No. 3/2011 7 BASEL III GLOBAL LIQUIDITY STANDARDS: CRITICAL DISCUSSION AND IMPACT ONTO THE EUROPEAN BANKING SECTOR Veronika Bučková – Svend Reuse Veronika Bučková: Masaryk University, Faculty of Economics and Administration, Department of Finance, Lipová 41a, 602 00 Brno, v.buckova@mail.muni.cz Svend Reuse: Masaryk University, Brno / FOM University of Applied Science Luxemburger Allee 121, 45481 Mülheim, Germany, Svend.Reuse@gmx.de Abstract: Together with the Basel III regulatory equity rules, two liquidity ratios have been published. Resulting from the illiquidity of some banks during the financial crisis in 2008, these ratios shall help to prevent further crisis in the European banking sector. But do they really fulfill their aim? This article presents the new liquidity ratios, the actual liquidity situation in banks and describes the consequences for banks at a simplified example. It has to be stated that implementing more detailed liquidity frameworks into the banking supervision process is necessary. The financial crisis in 2008 showed that several banks did not have adequate liquidity risk models and processes to prevent illiquidity. But the LCR and the NSFR seem to be wrong methods. Both ratios will increase. The implementation of both ratios has to be done very carefully in order to prevent this. Key words: Basel III, Liquidity Coverage Ratio LCR, Net Stable Funding Ratio NSFR, Maturity Transformation JEL classification: G21, G28 Introduction The IMF states correctly that “the financial crisis highlighted the lack of sound liquidity risk management at financial institutions and the need to address systemic liquidity risk.” (IMF, 2011, p. 75). As a result, the Basel Committee on Banking Supervision developed new principles of banking regulation, known as Basel III. On Financial Assets and Investing 8 October 19, 2010, the Basel Committee and central bankers from 27 countries agreed to phase in introduction of internationally harmonized global liquidity standards (see Basel Committee on Banking Supervision, 2010.09 and Frère/Reuse, 2010, pp. 3). The aim of these liquidity standards is to ensure liquidity of the banking system in times of stress. The standards establish the minimum liquidity requirements on a short-term and long-term basis. The aim of the paper is to discuss the new liquidity ratios critically and to answer the question whether they will help to make the European banking system more stable. 1 Presenting the new Basel III liquidity Rules The Basel Committee on Banking Supervision (BCBS) has developed two minimum standards for funding liquidity: - Liquidity Coverage Ratio (LCR) and - Net Stable Funding Ratio (NSFR). These minimum standards were developed to ensure a sufficient level of liquidity of banking system: the LCR focuses on the short-term liquidity while the NSFR focuses on the long-term liquidity. The objective of the LCR is to “promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient highquality liquid assets to survive a significant stress scenario lasting for one month” (Basel Committee on Banking Supervision, 2010.12, paragraph 4). The objective of the NSFR is to “promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis” (Basel Committee on Banking Supervision, 2010.12, paragraph 4). These standards establish the minimum levels of liquidity for internationally active banks. The standards will be introduced after an observation period. The observation period has begun in 2011. The LCR will be introduced on January 1, 2015. The introduction of the NSFR is planned for January 1, 2018. 1.1 Liquidity Coverage Ratio The aim of the LCR is to ensure the short-term liquidity of a bank. Under this standard, the bank has to maintain an adequate level of high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under a significantly severe liquidity stress scenario. The liquidity stress scenario will be No. 3/2011 9 specified by supervisors. The LCR standard binds the banks to hold a stock of highquality liquid assets to cover the total net cash outflows over a 30-day time horizon under the stress scenario. The LCR standard will be defined as follows: 100% dayscalendar30nextover theoutflowscashnetTotal assetsliquidquality-highofStock >=LCR (1) Figure 1 shows how the parts of the LCR are defined in detail. Fig. 1: Parts of the LCR Source: Basel Committee on Banking Supervision, 2010.12, pp. 42–45 and Schäfer, 2010, p. 7. Stock of high-quality liquid assets High-quality liquid assets must meet specific requirements. Generally, high-quality liquid assets must be easily and immediately converted into cash at a little or no loss of value (see Basel Committee on Banking Supervision, 2011.06, p. 9). These assets have to bear a low credit and market risk, listed on a developed and recognized exchange market or have a low correlation with risky assets. The market, where the asset is traded, should be of specific characteristics – e.g. low market concentration, active and sizable market and so on. Level 1 Assets 100% • Cash • sovereigns, central banks, public sector • Domestic sovereign debt for non-0% risk weighted sovereigns Cash Outflows Numerator: Stock of high-quality liquid assets Denominator: Total net cash outflows under stress Level 2 Assets 85% • Sovereign, central bank, and PSE assets qualifying for 20% risk weighting • Qualifying corporate/covered bonds rated AA- or higher • Maximum of 2/3 of adjusted Level 1 assets LCR = • Stable deposits (retail/wholesale) min. 5% • Less stable deposits (retail/wholesale) min. 10% • Term deposits with maturity >30 days 0% • Legal entities with operational relationships 25% • Furher unsecured wholesale 25% – 100% • Secured funding Level 1 assets 0% • Secured funding Level 2 assets 15% • Further secured funding 25% – 100% • Undrawn portion of committed credit 5% – 100% • Liabilities at maturity e.g. ABS / SPV 100% • Derivative outlflows 20% - 100% Cash Inflows + • Reverse Repos 0% – 100% • Amounts receivable: retail customers 50% • Amounts receivable: wholesale 50% • Amounts receivable: financial institutions 100% max. 75% of outlflows >100% Financial Assets and Investing 10 The assets should be unencumbered, which means not pledged to secure, collateralize or credit-enhance any transaction. Ideally, the assets should be central bank eligible (see Basel Committee on Banking Supervision, 2011.06, p. 9). The assets are divided into two categories: Level 1 assets and Level 2 assets. Banks can hold Level 1 assets, for example, in the form of cash, central bank reserves1 , marketable securities representing claims on (or guaranteed by) sovereigns, central banks, the Bank for International Settlements, IMF and others after satisfying stated conditions (see Basel Committee on Banking Supervision, 2010.12, paragraph 40). Assets of this category can be included without limit. Level 2 assets are limited to, for example, marketable securities representing claims on (or claims guaranteed by) sovereigns or central banks (and others), corporate bonds and covered bonds after satisfying certain conditions (see Basel Committee on Banking Supervision, 2010.12, paragraph 42). This category of assets can comprise only up to 40 % of the high-quality liquid stock. Total net cash outflows The total net cash outflows are defined as “the total expected cash outflows minus total expected cash inflows2 in the specified stress scenario for the subsequent 30 calendar days” (Basel Committee on Banking Supervision, 2010.12, paragraph 50). The total expected cash inflows are limited to 75 % of the total expected cash outflows. 1.2 Net Stable Funding Ratio The NSFR was developed to ensure medium and long-term liquidity of a bank. According to this standard, the long-term assets should be funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profiles. The standard aims to encourage better assessment of liquidity risk across all on-balance and off-balance sheet items. The NSFR is defined as follows: 100% fundingstableofamountRequired fundingstableofamountAvailable >=NSFR (2) 1 To the extent that they can be drawn down in time of stress. 2 The expected cash inflows and outflows should include interest expected to be received or paid in the time horizon of 30 days. No. 3/2011 11 The “stable funding” means that the types and amounts of equity or liability financing are reliable sources of funds over a one-year time horizon (i.e. long-term funding). Figure 2 describes the parts of the NSFR in detail. Available stable funding (ASF) is the sum of a bank’s capital, preferred stock or liabilities with maturity of one year or greater and others types of long term liabilities (see Basel Committee on Banking Supervision, 2010.12, paragraph 124). All components must be multiplied by the appropriate Associated ASF Factor (from 0 to 100 %) (according to Basel Committee on Banking Supervision, 2010.12, table 1). Required stable funding (RSF) can be defined as the sum of the value of the assets held and funded by the institution and the amount of OBS activity. Assets and OBS activities must be multiplied by the appropriate Associated RSF Factor (more liquid assets in the stressed environment receive a lower RSF factor) (according to Basel Committee on Banking Supervision, 2010.12, table 2 and 3). Fig. 2: Parts of the NSFR Source: Basel Committee on Banking Supervision, 2010.12, pp. 46–47 and Schäfer, 2010, p. 9. 2 Current situation in Europe • Tier 1 and Tier 2 Capital and other equity ≥ 1yr 100% • Other liabilities with an effective maturity of ≥ 1yr 100% • Stable deposits of retail and small business customers (non-maturity or residual maturity < 1yr) 90% • Less stable deposits of retail and small business customers (non-maturity or residual maturity < 1yr) 80% • Wholesale funding provided by non-financial corporate customers, sovereign central banks, multilateral development banks and PSEs (non-maturity or residual maturity < 1yr) 50% Numerator: Available Stable Funding Liabilites Denominator: Required Stable Funding Assets NSFR= • Cash 0% • Debt issued or guaranteed by sovereigns, central banks, BIS, IMF, EC, non-central government, multilateral development banks with a 0% risk weight under Basel II standardised approach 5% • Corporate bonds or secured bonds, Rating AA- or better, Basel II-20%, maturity ≥ 1yr 20% • Corporate bonds or secured bonds, Rating A+ to A-, maturity ≥ 1yr, Gold, equity securities 50% • Loans to non-financial corporate clients, sovereigns, central banks, and PSEs with a maturity < 1 yr 50% • Unencumbered residential mortgages of any maturity and other unencumbered loans 65% • Other loans to retail clients and small businesses having a maturity <1 yr 85% • All other loans with a maturity ≥ 1yr 100% • Undrawn amount of committed credit and liquidity facilities 5% >100% Financial Assets and Investing 12 The IMF (see IMF, 2011, pp. 75–110) analyzed the worldwide impacts of the new liquidity rules. The LCR could not be quantified seriously as the required information is not available publicly (see IMF, 2011, p. 78). But the IMF was able to quantify the NSFR with available official information for 60 globally oriented banks in 20 countries in Europe, North America and Asia. The analysis consists of commercial, universal and investment banks. The IMF added 13 further banks that became bankrupt during the financial crisis so that the sample consisted of 73 banks (see IMF, 2011, p. 78 for the detailed setup). The results are shown in the combined figure 3. These quantifications lead to several conclusions for the European banking sector: the NSFR is better in Asia and North America, Europe shows the lowest ratio of all regions. This leads to the conclusion that Europe has to do much more to achieve the minimum ratio of 100%. Further, it has to be stated that universal banks show the best ratio. This is consistent as these banks have higher volumes of stable refinancing funds. Investment banks offer the lowest ratio in figure 3 – these banks cannot have e.g. retail deposits. Analyzing specific banks confirms the fact that European banks have the lowest NSFR. If these banks want to fulfill the ratio, they have to do significant changes in their balance sheets – even though the NSFR does not seem to be a good indicator for illiquidity as shown in the last part of figure 3. Some of the banks with a low NSFR survived and vice versa, some with a relatively good NSFR became illiquid. The results for the European banking sector are as follows: the NSFR does not seem to be a significant indicator for illiquidity but European banks seem to have more to do to achieve the ratios compared to Asia and North America. For Europe it is important to use the observation period and to insist on a late introduction date. No. 3/2011 13 Fig. 3: First quantifications of the NSFR NSFR by region NSFR by Business Modell Net Stable Funding Ratio by Bank, 2009 NSFR Estimates for an Expanded Set Including Failed Banks, 2006 Source: Originally taken from IMF, 2011, pp. 79, 81, 82. 3 Setting up a simplified example The IMF analyzed the impacts of the NSFR on big banks of each region. Small or medium sized banks – which often hold a market share of more than 50% in the private customer segment – are not analyzed as the required data are not officially available. According to this, a fictive bank is modeled. It represents a typical local oriented small bank. Its main business is to grant customer loans and to manage customer deposits. Failed Banks Financial Assets and Investing 14 According to the low yield curve, the deposits have a low maturity while the loans on the asset side show maturities of five to ten years. This leads to a natural maturity transformation of this bank (see Reuse, 2011 for further details on the maturity transformation). The liquidity management has invested into German covered bonds, so-called “Pfandbriefe”. These bonds are very liquid and they offer a better yield than German sovereign bonds. As a consequence, only a small investment in sovereign bonds is made. The balance sheet of this fictive bank including the relevant LCR and NSFR weightings might look as shown in table 1. Tab. 1: Balance sheet of the fictive bank Source: Authors’ calculation. It becomes clear that this bank does not fulfill the actual Basel III liquidity standards. So the bank has to react: It switches covered bonds into sovereign bonds and it switches short-term interbank finance into long-term interbank finance (examples are shown in Basel Committee on Banking Supervision, 2010.08, p. 24). The result is visualized in table 2. Position Amount in t€ Interest rate LCR weight NSFR weight Position Amount in t€ Interest rate LCR weight NSFR weight Cash 20,000 0.00% 100% 0% Stable retail deposits, no maturity or ≤ 30d 50,000 0.00% 5% 90% Sovereign Bonds 25,000 3.00% 100% 5% less stable retail deposits, no maturity or ≤ 30d 195,000 1.50% 10% 80% Covered Bonds AAA 250,000 4.00% 85% 20% term deposits Corporate Bonds, A 25,000 6.00% 0% 50% …maturity , > 30d and ≤ 1yr 550,000 2.50% 0% 80% Retail loans < 1yr maturity …maturity , > 1yr 0 3.00% 0% 100% …maturity , > 30d 300,000 6.00% 0% 85% Legal entities with operational relationships < 1yr 80,000 2.50% 25% 50% …maturity , ≤ 30d 50,000 6.00% 50% 85% Unencumbered residential mortgages Long term interbank bonds ≥ 1yr 175,000 3.50% 0% 100% …maturity , > 30d 350,000 5.50% 0% 65% short term interbank finance 300,000 1.25% 100% 0% …maturity , ≤ 30d 75,000 5.50% 50% 65% All other loans with maturity ≥ 1yr 405,000 6.50% 0% 100% Equity 150,000 --- 0% 100% Sum 1,500,000 5.53% Sum 1,500,000 1.90% Interest Margin = 3.63% Level 1 Assets + Level 2 Assets 45,000 30,000 LCR = = 34.56% Cash Outflow - Cash Inflows 342,000 125,000 NSFR = = 96.5% LiabilitesAssets Available Fundings Required Stable funding 1,006,000 1,042,500 No. 3/2011 15 Tab. 2: Balance sheet of the fictive bank after the implementation of Basel III Source: Authors’ calculation. These two transactions have several consequences on the balance sheet and the income statement. First, the natural maturity transformation of the bank is lowered as the interbank liabilities have a longer maturity now. This leads to higher costs of interests on the liability side. Further, the interest earnings on the asset side decrease as the sovereign bonds have a lower interest rate than the covered bonds. The consequence is a lower interest margin of 0.22% - assuming that the bank has the possibility to receive long-term interbank finance. Position Amount in t€ Interest rate LCR weight NSFR weight Position Amount in t€ Interest rate LCR weight NSFR weight Cash 20,000 0.00% 100% 0% Stable retail deposits, no maturity or ≤ 30d 50,000 0.00% 5% 90% Sovereign Bonds 125,000 3.00% 100% 5% less stable retail deposits, no maturity or ≤ 30d 195,000 1.50% 10% 80% Covered Bonds AAA 150,000 4.00% 85% 20% term deposits Corporate Bonds, A 25,000 6.00% 0% 50% …maturity , > 30d and ≤ 1yr 550,000 2.50% 0% 80% Retail loans < 1yr maturity …maturity , > 1yr 0 3.00% 0% 100% …maturity , > 30d 300,000 6.00% 0% 85% Legal entities with operational relationships < 1yr 80,000 2.50% 25% 50% …maturity , ≤ 30d 50,000 6.00% 50% 85% Unencumbered residential mortgages Long term interbank bonds ≥ 1yr 275,000 3.50% 0% 100% …maturity , > 30d 350,000 5.50% 0% 65% short term interbank finance 200,000 1.25% 100% 0% …maturity , ≤ 30d 75,000 5.50% 50% 65% All other loans with maturity ≥ 1yr 405,000 6.50% 0% 100% Equity 150,000 --- 0% 100% Sum 1,500,000 5.46% Sum 1,500,000 2.05% Interest Margin = 3.41% Level 1 Assets + Level 2 Assets 145,000 96,667 LCR = = 206.55% Cash Outflow - Cash Inflows 242,000 125,000 NSFR = = 107.64% Assets Liabilites Available Fundings 1,106,000 Required Stable funding 1,027,500 Financial Assets and Investing 16 Conclusion and critical outlook The simplified example shows the results in the European banking sector. Sovereign bonds will become more attractive – as long as they have a 0% risk weight asset. European banks might come to the conclusion that mixing domestic sovereign bonds and “high yield European sovereign bonds” might be the best solution to meet the LCR. In the authors’ opinion, this is not the right way to regulate banks. Further, this will result in more long-term interbank finance. But if all banks have to fulfill these ratios, the worst case scenario might appear: as all banks need long-term money, no bank will offer it – or only at a very high price. This will lead to pressure in the banking sector as well. In addition, the attractive retail customer savings will become more and more important for banks. As all banks will come to this conclusion, this will lead to higher prices of these deposits. The pressure onto the interest margin might lead to a higher demand at interest rate swaps in order to increase the margin by a derivative maturity transformation. In the worst case, a bubble on the derivative market might be the consequence. Last, the banks will be more critical in granting loans so that economy will probably have problems to receive money. In the authors’ opinion it is right to regulate liquidity of the European banking sector, but the presented LCR and NSFR lead to additional risks that should be prevented. Especially, the NSFR has to be seen critically as Europe shows the lowest ratios in the international comparison. The necessary changes in the balance sheets are consequently high (examples are shown in Basel Committee on Banking Supervision, 2010.08, p. 24). So an implementation has to be done very carefully and has to be long-term oriented. Europe shall insist on a late introduction date for the NSFR. 2018 is the earliest possible implementation period. The economic costs resulting from Basel III have to be considered – even though the Basel Committee tries to convince the public that the economic benefits are higher than the economic costs (discussed in Basel Committee on Banking Supervision, 2010.08, p. 5). The LCR offers several problems as well: the definition of the Level 1 assets has to be seen critically. During the integration process into the European law, banking supervisors should care for implementing those assets that are really liquid in Europe. Otherwise a destabilization of the markets might be the consequence. The implementation period 2015 might be too early as banks must increase equity till 2017 to achieve the equity ratios of Basel III. No. 3/2011 17 In combination with the higher regulatory equity requirements, banks are faced with the following problem: they need to have a lower risk position, to hold higher liquidity and to increase equity to meet Basel III. This might lead to a new banking crisis if Europe makes too many mistakes during the implementation process. A possibility to prevent this is to act like the USA intend to: applying Basel III only to banks that have a significant influence on the stability of the banking sector (discussed in Haasis, 2011). This means vice versa that small savings and cooperative banks in Europe do not have to meet all Basel III rules. In the authors’ opinion, this is the right way – implementing Basel III in dependence on the complexity and size of a bank. References Basel Committee on Banking Supervision (2010.08). An assessment of the long-term economic impact of stronger capital and liquidity requirements. Retrieved from: , accessed on September 6, 2011. Basel Committee on Banking Supervision. (2010.09). Group of Governors and Heads of Supervision announces higher global minimum capital standards. Retrieved from: , accessed on September 6, 2011. Basel Committee on Banking Supervision. (2010.12). 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