Sunday, October 10, 2010

The Latest Basel III Controversy

In my post on Basel III's liquidity requirements, one thing I didn't cover was the controversy over "committed credit and liquidity facilities." And since I know how disappointed you all were about that, here's my take on the issue. (Sarcasm aside, it's actually a pretty big controversy.)

As a refresher, Basel III's Liquidity Coverage Ratio (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. "Net cash outflows" is calculated by applying different run-off rates to each source of funding (e.g., repos, unsecured wholesale, etc.). A run-off rate reflects the amount of funding maturing in the 30-day window that won't roll over, and is designed to simulate a severe stress scenario.

The LCR assigns a 100% run-off rate to "draw downs on committed credit and liquidity facilities" to financial institutions (such as banks, insurance companies, and asset managers). It also assigns a 100% run-off rate to draw downs on committed liquidity facilities to non-financial corporates. Essentially, this assumes that every single financial institution that has a lending facility (whether credit or liquidity) with the bank, and every single non-financial corporate that has a liquidity facility with the bank, will draw down 100% of the facility.

The banks are crying bloody murder over this. A 100% run-off rate, they argue, is way too high.

Liquidity Facilities

With regard to liquidity facilities, I think the banks are, for the most part, wrong, and the Basel Committee is right. Most "liquidity facilities" will be commercial paper backstop facilities — a company that issues commercial paper to finance its short-term operating costs will usually arrange a lending facility with a bank as a back-up plan, so that if the company for some reason can't roll over its commercial paper one month, it can draw down its line of credit with the bank to finance its operating costs. The "stress scenario" that the LCR is designed to simulate envisions a shut-down of the commercial paper market. It's only natural, then, to assume that the bank's financial and non-financial customers will draw down their liquidity facilities. That is, after all, what commercial paper backstop facilities are for.

I could be persuaded to lower the run-off rate for committed liquidity facilities to 75%, to reflect the fact that the size of commercial paper backstop facilities doesn't always correspond to the amount of commercial paper that the company will have outstanding at any one time. So, for example, if a company issues $100 million of commercial paper per month, it might arrange a $150 million commercial paper backstop facility. In that case, it wouldn't be realistic to force the bank to pre-fund the entire $150 million facility.

Credit Facilities

I'm of two minds on the 100% run-off rate for committed credit facilities to financial institutions. On the one hand, the banks' argument — that forcing them to pre-fund all of their credit facilities to financial institutions would be just disatrous for them — isn't exceptionally strong. If pre-funding all of your credit facilities to financial institutions would be disastrous, then maybe you shouldn't promise to lend so much money! It's not crazy to require that banks promise to lend only as much money as they can deliver.

On the other hand, it is a bit unrealistic to assume that every single financial institution that has a credit facility with the bank will draw down 100% of the facility. Since these are credit facilities rather than liquidity facilities, their purpose is expressly not to refinance maturing debt. What, then, is the logic behind assuming that every single credit facility will get drawn down all at once? I think a 50% run-off rate would be more appropriate — and even that is probably quite conservative.

Cash Inflows from Credit and Liquidity Facilities

Finally, I don't understand why the LCR assumes that banks can't draw down their own committed credit and liquidity facilities with other banks. With regard to a bank's "cash inflows" during the 30-day stress period, the proposal assumes that "other banks may not be in a position to honour credit lines, or may decide to incur the legal and reputational risk involved in not honouring the commitment." But isn't the point of the LCR to ensure that banks are "in a position to honour credit lines"?

If Bank #1 has a liquidity facility with Bank #2, and both banks are subject to Basel III's LCR, then Bank #2 will have pre-funded the liquidity facility. Pre-funding liquidity facilities is, after all, one of the requirements of the LCR. Thus, it seems very odd to require Bank #1 to assume that Bank #2 won't be in a position to honor a liquidity facility that Bank #2 has pre-funded. I understand — and very much support — the Basel Committee's desire to be conservative. But at some point, the desire to be conservative has to give way to logical consistency.

10 comments:

Byrne said...

If your position regarding inflows is adopted, it sounds like a banking system that passed the stress test could have two stable equilibria: either a) in a worst-case scenario, the system is solvent, and banks lend to one another (i.e. there are inflows as well as outflows, as intended), or b) the system is insolvent, everybody does whatever they can to avoid lending to one another (i.e. there are no inflows, or if there are inflows, the other party involved will try to counteract them by raising money elsewhere and/or reducing exposure to the bank they just lent to, through other means).

Basically, unless you assume zero inflows, you create the possibility of a run on the bank. If people suspect that banks would not pass the stress test unless it assumed that they would keep lending to each other, that assumption could be enough to justify a run.

Kseniya (Kate) Strachnyi said...

Thank you for the post! Great article!

For a concise summary of Basel II vs. Basel III see the following link:

http://tinesworld.com/?p=130

Anonymous said...

Basically, if you don't assume no inflows,Diablo 3 Gold you actually make the possibility of a run on the lending company. When persons suppose that banking companies wouldn't normally complete the worries check until that suspected they would keep GW2 Gold kaufenlending together, of which forecasts could be adequate to warrant the run.

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