Adjustments to liquidity management under Basel III

New challenges in the management of liquidity risk and equity

StellschraubenKeywords such as liquidity, liquidity risk and liquidity management have haunted the banking landscape for many years. However, Basel III gives liquidity assessment a new and more detailed focus. For banks at home and abroad, new indicators have been introduced in the past two years, which will allow regular monitoring of the short-and long-term availability of liquid funds. The indicators also place high demands on banks in relation to the determination of these values. The LCR, NSFR and the leverage ratio indicators have become central control and measurement parameters in relation to the level of debt. What the values mean and how they are determined is shown in the following individual assessment.

LCR – Liquidity Coverage Ratio

The liquidity coverage ratio, in short-LCR, measures the short-term liquidity risks of banks. The indicator was established through the implementation of Basel III and must be reported by default as of 01 January 2015. The LCR has been in a monitoring phase since 2011 and is ascertained by the banks.

LCR

The LCR represents the ratio between the stock of high-quality liquid assets and net outflows. The period of assessment is 30 days. The LCR must be at 100% or a higher amount to achieve the fulfillment value in accordance with Basel III. This indicator is to be determined using a stress scenario prescribed by Basel III.

Stress scenarios simulate extreme situations similar to the banking crisis

The so-called stress scenarios have been worked out as a consequence of the international banking crisis in 2007 and then made compulsory as a simulation test. They reflect both market-wide shocks and idiosyncratic stress situations. These include the deduction of a portion of the retail deposits or the simulation of the increase in market volatility affecting the quality of collateral or the future value of derivative positions. Today, this stress test forms part of the minimum regulatory requirements for banks. The banks need to conduct their own stress tests to determine how the size of their liquidity changes in these situations. The results of these tests are communicated to the banking regulators and should include longer time frames.
Overall, in assessing the LCR, the bank and the regulators should provide a time frame in which possible long-term measures can be decided upon, should unplanned circumstances emerge. Since the time frame of the LCR is 30 calendar days, the bank should ensure that it has sufficient stock of no-load, high-quality liquid assets that can be converted directly into cash for this period. Thus, the liquidity needs should be covered even in unfavourable and extraordinary situations for the said period and provide some leeway for reaction.

NSFR – Net Stable Funding Ratio

In addition to the LCR, Net Stable Funding , in short NSFR, was also introduced under Basel III. In German, this ratio is also referred to as "structural liquidity ratio" and assesses a significantly longer time frame than LCR. While the LCR refers to a period of 30 working days, the time frame of the NSFR is one year. This assessment is intended to ensure a sustainable maturity structure of assets and liabilities with the banks and thus serve to optimize structural liquidity.

NSFR

While the LCR has a short term focus, looking at quality, liquid assets and net outflows in the next 30 days, the NSFR shows the ratio of the amount of stable funding available to the amount of stable funding required. The amount available is intended to exceed the amount required. Here, the available stable funding represents an aggregate of equity and debt funds, which maps a reliable source of assets for the period of one year, even under stress conditions.

To determine this aggregate of equity and debt finance, various categories of liquid assets of a bank are considered. These include, among other things, equity and preferred stock and liabilities with a minimum residual maturity of one year or non-maturity deposits.
Simultaneously, time deposits or funds provided by major customers with a lower run-time may be considered as a year when it can be expected that they will remain with the bank for a long time. However, these assets can only be used on a proportionate basis. In this case the so-called ASF factor, Available Stable Funding factor, is defined indicating the eligible proportion.

The amount of stable funding, also required to determine the net stable funding ratio, is derived from the aggregate of the retained assets and off-balance sheet liabilities. For this purpose categories are created, as in the calculation of available stable funding, which are assigned an RSF factor, the so-called required stable funding factor. These factors express how much of the amounts determined from the categories are taken into account in the calculation. The RSF factor is assigned both for assets held, as well as various off-balance sheet transactions, as there may be a risk here of high liquidity deductions in stressful situations.

Widespread control through close-knit indicators

Liquidität

The LCR and NSFR indicators, which were established under Basel III as stated, require banks to have strategic and well-planned liquidity management. The focus on different time frames should actively counteract the possibility whereby only the status of necessary, liquid assets with short-term funds, which lie just above the 30-day observation period required for the LCR, is covered. LCR and NSFR together provide for a more comprehensive monitoring of the liquidity of banks to avert developments in crisis situations such as those which occurred during the banking crisis in 2007. It became painfully clear at that time that the liquidity situation of banks is crucial for the functioning of markets. The refinancing problems triggered by the crisis made it clear that requirements for liquidity management and its monitoring are essential. The indicators described are thus a response to the past and a hope for the future that such scenarios do not occur again.

Leverage ratio for more transparency in the equity ratio

Besides the indicators described for liquidity management, Basel III also sets the capital base of the banks, because capital adequacy of large banks is the prerequisite for the formation of trust. Capital is a buffer in a crisis. It should absorb the losses and lenders should only step in when it is exhausted. Thus it is clear that the position of the creditor can be secured by a high level of equity compared to debt. Therefore, the leverage ratio is the existing equity in relation to total assets. Currently, the value for the leverage ratio has not been established. As a guide, a minimum value of 3% was initially established. This calculation bases the leverage ratio in the banking sector on the equity ratio in the real economy and thus establishes comparability. This comparability between the real and financial economies creates transparency in relation to the risk position of the bank equity ratio. This risk measure is, on the one hand, already known and established in the industry and, on the other hand, easily calculated and therefore comprehensible. Complex risk assessments or external ratings are not required.

Leverage Ratio

In addition to the leverage ratio, the equity ratio is also considered within the scope of the Basel regulations. This indicator represents a risk-weighted capital adequacy ratio, while the leverage ratio is calculated independent of risk. The equity ratio considers the equity in relation to risk-weighted assets on the asset side of banks' balance sheet. The risk-weighted assets include, for example, corporate loans or private mortgage loans. Thus, only a part of total assets is considered and the equity ratio is usually higher than the leverage ratio. Since the basics of these indicators are not often known in the real economy and are equated to the equity ratio used here, there is a risk of the equity situation of the banks being incorrectly assessed.
In order to counteract these misconceptions and to increase transparency in the calculation and interpretation of ratios, equity and leverage ratio were imposed in parallel, whereby the leverage ratio was first introduced only as a monitoring quantity. The monitoring period runs from 2013 to 2017 and during this time the banks must calculate this indicator and also disclose it from 2015. The leverage ratio should apply as a binding debt limit for banks from 2018. What value will be used to define it precisely remains to be determined.
Basel III therefore saw the introduction of important regulations and control instruments for liquidity management and equity base. We will not know until a crisis situation occurs how far these measures will meet the expectations of the Basel Committee. Until then it is up to the banks to be guided by the minimum and limit values set and improve security and confidence with creditors and thereby with the markets.

Contact: Julia Pongratz; Turn on Javascript! and Raphael Gräbener; Turn on Javascript!

Sources:
www.diw.de (Deutsches Institut für Wirtschaftsforschung)
www.handelsblatt.com
www.bis.org
www.bundesbank.de
www.wikipedia.org