The Basel III liquidity standards and their implementation into EU legislation

Seminar on Basel II EnhancementsBasel, Switzerland, 27–29 April 2010

Stefan W. Schmitzstefan.schmitz@oenb.at

Disclaimer: The opinion expressed in this presentation is that of the author and does not necessarily reflect that of the OeNB/the Eurosystem/CEBS.

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Overview

1. Main Challenges

2. Why regulate? Feedbacks and Externalities

3. Basel III liquidity standards

4. Liquidity Identity Card (CEBS 2009 127 June 2009)

5. Liquidity Buffers & Survival Periods (CEBS December 2009)

6. Implementation in the EU

7. Impact on monetary policy implementation

8. Conclusions

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1. Main challenges

• Liquidity risk – low frequency/high impact & each crisis different & highly institution specific risk

– Probabilistic approach based on historical frequencies not feasible

• Psychological factors/confidence crucial for bank‘s liquidity

situation

• Externalities can be substantial

– Partly determined by psychological factors/confidence themselves

– Partly determined by very broad set of economic/financial conditions and

individual bank characteristics

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2.1 Why regulate? Feedbacks and externalities

• Due to asymmetric information a liquidity crisis at one bank can

lead to a loss of reputation and increasing uncertainty

– Bank runs on banks that are sound (often includes flight to quality)

– Dry-up of interbank markets (liquidity hoarding)

• Large and increasing share of interbank exposures and money

market instruments in banks’ funding

– Expected positive cash flow does not materialise

• Market liquidity in the capital markets

– Asset fire sales trigger market meltdown and cash flow from counter-

balancing capacity falls short of expectations

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2.2 Why is liquidity risk management an issue for central banks?

• Central banks rely on efficient and stable money markets

• Liquidity problems at one bank can negatively affect money market efficiency and stability

– Due to asymmetric information a liquidity crisis at one bank can lead to a loss of reputation and increasing uncertainty

– Large and increasing share of interbank exposures and money market instruments in banks’ funding

– Market liquidity in the capital markets

• Negative externalities of individual liquidity problems – a form of market failure – provide the major rationale for public intervention

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2.3 Central bank tasks affected by liquidity problems

Liquidity provision

Impact on central banks

Monetary policy implementation

Crisis management

Financial stability

Payment system

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2.4 Policy implications

Allow for institution specifity

All sources of material liquidity risk included

Reflect severity of potential contagion (proportionality)

Closely reflect underlying risk

(risk based)

Applicable to business as usual and under distress

Liquidity regulation

necessary to address contagion

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2.5 A functional approach

Business as usual• Banks should manage their expected liquidity needs in a

prudential manner under business as usual and …

Stress

• … be able to absorb liquidity shocks

• … also under times of market stress

• … for a pre-specified period of time

• … at acceptable costs.

Regulation & Supervision

• Supervision based on banks’ internal approaches.

• Minimum quantitative requirements.

Concerted rounds of common liquidity stress testsSources: Schmitz/Ittner (2007) Why central banks should look at liquidity risk, Quarterly Journal Central Banking Vol. XVII No. 4, 32-40; BSC (2008) Report on EU banks liquidity stress tests and contingency funding plans, European Central Bank.

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3.1 The Basel III liquidity standards

• No harmonisation of (quantitative) liquidity regulation

– Not even at the EU level

• Important high-level principles for qualitative liquidity regulation

– BCBS: Principles for Sound Liquidity Risk Management and Supervision in September 2008

– CEBS: CEBS’S Technical Advise on Liquidity Risk Management (2nd part) September 2008

• Liquidity Identity Card (June 2009), Guideline on Liquidity Buffers & Survival Periods (December 2009), Guideline on Liquidity Cost Benefit Allocation (work in progress)

– Widely accepted as standards for the assessment of banks‘ liquidity risk management practices

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3.2 Overview over the consultation document

International framework for liquidity risk measurement, standards and monitoring – BCBS December 2009

• Standards– Liquidity Coverage Ratio– Net Stable Funding Ratio

• Monitoring tools– Contractual Maturity Mismatch– Concentration of funding– Available unencumbered assets – collateral– Market related monitoring tools

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3.3 Liquidity Coverage Ratio (LCR)

Objective

• Liquidity even under very severe liquidity stress over 30 days w/o gov & CB assistence

• Minimum requirements

Definition LA (liquide Assets)

Narrow definition of liquid assets

• Cash, CB excess reserves

• Government bonds & gov guaranteed bonds

• Bonds of other public authorities

Broader definition

+ Covered bonds & non-financial corporate bonds (> A-) & high HC (20-40%) & substantial restrictions

Stress scenario

• Combination of market- & idiosynkratic stress

• Rating downgrade (3 notches)• Run-off of retail- & wholesale deposits• Primary & secondary markets (repo &

securitisation) dry-up for many assets• Large cash outflows due to off-balance items

1

30

T

OutflowCashNet

LA

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3.4 LCR: net-cashflow calibration

Cash outflows over 30 days

Retail deposits• 15%: Less stable deposits

• 7.5%: Stable retail deposits

Unsecured funding

• 100%: Unsecured wholesale funding (financials, banks, CBs & govs w/o operational relationship)

• 75%: Unsecured wholesale funding (non-financials, non-operational balance)

• 25%: Unsecured wholesale funding (non-financials, operational balance)

Secured funding

• 100%: Repos w asstes not eligible under LCR, margin calls (3 notche DG), ABCP & SIVs, Term ABS

• 0%: Repos w assets eligible under LCR

Credit & liquidity lines

• 100%: Planned outflows (e.g. new loans)• 100%: non-financial (li) & financials &

governments• 10%: Retail clients (credit & li), non-

financials (credit)

Cash intflows over 30 days

Retail loans• 100%: Planned inflows from performing

retail loans

Unsecured funding

• 100%: Planned inflows from performing wholesale loans

Secured funding

• 100%: Receivable from repo/reverse repo w assets not eligible under LCR

• 0%: Receivable from repo/reverse repo w assets eligible under LCR

Credit & liquidity lines

• 0%: Undrawn liquidity lines & other facilities

(Summary)

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3.5 Net Stable Funding Ratio (NSFR)

Objective

• Reduce maturity mismatch between funding and assets

– Assets > 1 y funded by liabilities > 1y

• Longterm stress scenario (market & idiosyncratic stress)

– Decline in profitability and/or solvency, downgrade in credit rating, reputational event

ASF (Available Stable Funding)

• 100%: Capital, hybrids, liabilities w residual maturity > 1 y

• 85%: Stable deposits

• 70%: Less stable deposits

• 50%: Wholesale funding (non-financials)

• 0%: Rest

2 x LCR run-offs

RSF (Required Stable Funding)

• 0%: Cash, CP, bonds w residual maturity < 1 y, non-renewable interbank loans

• 5%: Govies et al. ( AA)• 20%: Corporate bonds & covered bonds (

AA), residual maturity 1 y• 50%: Corporate bonds & covered bonds (

A-) 1 y, loans to non-financial corporates < 1 y

• 85%: Retail loans < 1 y• 10%: Off-balancesheet• 100%: Rest (incl. Govies > AA?)

1RSF

ASF

(Summary)

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3.6 Application issues

• Scope of application– At least on concolidated basis– Potentially also on sub-consolidated basis: treat affiliated entities same as third

parties.• Currencies

– At least aggregated across transferable and convertible currencies– Potentially on per currency basis

• Frequency of calculation & reporting– Calculation

– Ongoing basis – Meet requirements continuously

– Reporting– At least monthly, in stressed situation possibly weekly or daily– Time lag between calculation and reporting < two weeks

• Public disclosure– Value and level of the metrics, Size and composition of the components, drivers

behind the metrics. Frequency? Time lag?

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3.7 Monitoring tools

• Contractual Maturity Mismatch

– Report contractual inflows and outflows for the periods: overnight, 7 and 14 days; 1, 2, 3

and 6 months; 1, 3, and 5 years; and beyond 5 years.

• Concentration of funding

– Counterparties

– Products or instruments

– Currencies

• Available unencumbered assets that can be used as collateral in market and/or central

bank facilities

• Market related monitoring tools: market-wide information, financial sector information,

bank-specific information

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4.1 Liquidity Identity Card (I)

• Issued as CEBS 2009 127 in June 2009• Purpose

– Enable supervisors of EU cross-border banking groups to assess the liquidity risk exposure and risk bearing capacity of such groups

1. General and qualitative information to be provided at the group level

Objective: To clarify the degree of centralised management of liquidity risk and liquidity support of the group

2. Quantitative informationObjective: To allow supervisors to have a view on: short-term resilience as indicated by a liquidity buffer longer-term resilience and changes in balance sheet structure

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4.2 Liquidity Identity Card (II)

2.1 Liquidity Buffer

• Size of the buffer(s)

• Composition of the buffer(s) (type of assets, duration, and principal currencies)

• Contextual information (principal assumptions used for the combined stress scenario and time horizons considered)

2.2 Long-Term Funding Ratio

(Retail dep + wholesale funding > 1 y + equity instruments)/(Illiquid assets + contingent liabilities)

2.3 Diversification of the funding structure- Wholesale funding ratio

● Wholesale funding / total liabilities

● Unsecured wholesale funding as a percentage of total wholesale funding

- Funding Counterparty Concentration indicator

The amount of each of the five largest depositors held at the parent institution across all currencies

2.4 Domestic quantitative ratio (if any)

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4.3 Liquidity Identity Card (III)

3. Additional “à la carte” information

3.1 Market indicators

3.2 Synthetic Maturity ladder

3.3 “Core funding ratio” (Stable funding over liabilities)

3.4 Examples of additional metrics for specific vulnerabilities

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5.1 Liquidity Buffers & Survival Periods (I)

Issued in December 2009

Guideline 1 – A liquidity buffer represents available liquidity, covering the additional need for liquidity that may arise over a defined short period of time under stressed conditions.

Guideline 2 – Institutions should apply three types of stress scenarios: idiosyncratic, market specific, and a combination of the two. The core of the idiosyncratic stress should assume no rollover of unsecured wholesale funding and some outflows of retail deposits. The market-wide stress should assume a decline in the liquidity value of some assets and deterioration in funding market conditions.

Guideline 3 – A survival period of at least one month should be applied to determine the overall size of the liquidity buffer under the chosen stress scenarios. Within this period, a shorter time horizon of at least one week should also be considered to reflect the need for a higher degree of confidence over the very short term.

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5.2 Liquidity Buffers & Survival Periods (II)Guideline 4 - The liquidity buffer should be composed of cash and core assets that

are both central bank eligible and highly liquid in private markets. For the longer end of the buffer, a broader set of liquid assets might be appropriate, subject to the bank demonstrating the ability to generate liquidity from them under stress within the specified period of time.

Note: A few members advocate a more restrictive definition of eligible assets.

Guideline 5 – Credit institutions need to manage their stocks of liquid assets to ensure to the maximum extent possible that they will be available in times of stress. They should avoid holding large concentrations of particular assets, and there should be no legal, regulatory, or operational impediments to using these assets.

Guideline 6 – The location and size of liquidity buffers within a banking group should adequately reflect the structure and activities of the group in order to minimize the effects of possible legal, regulatory or operational impediments to using the assets in the buffer.

Annex 1: Institutions should develop cash-flow projections covering expected cash inflows and outflows and expected counterbalancing

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5.3 Example: behavioural maturity mismatch (I)

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5.4 Example: behavioural maturity mismatch (II)

Simple embedded stress test

Source: OeNB. Schmitz/Weidenholzer (2009) Recent Developments in the Austrian Banking System’s Liquidity Situation and the International Regulatory Debate, Financial Stability Report No. 18, 60-66

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6.1 CRD IV: Procedure

Tentative procedure and time table

• Public Consultation regarding further possible changes to the Capital

Requirements Directive (“CRD”)

– Launched on 26 February 2010

– Ended on 16 April 2010

• Analysis of consultation documents

• Next draft of CRD IV – end of 2010

• EU directive – end of 2011

• Implementation at national level – end 2012

• Bank compliance – as of 2013

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6.2 Public consultation EU COM

Regulation on EU level – Current State as of March 2010

• No quantitative regime as for example minimum ratios for liquidity risk

• No common reporting requirements in COREP

• High-level provisions for Liquidity risk management in Pillar II

– Measuring liquidity risk is broadly stipulated in Annex V (net funding

requirements)

– Contingency funding plans and Stress Testing are compulsory

– ICAAP does not require to hold capital against liquidity risk

• More detailed C-EBS Guidelines

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6.3 Public consultation EU COM

1. Scope of application– Individual stand-alone basis

– EU parent credit institution at consolidated level

– Investment firms (>730 K)

2. Waivers– Application to individual firms can be waived at domestic level

– Li risk managed centrally, legally binding mutual agreements and assets are freely transferrable even under stress, EU parent is subject to CRD IV and entities belong to the same group

– Application of waiver for legal entities located in different MS– : Assessed and agreed by all competent authorities of all relevant MS– Disagreement supervisor of subsidiary takes final decision

– No waiver for EU subsidiaries of non-EU parent credit institution– Free transferability questioned

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6.4 Public consultation EU COM

3. Treatment of intragroup exposure– EU COM favours symmetrical treatment

– Intra-group liquidity/credit lines: neither in- nor outflows of liquidity at respect group members

– Intra-group loans/deposits are assumed to be rolled

– Alternative 1 (symmetrical)– Intra-group liquidity/credit lines: consider in- and outflows

– Alternative 2 (non-symmetrical)– Intra-group liquidity/credit lines & loans/deposits: consider outflows but not inflows

4. Supervisory responsibility for branches– Article 41 sub-para 1, EU Directive 2006/48EC

– Host supervision of branch liquidity „pending further coordination“

– Harmonised li-standards home supervisor for branch liquidity– Legally all obligations of branch are obligations of the credit institution and subject to home

country insolvency procedure

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6.5 Public consultation EU COM

5. Monitoring tools

– Contractual maturity mismatch, concentration of funding, available

unencumbered assets (for CBs and repos), market related m,onitoring

tools

– Problems: behavioural maturity mismatch preferrable for < 12 months, less

detailed contractual maturity mmismatch for > 12 months less detailed

6. FX

– LCR not to calculated on currency basis

7. Liquid assets

– Broader definition than Basel III envisaged

8. Public disclosure currently not required

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6.6 Critique (I)

1. Positive: binding quantitative li-standards based on functional approach

2. Ratios can be circumvented– Insufficient picture of li-situation

– Definition of components product specific

3. Liquid assets too narrow– Inconsistent with functional approach

– Unintended consequences – Feedback on market liquidity through frozen portfolios?

– Increasing reliance on CRAs

– Feedback & contagion: fire sales price mark-to-market downward spiral

– Prudent risk management calls for portfolio diversification

– Exclusion of bank bonds – market for bank bonds?

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6.7 Critique (II)

4. Ratios too strict– Fight past battle

5. Scope of application– Size of liquidity reserves

– Trapped pools of liquidity

– Use of reserves under stress

6. Non-level playing field

– Decentralised sectors, commercial banks, custodian banks

– Non-rated banks – challenges to issue long-term debt

– Standards developed for large cross-border banking groups – applied across EU bifurcated approach needed

– Shift liquidity transformation outside banking system?

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6.7 Critique (III)

7. Inconsistencies between CRD IV and CEBS Guidelines

8. Potential impact

– Additional long-term funding in EU: 1,100 bn EUR to 3,000 bn EUR priced

into liquidity intensive products

– Competition for deposits intensivies – deposit growth/long-term debt issuance

constrain loan growth

– Challenges for emerging, fast growing economies

– Asymmetric treatment of intra-group exposure extremely liquidity intensive

– Interbank market – liquidity insurance, structural li-deficit & monetary policy

implementation

9. Preferrable approach – concerted rounds of common liquidity stress tests

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7.1 Impact on monetary policy implementation – first thoughts

D

R

∆RS

= structural liquidity deficit

D(rpol)

Sr S1

∆RD

LF

DF

rpol

Source: Schmitz (2006) Monetary Policy in a World without Central Bank Money, in: Stefan W. Schmitz, Geoffrey E. Wood (eds.), Institutional Change in the Payments System and Monetary Policy, Routledge, London, 131-157

Until 08/07: Unsecured and repo market close substitutes OMOs anchored unsecured M

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0

1

2

3

4

5

62

.1.2

00

7

2.3

.20

07

2.5

.20

07

2.7

.20

07

2.9

.20

07

2.1

1.2

00

7

2.1

.20

08

2.3

.20

08

2.5

.20

08

2.7

.20

08

2.9

.20

08

2.1

1.2

00

8

2.1

.20

09

2.3

.20

09

2.5

.20

09

2.7

.20

09

2.9

.20

09

2.1

1.2

00

9

2.1

.20

10

2.3

.20

10

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

3MEurepo

3MEuribor

~7 Bp

~ 28 Bp

Spread (rhs)

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7.2 Impact on monetary policy implementation

Individual bank

– Net short position on IB market < 30 days requires 100% liquid asset coverage

– Strong disincentive to borrow unsecured, rather repo in eligible assets

– Collateral demand increases

Interbank market – Reduced volume on unsecured interbank market– EONIA loses relevance & information content– Market loses insurance function– Market loses distribution & allocation function

Demand for CB money

– Banks self-insure higher, more volatile excess reserves– More aggressive bidding behaviour– Structural liquidity deficit more volatile

OMOs– More banks participate– Structural liquidity deficit harder to estimate more volatile allotment rate– Collateral bias towards less liquid assets ear-making?

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7.3 Impact on monetary policy implementation

r

D(rpol)

D

S

R

∆RS

= structural liquidity deficit

S1

∆RS²

LF

DF

rpol

S² S²*S²*

D²

D²*

D²*

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7.4 Reform options

• EONIA loses information content target Eurepo instead of Euribor

• Loss of allocation & distribution function broader participation & shift to repo

market in eligible assets demand for collateral increases

• Higher volatility of structural liquidity deficit more frequent OMOs/FTOs & more

LTRO

• More volatile short-term rate narrower interest rate corridor

• Collateral arbitrage higher, more risk sensitive haircuts

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8. Conclusions

+ Harmonisation important step forward

+ Functional approach welcomed

– Basel III and CEBS diverge in some points

– CRD IV: consultation – not final directive

– Fundamental divergence of opinions across MS and with

industry

– Number of critical points

– Monetary policy implementation needs to be adapted