of the “too big to fail” era and implicit government back-ups as well as the regulatory “bail-in” powers -- debt conversion into equity -- granted by recovery and resolution regimes are putting upward pressure on banks’ cost of debt.
- Raising equity -- the most expensive source of funding -- and allocating it to assets that put little pressure on funding requirements deteriorates the return on equity due to the low yields offered by those assets.
Banks falling short of meeting the NSFR requirement are thus pushed to consider more transformational adjustments, with significant impacts on business and operating models.
Business and operational implications of the NSFR
As illustrated below, banks with substantial capital markets/long-term lending activities having structural difficulties progressing towards the 100% target are incentivised to reposition their business mix in favour of deposit-taking and short-term lending activities.
The impacts on operating models go beyond the system and process upgrades required to compute, report and monitor the ratio. The most sweeping implications arise from the need to consider liquidity standards at sub-consolidated level.
Though Basel standards only require banks to comply with the NSFR requirement at consolidated level, they recommend that banks monitor their liquidity and match maturities at entity and currency level, to take into account the non-convertibility of currencies and liquidity transfer restrictions during periods of stress.
In addition, local recovery and resolution regimes call for banks to be locally self-sufficient to mitigate contagion risks arising from financial interconnectedness between affiliated entities. Those risks are increased when liquidity is pooled and redistributed from a central treasury hub.
To comply with the above, banks may have to rebalance their sources and uses of funding between entities, for instance by integrating “ASF-heavy” structures -- e.g. deposit-rich Private Banking entity -- with “RSF-heavy” structures -- e.g. CIB entity encumbered by derivatives and non-HQLA instruments.
Banks have remained to date relatively discrete about their NSFR and the actions taken to move towards compliance. Only 10% of the G-SIB have published their ratio in their 2015 filings and none have disclosed their plans, with some notable exceptions:
- Goldman Sachs’ Chief Strategy Officer declared4 that the acquisition of a $16 bn book of deposits from GE Capital and the subsequent launch of the online savings platform GSBank.com, aimed at broadening their sources of funding.
- HSBC disclosed in their 2015 annual report the implementation of a new liquidity framework introducing the establishment at operating entity level of minimum LCR and NSFR requirements that will depend on the “inherent liquidity risk categorisation” of the entity.
While the purchase of HQLA to reach “LCR-compliance” might seem like a relatively simple exercise, the NSFR may necessitate drastic and complex adjustments, such as business mix rebalancing or legal entity restructuring. For banks that have yet to meet the requirement, such structural work must be completed within the next 18 months, before the rule becomes effective.
1. Basel Committee on Banking Supervision, “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools”, January 2013
2. Basel Committee on Banking Supervision, “Basel III: The Net Stable Funding Ratio”, October 2014
3. Basel Committee on Banking Supervision, “Basel III Monitoring Report”, September 2014, March 2015, September 2015 and March 2016
4. The Financial Times, “Goldman Sachs opens to the masses”, April 2016
5. Bloomberg, “Why Goldman Sachs Is Launching an Online Bank”, April 2016
6. FitchRatings, “Fitch Reviews Global Trading and Universal Banks”, June 2016
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