Basel III—Liquidity Standards IIF Preliminary Analysis

December 2010

Headlines Liquidity Coverage Ratio Net Stable Funding Ratio Monitoring Tools Implementation Annex 1—Liquidity Coverage Ratio Detailed Template Annex 2—Net Stable Funding Ratio Detailed Template
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Today, the Basel Committee on Banking Supervision (BCBS) released the final text of the new Basel III framework, containing global regulatory standards on banks capital adequacy and liquidity agreed by the Group of Governors and Heads of Supervision. Also published today were the Results of the Comprehensive Impact Study and Guidance for National Authorities Operating the Countercyclical Buffer. The full text of these documents can be found at The BCBS published its original Basel III proposals in December 2009. Subsequently, the Group of Governors and Heads of Supervision published press releases on July 26 and September 12, 2010, outlining key decisions and revisions of the original proposals. The IIF commented extensively on all stages of this process The IIF has undertaken a quick analysis of the final standards published today. Below we present our initial assessment of the liquidity standards, focusing in particular on what we believe are the main issues and the most salient changes regarding the original proposals and the July and September 2010 decisions. The reader should note that these comments reflect a first reading of the new language, and have not had the benefit of discussions with members. Comments are therefore tentative and subject to correction and amplification as more analysis is done. We hope this document is useful as you navigate through the complex new set of regulatory standards. In the coming days and weeks the IIF will produce additional analysis of the Basel III framework. The IIF Regulatory Team

David Schraa Questions or comments regarding this publication may be addressed to: +1.202.857.3312 Stefano Mazzocchi +1.202.857.3309

Andrés Portilla +1.202.857.3645 Jermy Prenio +1.202.682.7455 Dave Sunstrum +1.202.857.3615

Global Regulatory Update and other IIF publications are available on the Institute’s website:

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.

Operational Requirements: The BCBS has provided a new definition of “unencumbered”: the asset cannot be pledged to secure. Cooperative Banks: Both the NSFR and LCR now contain specific provisions for cooperative banks that are required to hold deposits at central institutions. . and loans from financial institutions are some of the areas where the BCBS revised its initial proposals to make the treatment of flows more balanced. In this case the BCBS readily acknowledges that the impetus for such treatment is to reduce interconnectedness and the likelihood of contagion during a crisis. the BCBS has placed a cap that limits the amount of inflows to 75% of the cash outflows. with a fee to reflect a yield comparable to other liquid assets. Credit Ratings: In a move that goes against the current initiatives to reduce dependence on credit ratings (e. the disfavored treatment of financial institutions has not changed. despite the argument that unencumbered assets anywhere in the institutions may become available for liquidity purposes in an emergency. and will do a QIS with midyear and year-end 2010 data to monitor the effects of the current format and capture any unintended consequences. Pillar 1 ratios that will be implemented according to the timeline provided earlier in the year – LCR becoming binding in January 2015.. FSB).. There is no information on what disclosure policy could be. Capping Cash Inflows: In order to ensure a firm does not rely solely on cash inflows to fulfill its LCR requirement. instead of basing runoff factors and haircuts on experience. collateralize. Dodd-Frank.g. bank are extremely limited. Firms can 1) set up committed liquidity facility lines with the central bank. subject to additional haircuts. Exceptions may be made in jurisdictions where the assets accepted by the central IIF. Potential Changes: The BCBS remains open to changes to the ratios during implementation based on observation of the performance of the ratios prior to their becoming binding. the BCBS took steps to make the treatment of funding more symmetrical when comparing outflows and inflows. The requirement that assets available for the buffer must be controlled by treasury (or equivalent) has not been changed. Both Level 1 and Level 2 assets “ideally” should be central bank eligible. secured funding. unless part of reverse repo or securities borrowing transaction (there is also an exception made for assets pledged to a central bank or public sector entity (PSE) but not used). NSFR becoming binding in January 2018. the definition of Level 2 liquid assets and the required stable funding factor for corporate bonds still relies on external credit ratings. Symmetry: Addressing an issue raised by many observers. clarifying how the rules would work for this special structure. as funding from firms classified as such is still heavily penalized. even in a crisis scenario. There is no mention of a consultative process. Liquid Assets and Central Bank Eligibility: The criteria for inclusion as Level 1 and Level 2 assets in the LCR have not changed very much from the July 26 press release. in addition to the previous requirement that the assets be highly liquid. the document pledges to develop alternative sources of information on the stability of these instruments during the implementation process to reduce the ratios’ credit rating reliance. Firms must begin reporting the ratios. or 3) allow Level 2 assets above the current 40% threshold. However. the IIF included. Treatment of Financial Institutions: However. guaranteeing that firms must cover 25% of anticipated outflows with liquid 2 Basel III—Liquidity Standards Headlines Ratios: Both the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) retain their original design as binding. or credit enhance any transaction. All rights reserved. 2) use liquid assets denominated in a foreign currency. so that related liquidity doesn’t disappear from the analysis at the systemic level. Reverse repos. Inc. Insufficient Liquid Assets: The BCBS proposes three different approaches for jurisdictions that do not have enough Level 1 or Level 2 liquid assets to meet the standards. but a footnote makes it appear that the expectation under most circumstances would be high liquidity and central-bank eligibility. in January 2012 – a slight delay from the original reporting date for the LCR of January 2011. The Institute of International Finance. com © Copyright 2010. along with the underlying components.

will still not qualify as Level 2 assets. a firm would marshal all available liquidity across the firm in order .” This is notable. the guidance had only stipulated that the assets be unencumbered and available to the treasurer. The BCBS has now clarified this benchmark – this 40% total is not calculated on the total amount of Level 1 assets. such as bidask spread. Level 2 assets now have a specific quantitative benchmark to prove they are reliable during stressed conditions: a maximum price decline (or increase in haircut) over a stressed 30 day period not exceeding 10%. The BCBS is also looking for ways to move away from the current use of external credit ratings as part of the criteria for liquid assets. and resulting asset concentrations. The specific assets defined as liquid. The measure has undergone numerous revisions of detail from its original conception in December 2009. assets pledged to CBs and PSEs but not used. and the percent of funds flowing in and out as a result of the crisis are all set in the standards. it has stipulated additional criteria that may narrow applicable assets. Another open issue the BCBS addresses is establishing operational requirements for liquid assets. as follows: • assets must be managed with the “clear and sole intent for use as a source of contingent funds”. There is little evidence that the BCBS has taken either market-focused comments or the current travail in government bond markets into account. there are numerous restrictions. as many market participants made the case that. and turnover. or designated for operational costs. but the amount of net Level 1 assets taking into account the impact of secured funding transactions unwinding within the 30 day window that would involve the exchange of a Level 1 asset for a non-Level 1 asset. and not co-mingled with or used as hedges on trading positions. • not pledged to secure. All rights reserved. will be tested. their respective haircuts. was overly restrictive and may create unintended risks as a result of the market effects of demand for qualifying assets. in a crisis as severe as the one prescribed by the BCBS. firms could be vulnerable to cliff effects due to a sudden downgrade or change in market liquidity: firms are now allowed to include downgraded assets for 30 days after the asset no longer qualifies. other restrictions regarding eligibility are also still in place. or creditenhance any transaction. While the language now acknowledges the importance of central-bank liquidity. designated as collateral or credit enhancement. which are centralIIF. strict Pillar 1 ratio. com © Copyright 2010. bank eligible in some jurisdictions. and are detailed in Annex 1. to give sufficient time to liquidate holdings. As well. volume. with banks holding a heavy concentration of these narrowly-defined liquid assets. Inc. The document provides an exception for jurisdictions where central banks accept a very limited range of assets – in these places Level 1 and 2 assets can qualify as long as they fulfill all the other eligibility criteria. collateralize. • The operational requirements also maintain an early provision that the stock be “under control of the… functions charged with managing the liquidity risk of the bank. In addition to the liquidity requirement. The BCBS has also addressed the concern that. Both Level 1 and Level 2 assets should “ideally” also be eligible for intraday or overnight liquidity facilities at central banks. Despite concerns that the definition of liquid assets. which qualify for the numerator of the ratio. Level 1 and Level 2 3 Basel III—Liquidity Standards Liquidity Coverage Ratio The LCR is a ratio meant to ensure that the firm has enough unencumbered liquid assets to cover a short term crisis based on a predetermined set of cash inflows and outflows established by the BCBS. The Institute of International Finance. so own-issued covered bonds and self-securitizations. but is still fundamentally the same. Liquid Assets (paragraphs 21-49) There are two categories of liquid assets. It had been previously established that Level 2 assets could only make up 40% of the total stock of liquid assets. Moreover. even including the new Level 2 category. During the observation period numerous measures. the BCBS has not made any changes to the types of assets that qualify. Whereas it is now explicitly allowed for firms to hedge the price risks of liquid assets. ο exceptions – assets received by reverse repo and securities-borrowing transactions. There is now considerable more detail. Previously. cumulative requirements of high liquidity and central-bank eligibility will not meet the substance of the industry’s comments that greater credit should be given for central-bank eligible assets.

whose special structures would have been heavily penalized by the original proposals. • Must be done with freely and reliably convertible currency. . as the Institute had repeatedly urged the BCBS to consider.” This responds to comments about the lack of clarity between “credit” and “liquidity” facilities. To determine which jurisdictions fall into this category. stating that a liquidity facility is “any committed. definitions. • Irrevocable. but without a great deal of definitional detail. the document stresses in paragraph 18 that IIF. and (b) what products will be caught by the “liquidity” definition. com © Copyright 2010. Prime brokerage and correspondent banking accounts are explicitly disallowed from receiving the “operational” designation. a prescriptive quantitative threshold will be developed during transition. with higher haircut. there are three potential remedies: Option 1 – contractual committed liquidity facilities from the CB. Option 2 – use foreign currency liquid assets: • Regulators would ease currency match requirement currently in place for the LCR. the runoff is now net of any Level 1 or Level 2 assets posted as collateral. • Firm must take into account risks in FX market. The BCBS recognizes that some jurisdictions will not have enough assets that qualify for Level 1 and Level 2 to make up the buffer AND keep a deep active market. It is still not entirely clear (a) whether the definition is workable in practice. central banks and PSEs are assumed to maintain funding during the crisis. The Institute of International Finance. Clearing. but with a 15% haircut. undrawn backup facility put in place expressly for the purpose of refinancing the debt of a customer in situations where such a customer is unable to obtain its ordinary course of business funding requirements in the financial markets. though detailed. with possibly qualitative criteria as well. This factor only applies to operational deposits which exist to maintain minimum requirements and are in place as pooled task-sharing funds. Equities are still not recognized as being a source of any stable secured funding during a short term crisis. and it is stipulated that only the funds which directly meet these operational requirements – and no excess funds in the same account – will be eligible. which get radically different treatment (10% and 100% respectively). The BCBS has also addressed the concerns of cooperative banks. There is still a heavy emphasis on retail and SME deposits. • Maturity date outside 30-day window. and custody are all given generic. This change reflects the reality that such entities are unlikely to withdraw funding from the market during the prescribed crisis. the BCBS has left in place the allowance for national discretion on all other contingent funding liabilities. cash management. The document also goes into detail defining what constitutes “operational relationships” with other financial institutions – this was necessary following the July announcement that deposits from financial firms for operational reasons would be given a 25% runoff requirement. funding from domestic sovereigns. for example. Inc. so short term funding from these bodies backed by non-liquid assets is given a 25% runoff. Deposits in institutional networks of cooperative banks have been given a 25% runoff factor. As well. Working capital facilities are explicitly excluded. The document also attempts to delineate between credit and liquidity facilities more clearly. Option 3 – use Level 2 assets in place of Level 1 assets. A 100% runoff is given to derivative payables. on a first glance. Cash Outflows (paragraphs 54-104) The BCBS has not made serious changes to the outflow assumptions that were originally proposed in December 2009 and slightly tweaked earlier this year – the final numbers can be found in Annex A. presumed to be highly stable funding. and addresses the Institute’s contention that such facilities would not be withdrawn. instead of the previous 100%. For the draws on credit and liquidity facilities. Short-term funding backed by Level 2 assets is able to be rolled over. it appears to catch CP and municipal backup lines. such as trade finance and letters of 4 Basel III—Liquidity Standards to remain healthy. All rights reserved. for a fee: • Fee must reflect equivalent yield for level 1 & 2 assets. While this may be a fragmentation issue going forward. and punitive runoff rates for financial-institution funding in order to reduce interconnectedness and prevent contagion. Finally. There have not been significant changes made to the off-balance sheet assumptions. The framework for secured funding has also been revamped. Once the designation is made.

Much like the LCR. 0% runoff for Level 1 and 15% runoff for level 2. and fixing any major issues during the observation period. and PSEs can be included in the 50% ASF factor bucket along with non-financial corporates. Cash inflows in excess of 75% of the total cash outflows calculated by the firm will not count towards the LCR – a new development in the Basel liquidity regime. following the same definition given for liquid assets in the LCR. and increased the odds of consistent implementation across jurisdictions. and PSE debt with a maturity of greater than one year is included in the denominator in the new language. As well. the NSFR depends upon a predetermined set of run-off factors for different categories of funding. operational deposits with other financial firms (including those from cooperative banks to the centralized institution) are given a 0% inflow rate. Also like the LCR. The full structure of the ratio can be found in Annex 2. which should help industry participants monitor implementation. Previously included in the 0% required factor bucket were secured funding arrangements that are assets of a bank maturing within one year. and to guarantee a firm has a minimum amount of liquid assets at its disposal. and mandates that the amount of “available stable funding” a firm has must match the stable funding required for its assets. This restriction is to ensure a firm does not depend solely on inflows in a crisis. That being said. The only major change here from previous releases is that the BCBS has clarified that funding from domestic sovereigns. Inc. and gives a haircut for each accordingly. Required Stable Funding (paragraphs 129-136) The BCBS also delineates different types of assets by stability. and stipulates how much stable funding is required for each type. These new details have helped to increase the symmetry of treatment of many types of funding in the ratio. If these securities are given a risk weight of 20%. Net Stable Funding Ratio The NSFR is a long-term ratio that measures how much stable funding a firm has to endure a year-long liquidity crisis. central banks. The BCBS seems intent on beginning implementation as 5 Basel III—Liquidity Standards these parameters “should be transparent and clearly outlined” by regulators. the minimum external credit IIF. Available Stable Funding (paragraphs 124-128) The BCBS lays out four buckets of funding types that have different levels of stability. as the firm is assumed to continue extending some of the funding. The BCBS has now mandated that firms must look through the secured funding transaction and apply the required stable funding factor for the asset used to settle the transaction at the maturity date. This is a more conservative approach. There is one exception: if the collateral is used to cover short positions. All rights reserved. central bank. Sovereign. the NSFR has not been fundamentally changed. Cash Inflows (paragraphs 105-118) Cash inflows were originally left to national discretion in the December 2009 proposals. com © Copyright 2010. The Institute of International Finance. For reverse repos. as long as they are fully performing. they only require 20% stable funding. rollover assumptions are the same as for the outflows: repos backed by highly liquid assets. 100% of contractual inflows from financial institutions are assumed to flow back into the firm as financial firms withdraw funding from each other. then the inflow is not recognized. As well. but are now explicitly defined by the BCBS and will require a more thorough analysis in the near future – in particular the assumptions on reverse repos and securities borrowing. Inflows for all other transactions are determined by counterparty. as firms will only be able to maintain the 0% factor if the transaction is settled in cash. all other repos. The one general change noticeable in this section is that all loans and bonds now must be unencumbered. despite the further deliberations of the BCBS announced over the summer. the cash is fully expected to flow back into the firm. . there have been some notable changes to the assumptions on types of funding. Lines of credit are not recognized as producing cash flows at all – this is a notable point of asymmetry that is justified as necessary to reduce contagion. 50% of contractual flows from all other customers are counted.

letters of credit and other trade finance instruments . Off-balance sheet designations have not changed from the July release – undrawn portions of credit and liquidity facilities require 5% stable funding. although this only slightly addresses industry concerns that the original level was set too high. Inc. All rights reserved. The BCBS still plans to evaluate possible interim buckets for matching assets and liabilities in the NSFR during the observation period. The ratio will also only apply to currencies if aggregate liabilities in that currency make up more than 5% of total liabilities. up from 100%. this work is due to be finalized by the end of 2011. The Institute of International Finance. This will make sure there are no major currency mismatches in the LCR. The paper also explicitly defines the “Leverage Coverage Ratio by Currency” ratio. The LCR will be calculated and reported at least monthly. which earlier had just been part of the LCR implementation.are determined by national supervisors. as well as all customer collateral and whether they are permitted to rehypothecate it. there are developments here that will IIF. and understandably so – the hard. This concern has not been addressed. except where permitted by the exception stated above. binding ratios are going to have a much larger impact on financial firms. the paper gives a view regarding what the next project the Basel Liquidity Working Group will take on: "One area in particular where more work on monitoring tools will be conducted relates to intraday liquidity risk. as large cap equities and gold are still given only a 50% stable funding factor. noting especially its intention to provide incentives for firms to have longer-dated funding within the one-year period.g. This recognizes that the industry would not be ready for the original observation period start date of January 1. This ratio will also be used by host supervisors to monitor whether cross-border firms have enough liquidity to handle the liquidity needs of the legal entity. The BCBS sets a two-week limit for the . Finally. The treatment of small businesses as analogous to retail customers has been reinforced in the 85% bucket. 2012. Monitoring Tools (paragraphs 137-183) The monitoring tools the BCBS proposed last December received considerable less 6 Basel III—Liquidity Standards rating for corporate and covered bonds at the 20% stable funding level has been lowered from AA to AA-. The BCBS had announced earlier this year that residential mortgages that qualify for the 35% or lower risk weight would only require 65% stable funding. and all other contingent funding obligations – e. However. Equities and gold were pointed out during the consultation process as two assets that were given unduly high required stable funding factors. gold tends to increase in value during a crisis. This category has now been expanded to include other loans to non-financial firms with a maturity greater than one year that qualify for the 35% risk weight. for firms. 2011 for the LCR. where loans to small businesses with maturity less than one year now qualify along with loans to retail customers with the same maturity. definitely create a burden. The NSFR will be calculated and reported at least quarterly. This same designation applies to the corporate and covered bonds in the 50% required stable funding category." Implementation (paragraphs 184-197) Firms are expected to begin reporting the underlying data for the ratios on January 1. or at least increased work. these securities now carry the same definition as Level 2 liquid assets – meaning they should “ideally” central bank eligible. firms are going to need to record “all securities flows”. However. with the operational capacity to increase the frequency to weekly or even daily in stressed situations at the discretion of the supervisor. com © Copyright 2010. as neither was shown to lose 50% of value during a crisis – in fact. The “Concentration of Funding” ratio will probably be used by the BCBS in their work investigating concentrations and large exposures in the financial system. The four ratios are: • Contractual Maturity Mismatch • Concentration of Funding • Available Unencumbered Assets • LCR by Significant Currency For the Contractual Maturity Mismatch ratio.

The standards also confirm as a general principle the need for firms to factor in the availability of liquidity from different jurisdictions in their ratios. In any case. taking into account restrictions that inhibit the transfer of assets and flows within a cross-border 7 Basel III—Liquidity Standards time between the end of the reporting period and when the data should be available. But despite the lack of clarity right now. Any revision as a result of these finding will be made to the LCR by mid-2013 and to the NSFR by mid-2016. The new language seems to set a high standard in determining the assets as “freely available”: “no liquidity should be recognized by a cross-border group in its consolidated LCR if there is any doubt about the availability of the liquidity. The implementation of the LCR for cross-border groups will require firms to apply the liquidity parameters of their home supervisors for all categories of funding. and the NSFR will become a minimum standard by January 1. whereas others may wish more disclosure. on a legal entity basis. 2018. such as the treatment of lines to non-financial corporations. The standards and tools are allowed to be used “on any subset of entities of internationally active banks”. the impact on different business types and sizes. Comments by leading regulators indicate divisions of opinion about disclosures: some clearly prefer not to require disclosures. This analysis will focus on the impact of the standards on financial markets and the broader economy. there has been a push since the crisis to increase transparency of risk. New QIS. Inc. except for retail and SME deposits. which means host supervisors may ask for calculations of the ratios and monitoring tools. and both the FSB and the BCBS are considering further risk disclosures. The ratios and underlying components will need to be reported to supervisors starting January 2012. All rights reserved. assets. 2015. banks “should actively monitor and control” liquidity exposures and funding needs at the levels of legal entities and foreign branches and subsidiaries. but any assets in excess of the stressed not cash outflows must be excluded.” Liquid assets held by a consolidated entity that are used to meet its local LCR requirements can be included in the consolidated LCR insofar as used to cover the outflows of the entity. There is no information on disclosure as of now. which may be IIF. as well as specific issues. The document expressly permits supervisors to set minimum monitoring ratios for the LCR by currency in jurisdictions where the banks’ ability to raise funds in foreign currency or transfer liquidity from one currency to another may be limited. decided by the end of 2011. and demand adherence to the ratios. The LCR will be introduced as a binding constraint on January 1. There may also be many more demands by supervisors across jurisdictions to report ratios. which will be given the factors of the host jurisdiction. there will be a QIS using data from year-end 2010 and mid-year 2011 focusing on the liquidity aspects of the new Basel regime. and flows. com © Copyright 2010. as well as at the group level. The Institute of International Finance. As part of the BCBS’s pledge to monitor closely the implementation of the ratios and their wider effects. .

All rights reserved. . 8 Basel III—Liquidity Standards Annex 1—Liquidity Coverage Ratio Detailed Template Taken from BCBS 188 IIF. com © Copyright 2010. The Institute of International Finance.

com © Copyright 2010. Inc. All rights reserved. The Institute of International 9 Basel III—Liquidity Standards Annex 1—Liquidity Coverage Ratio Detailed Template IIF. .

com © Copyright 10 Basel III—Liquidity Standards Annex 1—Liquidity Coverage Ratio Detailed Template IIF. . All rights reserved. Inc. The Institute of International Finance.

com © Copyright 2010. All rights reserved. 11 Basel III—Liquidity Standards Annex 1—Liquidity Coverage Ratio Detailed Template IIF. The Institute of International Finance. .

. All rights 12 Basel III—Liquidity Standards Annex 2—Net Stable Funding Ratio Detailed Template Taken from BCBS 188 IIF. The Institute of International Finance. com © Copyright 2010. Inc.

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