Sunday, August 15, 2010

Basel III Liquidity Requirements

As I noted in my post on Lehman's liquidity pool, the financial crisis of 2008 — and the Lehman episode in particular — highlighted the pressing need for formal liquidity requirements. Fortunately, the Basel Committee has made a new liquidity regime a focus of Basel III. The new liquidity regime can be found in the December 2009 consultative document as amended by last month's Annex.

The main component of Basel III's liquidity regime is the Liquidity Coverage Ratio (LCR), sometimes known as the "Bear Stearns rule." The LCR requires banks to maintain a stock of "high-quality liquid assets" that is sufficient to cover net cash outflows for a 30-day period under a stress scenario. The formula is:

          Stock of high quality liquid assets               ≥  100%
 Net cash outflows over a 30-day time period
Net cash outflows, in turn, is calculated by applying run-off rates to different sources of funding (e.g., repos, unsecured wholesale, etc.). So the action here is in (1) the definition of "high quality liquid assets," and, more importantly, (2) the run-off rates used to calculate "net cash outflows."

1. High-Quality Liquid Assets

In the initial consultative document, the Basel Committee defined "high-quality liquid assets" extremely conservatively, such that the only eligible assets were essentially cash, central bank reserves, and sovereign debt. Crucially, Agencies and Agency MBS were excluded, due to the requirement in Paragraph 34(c)(i) that the assets have a 0% risk-weight under Basel II (Fannie and Freddie obligations have a 20% risk-weight). In last month's Annex, the Commmittee fixed this, adding a "Level 2" category of liquid assets that includes GSE obligations (but with a 15% haircut). Level 2 assets, which also includes non-financial corporate and covered bonds rated AA- or above, can't comprise more than 40% of a bank's total stock of high-quality liquid assets. I have to think this was a deliberate strategy — the Committee was always going to allow GSE obligations in the liquidity pool, but they wanted to give the banks something to howl about, and focus all their energy on.

So in sum, banks' liquidity pools have to be at least 60% Level 1 assets (cash, central bank reserves, and sovereigns) and no more than 40% Level 2 assets (GSE obligations, and non-financial corporate or covered bonds rated AA- or above). That's appropriately conservative, in my view — all of these assets would have been monetizable in 24 hours or less during the financial crisis.

2. Run-Off Rates

This is where most of the action is. The LCR proposal assigns run-off rates to each source of funding, which are designed to simulate a severe stress scenario. A run-off rate just reflects the amount of funding maturing in the 30-day window that won't roll over. I don't have the space to list all of the run-off rates — there's a handy table on pg. 32 of the consultative document, although some of the run-off rates were amended by last month's Annex. Here are the most important run-off rates (as amended by the Annex):
Retail Deposits

- Stable deposits: 5%
- Less stable deposits: 10%

Unsecured Wholesale Funding (e.g., Commercial Paper)

- Non-financial corporates, sovereigns, central banks, and public sector entities:
           - Without operational relationships: 75%
           - With operational relationships: 25% of deposits needed for operational purposes

- Financial institutions and other legal entities: 100%

Secured Funding

- Repos and securities lending/borrowing of non-liquidity pool eligible assets: 25%

Additional Requirements

- Liabilities related to derivative collateral calls related to a downgrade of up to 3-notches: 100% of collateral that would be required to cover the contracts in the case of a 3-notch downgrade

- Liabilities from maturing ABCP, SIVs, and SPVs: 100% of maturing amounts and 100% of returnable assets

- Currently undrawn portion of committed credit and liquidity facilities to non-financial corporates (including central banks, sovereigns, and PSEs):
           - Credit failities: 10%
           - Liquidity facilities: 100%
What do I think of these run-off rates? I think they're mostly appropriate and sufficiently conservative. I was pleasantly surprised by how comprehensive the LCR proposal was — that is, the Committee seems to have anticipated all the meaningful sources of funding outflows. For example, I was impressed that the LCR proposal addressed changes in the value of collateral posted on derivatives trades. I'm also glad the Committee held the run-off rate for unsecured wholesale funding from financial institutions at 100%. Given what we saw during the financial crisis, that's entirely warranted.

I was disappointed that the Basel Committee gave so much back on repos of non-liquidity pool eligible assets. Initially, the run-off rate was 100%. That was probably too high, but not outrageously so. The banks cried bloody murder, of course. Their main argument was that they were able to reliably repo out equities during the financial crisis (albeit with substantial haircuts), due to the deep market, and thus reliable marks, for most equities. That's a legitimate point; I just don't think it merits reducing the run-off rate from 100% to 25%. I thought the Committee would, at most, reduce the rate to 50%, and I think 75% would be more appropriate.

For the most part, though, the Basel Committee held firm. Partly that's because the banks' comment letters were surprisingly weak. Their main argument involved claiming that the run-off rates they experienced during the financial crisis were materially lower than the Committee's proposed run-off rates. This, they argued, demonstrated that the Committee was being excessively conservative. (See e.g., JPMorgan, passim)

The problem with this is that it's a really, umm, stupid argument. Yes, the run-off rates were probably lower during the financial crisis, but there were also massive government bailouts during the financial crisis. After Lehman failed, the market only made it 2 days without a government bailout — the Fed rescued AIG on Tuesday night, and Schumer leaked that the government was planning a system-wide bailout on Thursday. Regulators were kinda sorta hoping that we could do the next financial crisis without massive government bailouts.

Okay, that's enough on Basel III for right now.

Add: It just occurred to me that I didn't address the "expected cash inflows" aspect of the LCR. (Cash inflows are subtracted from cash outflows to arrive at "net cash outflows" for the 30-day window.) It's not that big of a deal though, because the rule for expected cash inflows is basically this: You get no cash inflows for 30 days, and you will like it.

19 comments:

Anonymous said...

Please spell out your acronyms. We are not all finance insiders.

GAR said...

a lot of detail and thought put into constructing a system that provides the safety and soundness of the global financial system ...

JPMC comment about balance is appropriate as to not being so conservative that prices go up, cause unintended cost and/or enable participants to find non-regulated avenues endangering the system. However any errors in balance should accrue on the safety and soundness side.

As a first approximation rule of thumb, if the banksters are screaming then the regulators are likely on the right track.

Anonymous said...

Lots of US Banks have negative LCR Ratios. But large amounts of High Quality Liquid Assets. (6 - 7 percent of total assets.)

Anonymous said...

And just how many banks in the US have been or intend to be compliant with Basel I, II or III?

FFIEC regulatory agencies are "recalibrating" Basel which goes to last comment that most banks in US will have negative LCR ratios and thus, these measures will not make it to the US financial sector scene in any meaningful way...

Anonymous said...

this is all so obvious to anyone with a decent engineering background. Is this the 'state of the art' in 2010 for finance?
My single solution to prevent a future financial crisis: can please any student in finance/economics get mandatory 1 year of basic 'physics/mathematics/systems approach' classes ...
maybe then the models and regulation used in finance will be less archaic..

greybeard said...

I see from the original post that eligible Level 1 highly liquid assets include cash, central bank reserves and treasuries.

While it might be blindingly obvious to the finance and treasury types out there, I'd be interested to know whether eligible Level 1 cash:
1. only includes currency & coin, or
2. also includes overnight deposits with domestic banks.

I'm assuming that cash only includes currency (i.e. central bank notes issued), given the concern about wrong-way risk by the BCBS.

Also, just wondering why "cash" would be included as a Level 1 asset at all, when (at most commercial banks) currency on hand is limited to that level necessary to support daily withdrawals by customers through the branch network. And hence, at best, only a small portion of that "cash" is actually available as a liquidity reserve. So why include "cash" as a Level 1 asset for LCR purposes at all?

Runescape Gold said...

plenty of details plus considered put into building a head unit that provides the protection as well as soundness of your international financial system ...

Runescape Gold
Eden Gold
Buy Cheap RS Gold

price per head said...

hey guys that,s really amazing posts...

Anonymous said...

Also, simply questioning why "cash" could D3 Items be incorporated to be a Level 1 asset by any means, as soon as (at many business financial institutions) foreign currency readily available is restricted to this amount needed to help each day distributions by simply buyers over the branch network. Thus, at very best, just a modest component of which "cash" is in fact readily available being a liquidity pre-book. So why Guild Wars 2 Itemsconsist of "cash" to be a Level One particular advantage for LCR reasons by any means?

ice machine said...

that requires to cool completely the cage when the space is very not used inside of the cage during the delivery of the frozen foods.

Emily said...

Neben wenn guild wars 2 gold kaufen Sie bis zum höheren Niveau schnell zielen wollen, können Sie zum Internet dazu ausgehen, einen Goldbilden-Führer zu haben, der Ihnen einige Tipps geben kann. Reparaturen und Sachkenntnisse zu kaufen. Unglücklich, um zu sagen, ist Geld zum Bilden in der Welt von warcraft dasselbe als in der echten Welt hart. Wissend, wie zum Macht-Niveau selbst in der Welt von warcraft Sie im Stande sein werden, Finden guild wars 2 erscheint Sie vier oder mehr Spieler heraus, um einen Kerker mit Ihnen zu führen. Kerker können völlig relevant schneller sein und Ihnen erlauben, in der kürzesten Zeit nach oben hin anzugleichen. Die Welt des warcraft Spiels ist das vierte Spiel der warcraft Reihe der veröffentlicht durch den Schneesturm. Das erste warcraft Spiel wurde an vor 12 Jahren veröffentlicht. Es gibt weniges Spiel, billig gw2 gold das heiß seit so vielen Jahren dauern kann.

murs dask said...

yemek tarifleri
ekol hoca
android market
twitter aç

gw2 gold said...

a lot of detail and thought put into constructing a system that provides the safety and soundness of the global financial system ...

JPMC comment about balance is appropriate as to not being so conservative that prices go up, cause unintended cost and/or enable participants to find non-regulated avenues endangering the system. However any errors in balance should accrue on the safety and soundness side.

As a first approximation rule of thumb, if the banksters are screaming then the regulators are likely on the right track. cheap GW2 Gold

de wo said...

We have known that there are many professions in WOW, but which combination gw2 gold is the best one and why? Here we will describe some information about the best profession for class in WOW and the reason. We hope it will do great help to you, please read the details and get the points you need buy gw2 gold.

nana said...

D3 Gold Chest Armor and Boots: Within the chest armor, we've to accept Overall health Globe into consideration. The Well being must be at the least 30,000. What item would be the greatest selection to boost the health globe? MMO Game Obviously, the BalckThorne's Set will be the ideal decision. Inside the Chest Armor, I decide on a higher vitality armor with 186 Vitality. Together with the further bonus of Blackthorne set, I acquired 286 vitality during these two items. Both of these things only cost me 600,00K gold. www.gw2field.com

casino online said...

You got numerous positive points there. I made a search on the issue and found nearly all peoples will agree with your blog. Judi Bola Bandar Bola

Frandis Charles said...

It sounds pretty good. I really like your blogging skills

Bane Coat

Yakenzu Toby said...

I was delighted to find this web site.I wanted to thank you for your time reading this wonderful! I really enjoyed every bit of it and I've marked to ensure that the blog post something new.
agen bola, agen sbobet, agen ibcbet, agen bola, sbobet, agen bola

PENNY STOCK INVESTMENTS said...

Not a bad post about average.