Published: January 01, 2000
The proposed US liquidity coverage ratio, which is a crucial part of the Basel III global regulatory accord, is broadly seen as more stringent than the Basel Committee’s version and is likely to require investment in systems as well as a reconsideration of business models by some financial institutions.
In October 2013, US financial regulatory bodies published their proposals for the implementation of the Basel III liquidity coverage ratio (LCR) in the US. While the final version of the proposal is yet to be published, the principal features of the plan – and its variations from the Basel Committee’s LCR Framework – are now clear: they have implications for many financial institutions (FIs) in the US.
The regulatory proposal defines operational deposits and lists specific criteria that must be met for a deposit to qualify for the more favourable ‘operational’ classification within a bank’s LCR calculation. It also includes specified outflow rates for credit and liquidity facilities and defines High Quality Liquid Assets (HQLA), which must be held against assumed outflows.
One difference between the US proposed LCR and that of the Basel Committee is that the latter calls for a 2015-2019 timeframe with 60% compliance in the first year, while the US approach has a 2015-2017 timeframe with 80% compliance in 2015. The accelerated timetable reflects a “desire to maintain the improved liquidity positions that US institutions have established since the financial crisis,” according to the Federal Reserve [1].
In order to reach 80% compliance by January 1, 2015, FIs’ systems must be 100% capable of calculating all measurements required by the LCR. Therefore, FIs need to invest, build, test and plan for adoption of the LCR immediately.
The US approach to the LCR has eight specific criteria relating to operational deposits (see box), which are the most crucial aspect of the LCR for banks involved in treasury services or custodian business. As well as setting out minimum notice periods and the importance of linking deposits to operational services, these criteria highlight the central importance of deposits being held in a designated operational account if they are to be recognised as an operational deposit.
At face value, these criteria appear straightforward. However, they may require some changes in how FIs do business. For example, an insurance company may supply a bank with deposits from its premium collections and claim payments, which under current rules would count as operational deposits. However, if the bank cannot empirically link those deposit levels to the operational services, they may not be classified as operational under the US LCR proposal.
The eight criteria must be met in their entirety for an operational deposit to be recognised by regulators for LCR purposes, and FIs will need to build a system that enables monitoring of all eight – for all their clients – on an ongoing basis.
The US LCR proposal defines a credit facility as a legally binding agreement to extend funds, including revolving credit facilities for general corporate or working capital purposes. Credit facilities do not include facilities extended to refinance clients’ debt. In contrast, a liquidity facility is characterised as being specifically for refinancing a client’s debt when the client is unable to obtain a primary or anticipated source of funding.
The distinction between the uses of credit and liquidity facilities informs their outflow rates: the proposed rule sets higher outflow rates for liquidity facilities (for example, 30% for a non-FI wholesale customer) than credit facilities (10% for the same type of customer). Credit and liquidity facilities extended by FIs to depository institutions, depository institution holding companies and foreign banks are assigned an outflow rate of 50%, while liquidity facilities extended to other types of regulated financial companies have a 100% outflow rate.
Overall, the prescribed rate of outflows for credit and liquidity facilities during a liquidity stress scenario under the US proposal is seen as more stringent than the Basel Committee’s LCR framework.
The provision of credit and liquidity facilities to clients under Basel III requires FIs not only to hold capital but also HQLA. The higher costs associated with holding HQLA against credit and liquidity facilities will likely affect returns.[[[PAGE]]]
The US LCR proposal applies a more stringent definition of the assets that can be defined as HQLA than the Basel Committee’s version. Crucially, the proposal requires that HQLA must be unencumbered, meaning they cannot be used anywhere else for any other purpose (such as providing credit enhancement to a transaction), while the high quality stipulation means that higher-yielding assets already on an FI’s balance sheet may not qualify as HQLA. Both requirements are expected to have implications for FIs’ flexibility and profitability.
The US LCR proposal has different tiers of HQLA: Level 1 assets include cash, US Treasuries and US government-guaranteed agencies (such as Ginnie Mae bonds) and zero per cent risk weighted sovereign debt, while Level 2 assets are split into two categories. Level 2A assets include US government sponsored enterprise debt (such as Fannie Mae and Freddie Mac bonds) and certain 20% risk weighted sovereign debt. Level 2B assets include some publicly traded corporate debt and equities. Securities other than US Treasuries are required to be “liquid and readily marketable” and must satisfy other operational requirements for inclusion as HQLA in FIs LCR calculations.
While the Basel Committee has a single version of the LCR, the US proposal contains two versions, depending on the size and type of organisation. The standard LCR is applied to all internationally active banking organisations with over $250 bn in total consolidated assets while a modified ‘light’ LCR applies to FIs with $50 bn to $250 bn in total assets (the LCR does not apply to FIs with assets of less than $50 bn).
The standard and light versions of the LCR under the US proposal differ in their specified stress periods: the regular LCR specifies 30 days while the light version specifies 21 days. While this means that smaller FIs will require a lower liquidity buffer, it is important to note that the requirement to measure the various LCR parameters is substantially the same for both versions. Smaller FIs could, therefore, face significant challenges in building the necessary systems to implement the LCR.
The differing treatment of FIs depending on their size could have competitive implications within the US, (which may or may not have been intended by regulators) as smaller banks (with below $50 bn in assets) will have no HQLA requirements on deposits or liquidity facilities. This could have consequences for non-operational deposit buying behaviour.
In addition, the more stringent requirements of the US LCR proposal could affect the competitiveness of banks from different countries. Large US banks must comply with the US LCR globally (plus local standards in certain cases) while some international banks may be held to lower standards domestically and internationally.
The proposed US LCR includes a number of important criteria banks must analyse to classify their portfolio accurately in a defensible and auditable manner. Some of these analytics are likely to require investment and resources to implement. For example, specific standards apply to specific client types (such as hedge funds) so it is necessary to identify these entities consistently and properly classify them within the LCR calculation.
Perhaps most challengingly, the US proposal requires FIs to test all relevant LCR measurements – such as credit and liquidity facilities and HQLAs – on a daily basis. This will prevent FIs from smoothing one-day spikes (as would be possible with a monthly average) and poses a potential challenge for FIs. Moreover, it could add complexity to reporting requirements, which may have cost implications.
An additional challenge is that while both the Basel LCR and the US LCR have a minimum LCR requirement of 100%, most banks will probably want to create a buffer over that amount given the potential impact of business as usual flows, and the potential negative consequences of breaching the minimum requirement.
The US LCR proposal will have three major implications for FIs’ business models in relation to internal and external pricing. First, internal pricing policies and guidelines may have to change in order to secure business that will be profitable under the new regulation. Second, there is likely to be a broad impact on both revenue and profit as costs associated with HQLA requirements and other aspects of the LCR are priced in.
A third potential reaction to the US LCR proposal is that FIs will have an incentive to develop products that are more profitable under LCR guidelines.
For example, FIs could change their product mix in order to achieve cost-effective funding. Operational deposits from corporates (or FIs subject to a 25% run-off assumption and HQLA requirement) will be most desirable, with corporate non-operational deposits (which have a 40% run-off assumption) the second most attractive. Deposits that have terms beyond 30 days, whether operational or non-operational, might also be attractive in certain circumstances. Non-operational deposits from FIs (which have a 100% run-off assumption) would be least attractive.
The level of competition for the most attractive deposits will be high; however, the bar to classify these deposits is high and includes warnings against incenting ‘excess’ balances into otherwise operational accounts. Banks will also have to make decisions about how to address non-operational deposits, and determine whether, or how best, to serve different types of clients.
Comments on the US LCR proposal closed on January 31, but some details may yet change before the final version is published. Nevertheless, it is clear that the US LCR proposal will have important implications for FIs’ business models, their clients and their own banks. It is therefore essential for FIs to talk to their own clients on an ongoing basis so they understand – and plan for – the impact of the US LCR implementation in 2015.
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