Capco Institute Blog

On January 6, the Group of Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, unanimously endorsed amending the Liquidity Coverage Ratio (LCR) as a minimum standard while reaffirming that it remains an essential component of the Basel III reforms. This amendment to the LCR addressed three of the major objections raised by banks to the December 2010 consultative paper, which were:

• The regulatory assumptions (forecasts) of the likely run-offs or drawdown amount of deposits in a time of stress were unrealistic.
• The definition of high-quality liquid assets (HQLA) was too narrow.
• The timeline for compliance was too short.

These objections were addressed as follows:

• Most of the outflow forecast assumptions for the stress scenario were reduced.
• The definition of HQLA was expanded through the introduction of a new level 2 of assets.
• The deadlines for compliance were extended, with the phase-in beginning in 2015 but not fully enforced until 2019.

Outflow forecasts
The net cash outflow over the next 30 calendar days is defined as – (Total expected cash outflow – minimum {Total expected cash inflow; 75 percent of total expected cash flow}). The challenge with the original rules was that the assumptions for expected net cash outflows were too aggressive. To address the objections raised by the banks, the committee made refinements to the assumed inflow and outflow rates to better reflect actual experience in times of stress. For example, the outflow or the run-off rates for:

• Fully insured stable deposits (retail) are revised down from 5 percent to 3 percent and higher.
• The unused portion of committed liquidity facilities to non-financial corporates are revised down from 100 percent to 30 percent.
• Fully insured non-operational deposits from non-financial corporates, sovereigns, central banks and public sector entities (PSEs) are revised down from 40 percent to 20 percent.
• Deposits from non-financial corporate, sovereigns, central banks and PSEs are revised down from 75 percent to 40 percent.
• Committed but unfunded interbank liquidity and credit facilities are revised down from 100 percent to 40 percent.
• Equivalence of central bank operations on maturing secured funding transactions with central banks are revised down from 25 percent to 0 percent.

Expanded definition of HQLA
The committee introduced changes to the definition of the LCR, which were developed and agreed by the Basel Committee over the past two years. Changes include an expansion in the range of assets eligible as HQLA with the inclusion of level 2B assets. Level 2B assets include the following:

• Residential mortgage-backed securities (RMBS) – must be rated AA or higher and are subject to 25 percent haircut
• Corporate debt securities (including commercial paper) – with ratings of A+ to BBB- and are subject to 50 percent haircut
• Common equities – are subject to 50 percent haircut

Level 2 assets (level 2A + level 2B) may not in aggregate account for more than 40 percent of a bank’s stock of HQLA (or LCR buffer). Level 2B assets may not account for more than 15 percent of a bank’s total stock of HQLA. Additionally, note that 2B assets are subject to additional qualifying criteria as detailed in the LCR guidance document. The Committee also reaffirmed the usability of the stock of liquid assets in periods of stress, including during the transition period.

Enforcement schedule
Banks will be expected to comply with the LCR requirements as planned on January 1, 2015; however, the minimum requirement will begin at 60 percent, rising in equal annual steps of 10 percentage points until it reaches a full 100 percent on January 1, 2019.

What affected banks need to do
Given this reaffirmation, LCR remains an essential component of the Basel III reforms, and affected banks should continue to:

• Maintain sufficient liquidity, including a cushion of unencumbered, high-quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources, which could be bank-specific or market-wide.
• Ensure their liquidity risk management programs are well integrated into bank-wide risk management processes.
• Make certain their liquidity cushion is commensurate with the complexity of their on- and off-balance sheet activities, the liquidity of their assets and liabilities, the extent of their funding mismatches, and the diversity of their business mix and funding strategies.
• Use conservative assumptions about the marketability of assets and access to both secured and unsecured funding.
• Confirm that appropriate haircuts are applied in stress scenarios.
• Clearly articulate a liquidity risk tolerance that is appropriate for the business strategy of the organization and its role in the financial system.
• Set a liquidity risk tolerance in light of their business objectives, strategic direction and overall risk appetite.
• Ensure the integrity of their liquidity risk management, control functions and limits.

Above all, remain flexible. This may not be the last time this standard is changed, and it wouldn’t surprise us if it was further postponed or significantly changed. It may even be abandoned in the future, if the economic environment remains poor or experience shows that many of the explicit and implicit assumptions involved in the drafting of this standard are flawed, as we suspect they are.

How is your organization preparing for the proposed changes to the LCR standard? Join the discussion.