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The Liquidity Coverage Ratio (LCR)
Basel iii Compliance
Professionals Association (BiiiCPA)
Liquidity Coverage Ratio
The Basel Committee has developed
two standards for supervisors to use
in
liquidity risk supervision.
One standard, the
Liquidity Coverage Ratio, addresses
the sufficiency of a stock of high quality
liquid assets to meet short-term liquidity needs under a specified
acute stress scenario.
The complementary standard, the
Net Stable Funding Ratio, addresses longerterm structural
liquidity mismatches.
To raise the resilience of
banks to potential liquidity shocks, the standards should be
implemented consistently as part of a global framework.
To this end, most of the specific
parameters used in these metrics are internationally harmonised,
with specific and concrete values.
Certain parameters, however, will
need to be set by national
supervisors to reflect
jurisdiction-specific conditions.
In these cases, the parameters
should be transparent and clearly outlined in the regulations of
each jurisdiction.
This will provide clarity both
within the jurisdiction as well
as across borders.
In addition, supervisors may require an
individual institution to adopt more stringent standards or
parameters to reflect its liquidity risk profile and the
supervisor’s assessment of the institution’s compliance with the
Committee’s sound principles.
The liquidity coverage ratio
identifies the amount of unencumbered, high
quality liquid assets an institution holds that can be used
to offset the net cash outflows it
would encounter under an acute short-term
stress scenario specified by supervisors.
The specified scenario entails
both institution-specific and systemic
shocks built upon actual circumstances experienced in the
global financial crisis.
The scenario entails:
• a significant downgrade of the
institution’s public credit rating;
• a partial loss of deposits;
• a loss of unsecured
wholesale funding;
• a significant increase in
secured funding haircuts; and
• increases in derivative
collateral calls and substantial calls on contractual and
noncontractual off-balance sheet exposures, including committed
credit and liquidity facilities.
As part of this metric, banks
are also required to provide a list of contingent liabilities
(both contractual and non-contractual) and their related triggers.
Liquidity
coverage ratio
Objective
This metric aims to ensure that a
bank maintains an adequate level of unencumbered, high quality
assets that can be converted into cash
to meet its liquidity needs for a
30-day time horizon under an acute liquidity stress
scenario specified by supervisors.
At a minimum, the stock of liquid
assets should enable the bank to survive
until day 30 of the proposed stress scenario, by which time
it is assumed that appropriate actions can be taken by management
and/or supervisors, and/or the bank can be resolved in an orderly
way.
The Liquidity Coverage Ratio
(LCR) builds on traditional liquidity
“coverage ratio” methodologies used internally by banks to
assess exposure to contingent liquidity events.
Net cumulative cash outflows
for the scenario are to be calculated for 30 calendar days into
the future.
The standard would require that
the value of the ratio be no lower than
100% (ie the stock of liquid assets should at least equal the
estimated net cash outflows).
Banks are expected to
meet this requirement continuously
and hold a stock of unencumbered, high quality assets as a defence
against the potential onset of severe liquidity stress.
Banks and supervisors are also
expected to be aware of any potential mismatches within the 30-day
period and ensure that sufficient liquid assets are available to
meet any cashflow gaps throughout
the month.
The scenario proposed for this
standard entails a combined idiosyncratic and market-wide shock
which would result in:
(a) a three-notch downgrade in the
institution’s public credit rating;
(b) run-off of a proportion
of retail deposits;
(c) a loss of unsecured
wholesale funding capacity and reductions of potential sources of
secured funding on a term basis;
(d) loss of secured,
short-term financing transactions for all but high quality liquid
assets;
(e) increases in market
volatilities that impact the quality of collateral or potential
future exposure of derivatives positions and thus requiring larger
collateral haircuts or additional collateral;
(f) unscheduled draws on all
of the institution’s committed but unused credit and liquidity
facilities; and
(g) the need for the
institution to fund balance sheet growth arising from
non-contractual obligations honoured in the interest of mitigating
reputational risk.
In summary, the stress
scenario specified incorporates many of the shocks experienced
during the current crisis into one acute stress for which
sufficient liquidity is needed to survive up to 30 calendar days.
This
stress test should be viewed as a minimum supervisory
requirement for banks.
Banks are still
expected to conduct their own stress tests
to assess the level of liquidity they should hold beyond this
minimum, and construct scenarios that could cause difficulties for
their specific business activities.
Such internal stress tests should
incorporate longer time horizons than the ones mandated by this
standard. Banks are expected to share these additional stress
tests with supervisors.
The proposed standard should be a
key component of the regulatory approach, but must be supplemented
by detailed supervisory assessments of other aspects of the bank’s
liquidity risk management framework in line with the
Committee’s Sound Principles.
The
LCR consists of two components:
A. Value of the stock of high
quality liquid assets in stressed conditions.
B. Net cash outflows,
calculated according to the scenario parameters set by
supervisors.
A. Stock of high
quality liquid assets
The numerator of the LCR is
the “stock of high quality liquid assets”.
Under the proposed standard,
banks must hold a stock of unencumbered,
high quality liquid assets which is clearly sufficient to cover
cumulative net cash outflows (as defined below) over a 30-day
period under the prescribed stress scenario.
As
supported by the Financial Stability Board in its September 2009
report to the G20, the LCR establishes a harmonised framework to
ensure that global banks have sufficient high-quality liquid
assets to withstand a stressed scenario (as set out in the LCR).
In order to qualify as a
“high-quality liquid asset”, assets should be liquid in markets
during a time of stress and, ideally, be central bank eligible.
Characteristics of high quality liquid assets
The 2007-2009 crisis
reinforced the need to examine carefully the liquidity of asset
markets, and relatedly, the characteristics that allow some
markets to remain liquid in times of stress.
Banks need to be careful not to
be misled by the wide range of liquid markets during booms.
Assets are considered to be high
quality liquid assets if they can be easily and immediately
converted into cash at little or no loss of value.
The liquidity of an asset depends
on the underlying stress scenario, the volume to be monetised and
the time-frame considered.
Nevertheless,
there are certain assets that are more
likely to generate funds without incurring large fire-sales even
in times of stress.
This section outlines factors
which influence whether or not the market for an asset can be
relied upon to raise liquidity when considered in the context of
possible stresses.
During the consultative
period and quantitative impact study, the Committee will analyse
the trade-offs between the severity of the stress scenario and the
definition of the stock of liquid assets which will be held to
meet the standard.
The final calibration of the
factors of the outflows and inflows, as well as the composition of
the stock of liquid assets, will be sufficiently conservative
to create strong incentives for banks to maintain prudent funding
liquidity profiles, while minimising the negative impact of its
liquidity standards on the financial system and broader economy.
As such, the Committee is
assessing the impact of both a narrow definition of liquid assets
comprised of cash, central bank reserves and high quality
sovereign paper, as well as a somewhat broader definition which
could also include a proportion of high quality corporate bonds
and/or covered bonds.
The Committee will gather data on
this defined range of asset classes to analyse the impact and
trade-offs of various options involved in defining the stock of
high quality liquid assets.
The text below describes the
general characteristics of high quality liquid assets and outlines
the specific instruments for which the Committee will collect
data, along with information on haircuts currently associated with
these assets in both normal times and periods of stress.
Fundamental characteristics
•
Low
credit and market risk: assets which are less risky tend to have
higher liquidity.
On the credit risk front, high
credit standing of the issuer and a low degree of subordination
increases an asset’s liquidity.
On the market risk front, low
duration, low volatility, low inflation risk and being denominated
in a convertible
currency with low foreign exchange rate risk
all enhance an asset’s liquidity.
•
Ease
and certainty of valuation: an asset’s liquidity increases if
market participants are more likely to agree on its valuation.
A liquid asset’s pricing formula
must be easy to calculate and not depend on strong assumptions.
The inputs into those pricing
formula must also be publicly available. In practice this should
rule out the inclusion of any exotic product.
•
Low correlation with risky assets: the
stock of high quality liquid assets should not be subject to
wrong-way risk.
Assets issued by financial firms,
for instance, are more likely to be illiquid in times of liquidity
stress in the banking sector.
•
Listed on a developed and recognised exchange market: being listed
increases an asset’s transparency.
Market-related characteristics
•
Active and sizable market: the asset should have active outright
sale and repo markets at all times (which means having a large
number of market participants and a high trading volume).
Market breadth (price impact per
unit of liquidity) and market depth (units of the asset can be
traded for a given price impact) should be good.
•
Presence of committed market makers: quotes will always be
available for buying and/or selling the asset.
•
Low
market concentration: diverse group of buyers and sellers in an
asset’s market increases the reliability of its liquidity.
•
Flight to quality: historically, the market has shown tendencies
to move into some types of assets in a systemic crisis.
As outlined by these
characteristics, the test of the “high quality” of assets is that
by way of sale or secured borrowing, their liquidity-generating
capacity is assumed to remain intact even in periods of severe
idiosyncratic and market stress: indeed such assets often benefit
from a flight to quality in these circumstances.
Lower quality assets fail to meet
that test.
An attempt by a bank to raise
liquidity from lower quality assets under conditions of severe
market stress would entail acceptance of a large fire-sale
discount or haircut to compensate for high market risk.
That may not only erode the
market’s confidence in the bank, but would also generate
mark-to-market losses for banks holding similar instruments and
add to the pressure on their liquidity position, thus encouraging
further fire sales and declines in prices and market liquidity.
In these circumstances, private
market liquidity for such instruments is likely to evaporate
extremely quickly, as evidenced in the current crisis.
Taking into account the
system-wide response, only high quality liquid assets meet the
test that they can be readily converted into cash under severe
stress in private markets.
High quality liquid assets
should also ideally be eligible
at central
banks.
Central banks provide a further
backstop to the supply of banking system liquidity under
conditions of severe stress.
Central bank eligibility should
thus provide additional confidence that banks hold a reserve of
high quality liquid assets that could be used in events of severe
stress without damaging the broader financial system.
That in turn would raise
confidence in the safety and soundness of liquidity risk
management in the banking system.
Operational requirements
This stock of high quality
liquid assets must be available for the bank’s treasury to convert
into cash to fill funding gaps at any time between cash inflows
and outflows during the stressed period.
These assets must be unencumbered
and freely available to the relevant group entities.
At the consolidated level, banks
may also include in the stock qualifying liquid assets which are
held to meet legal entity requirements (where applicable), to the
extent that the related risks are also reflected in the
consolidated standard.
The stock of liquid assets should
not be co-mingled with or used as hedges on trading positions, be
designated as collateral or be designated as credit enhancements
in structured transactions, and should be managed with the clear
and sole intent for use as a source of contingent funds.
The stock should be under the
control of the specific function or functions charged with
managing the liquidity risk of the institution.
A bank should periodically
monetise a proportion of the assets in its liquid assets buffer
through repo or outright sale to the market in order to test the
usability of the assets.
While the LCR is expected to
be met and reported in a common currency, supervisors and banks
should also be aware of the liquidity needs in each significant
currency.
The bank should be able to use
the stock to generate liquidity in the desired currency and in the
jurisdiction in which the liquidity will be required.
As such, banks are expected to be
able to meet their liquidity needs in each currency and maintain
high quality liquid assets consistent with the distribution of
their liquidity needs by currency.
Definition of liquid assets
The stock of high quality
liquid assets should be comprised of assets which meet the
characteristics outlined above.
The following list describes the
assets which meet these characteristics and can therefore be used
as the stock of liquid assets:
(a) cash;
(b) central bank reserves, to
the extent that they can be drawn down in times of stress;
(c) Marketable securities
representing claims on or claims guaranteed by sovereigns, central
banks, non-central government public sector entities (PSEs), the
Bank for International Settlements, the International Monetary
Fund, the European Commission, or multilateral development banks
as long as all the following criteria are met:
(i) they are assigned a 0%
risk-weight under the Basel II standardised approach, and
(ii) deep repo-markets exist
for these securities, and
(iii) the securities are not
issued by banks or other financial services entities.
(d) government or central
bank debt issued in domestic currencies by the country in which
the liquidity risk is being taken or the bank’s home country.
B. Net cash
outflows
Net cash outflows are defined
as cumulative expected cash outflows minus
cumulative expected cash inflows arising in the specified
stress scenario in the time period under consideration.
This is the
net cumulative liquidity mismatch position
under the stress scenario measured at the test horizon.
Cumulative expected cash outflows
are calculated by multiplying outstanding balances of various
categories or types of liabilities by assumed percentages that are
expected to roll-off, and by multiplying specified draw-down
amounts to various off-balance sheet commitments.
Cumulative
expected cash inflows are calculated by multiplying amounts
receivable by a percentage that reflects expected inflow under the
stress scenario.
While most of these factors
will be applied in a harmonised way across jurisdictions,
there are a few select parameters for which
each supervisory regime will determine the percentages to apply to
banks in their jurisdiction.
In the latter case, parameters
and factors need to be transparent and made publicly available.
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