Financial regulation through new liquidity standards and implications for institutional banks

Table of contents

List of figures

List of tables

List of abbreviations

I Introduction

II Objectives

III Methodology

1 Financial regulations
1.1 History of the Basel Committee and financial reforms
1.2 Development of Basel III
1.3 Main contents of Basel III

2 The liquidity standard
2.1 General remarks on the new liquidity standards
2.2 Liquidity Coverage Ratio
2.2.1 LCR objective and formula
2.2.2 Meaning of: Stock of high quality liquid assets
2.2.3 Total net cash outflows
2.2.5 LCR by currency
2.3 Net Stable Funding Ratio
2.3.1 NSFR objective and formula
2.3.2 Available amount of stable funding
2.3.3 Required amount of stable funding
2.4 Monitoring tools
2.5 Transitional arrangements and jurisdiction

3 First results by measuring the proposed changes
3.1 Results from different institutions
3.2 Results from the IMF
3.3 Results from the IIF
3.3.1 Content of the IIF report
3.3.2 Special LCR assumption and the calculation results
3.4.1 Content of the QIS
3.4.2 QIS results for the LCR impact
3.4.3 QIS results for the NSFR impact

4 Banks business strategy adjustment as impact of the new LCR
4.1 LCR distorting bond markets
4.2 Assumed refinancing demand of liquid assets cost profitability
4.3 The benefit of ECB collateral
4.4 Implications for covered bond issuers and investors

5 Banks business strategy adjustment as impact of the new NSFR
5.1 Banks need to increase stable funding
5.2 Stable funding alternatives
5.2.1 Deposit gathering
5.2.2 Covered bonds as secured funding gets an important status
5.2.3 Securitization disruption
5.2.4 Unsecured wholesale funding

6 Regulatory extensions as impact of the new liquidity requirements
6.1 The same regulation standard for all financial institutions
6.2 Existing German regulation in comparison with new rules

7 Discussion and improvements for the new liquidity standard
7.1 Supply of liquid assets and demand for stable funding
7.2 Important senior unsecured funding for banks and their effects
7.3 Sufficient acceptance of covered bonds
7.3.1 Covered bonds versus government bonds
7.3.2 Distinction within the covered bond sector
7.4 Higher consideration of certain ABS

8 Conclusion

Annex

Bibliography

Internet references

List of figures

Figure 1: LCR formula

Figure 2: Two categories of high quality liquid assets

Figure 3: Total cash out- and inflow in detail

Figure 4: NSFR formula

Figure 5: ASF - types, amounts and allocations

Figure 6: RSF - funding classes and haircuts

Figure 7: Spreads Jumbo-Pfandbriefe versus other jumbo covered bonds

Figure 8: Outstanding European jumbo covered bond volume

Figure 9: Basel III with more or less two more new pillars

Figure 10: Formula for standardised approach

List of tables

Table 1: LCR results

Table 2: NSFR results

List of abbreviations

illustration not visible in this excerpt

I Introduction

The global financial crisis which began in mid-2007 revealed the significant risks posed by large, complex and interconnected institutions and the faultlines in the regulatory and oversight systems. The drying up of market liquidity caused lacks of funding for financial institutions and their reactions to the market stress increased the market tensions which highlighted the strong link between banks funding liquidity and market liquidity.^[1] Over the past two decades preceding the crisis, banks in advanced countries significantly expanded in size and increased their outreach globally. In many cases, they moved away from the traditional banking model towards globally active large and complex financial institutions. The majority of cross-border finance was intermediated by some of these institutions with growing interconnections within and across borders. The result were trends in the banking industry which include a sharp rise in leverage, significant reliance on short-term funding, significant off-balance sheet activities, maturity mismatches and increased share of revenues from complex products and trading activities. This development has moved on to a systematic risk and it has been identified a need in the financial sector to measure those aspects, to assess the resilience of the financial sector to liquidity shocks and give guidance to the policy of central banks and regulators.^[2]

At the same time, the financial industry has started a fast process of consolidation worldwide. Regulators, organized in the Basel Committee on Banking Supervision (BCBS) have responded to the financial crisis by proposing new regulation which is known as "Basel III”. The reform program leads to fundamental changes and implements capital and liquidity reforms. The liquidity reform represents the first attempt by international regulators to introduce harmonized liquidity minimum standards for financial institutions.^[3] Extensive efforts through the Basel Committee, with the "Basel III” program, are being considered internationally and domestically to revise these deficiencies and failures, in order to safeguard the stability of the financial system. The key objective is to promote a less leveraged, less risky, and thus a more resilient financial system that supports strong and sustainable economic growth. The bulk of the proposals have focused on revising existing regulations applicable to financial institutions and to influence the extent and consequences of their risk taking. These include enhancing the quality and quantity of capital and liquidity buffers, strengthening risk assessment, and enhancing the supervision and governance of financial institutions.^[4]

The impact of the new rules is substantial. In the absence of any mitigating actions, the banking industry will face a major challenge merely to achieve technical compliance with the new rules and ratios, let alone to reorient the institution for success. The implementation of the new regulation is easier by long transition periods prescribed by Basel III with some rules which must not being fully implemented until 2019. Banks have now the opportunity to rethink their portfolio of business and the business model of each. Some business may require only a few adjustments, while others will be fundamentally affected.

II Objectives

This paper will present the fundamental aspects of the implementation of the Basel III liquidity requirements and resultant implications for institutional banks. Institutional banks are in this connection always banks with a strong relation to capital market business. Due to the level of complexity of these described implications are only be considered with examples of institutional banks in the European banking environment and especially in the German banking environment. In addition, the analysis of the new liquidity standard and resulted implications for institutional banks can either be done in detail concerning the so far proposed liquidity requirements, or with regard to less detailed information and possible adjustments within the framework in near future, relating to the main topics which the liquidity standard require and banks primarily in touch with. Due to time restriction as well as nature and extent of the given FOM standards for Master Thesis the main topics will be analyzed with which banks primarily will be in touch with.

III Methodology

The first chapter following the introduction presents the history of the Basel Committee and its designed financial reforms. Especially the development of the new Basel III reforms as well as the main features of the regulation will be discussed. The second chapter deals with the explanation and the purpose of the liquidity standard. The increasing importance of new liquidity requirements makes it necessary to imbed the broadest definitions of the so far implemented components in the liquidity framework in a closed summary which will be illustrated also with figures. Chapter three gives an overview over three different studies from approved experts about the current degree of achievement by different financial institutions in different countries. The fourth chapter deals with the effect of banks business strategy adjustment as impact of the new "Liquidity Coverage Ratio” (LCR). The main subject of this ratio is the increase of liquid assets and hence possible resulting effects. As in chapter four, the fifth chapter deals with the banks business strategy adjustment as impact of the new "Net Stable Funding Ratio” (NSFR). The primary subject of this ratio is the need of medium/long-term funding and will be analyzed on the basis of three different funding instruments. Chapter six deals with the subject of regulatory extensions which are also implemented in the Basel III liquidity requirements. Building on this, chapter seven investigates possible improvements for the new liquidity standard which have a primarily impact for institutional banks. The eighth chapter concludes the paper with a summary of the acquired findings and a critical assessment of the new Basel III liquidity standard and the implications for institutional banks.

1 Financial regulations

1.1 History of the Basel Committee and financial reforms

The Basel Committee was created in 1974 by the heads of both: central banks and the organisations in charge of the banking regulation and supervision of the main industrialised countries. Its name is derived from the fact that it is based in Basel within the Bank of International Settlements (BIS). The mission of the Basel Committee is to encourage the implementation of stricter supervision and regulation of the banking system. The Basel Committee publishes regular recommendations under the aegis of the BIS. European governments and organisations are in charge of transferring these recommendations into European and national law. These recommendations are resulted in the adoption of the Capital Requirement Directive (CRD) and the Basel Agreement.^[5]

In 1988, when the capital ratios of the world’s largest banks fell to dangerously low levels due to competitive pressure, the Basel Committee on Banking Supervision felt compelled to take action. From the mid-1970s onward, the committee had mainly been making efforts to close gaps in international supervision and to develop suitable supervisory standards. At that point they decided to publish capital adequacy recommendations.^[6] The result was the Basel Capital Accord, which was applied to international banks in the G-10 countries. This system of capital measurement (called "Basel I" in retrospect), which is still in force today, was a milestone in the international harmonization of regulatory capital requirements.^[7]

In June 1999, the Basel Committee on Banking Supervision (BCBS) began the process of developing the 10-year-old Basel I with a more up-to-date regulation. The new Basel Framework with the name "Basel II” has the aim to improve the stability and reliability of the financial system. "Basel II is based on three mutually reinforcing pillars: minimum capital requirements (Pillar I), the supervisory review process (Pillar II) and market discipline (Pillar III).“^[8] In June 2004, the Basel Committee published its new Basel Framework which it came into force at the end of 2006.^[9]

1.2 Development of Basel III

The recent crisis, which started in mid 2007, revealed the significant risks posed by large, complex and interconnected financial institutions and unsatisfactory regulatory supervision over the financial system. Many banks struggled to maintain

adequate liquidity and unprecedented levels of liquidity support from central banks

were required in order to sustain the financial system.^[10] Almost from the start of the financial crisis, there has been broad agreements that the global banking system needed a less leveraged, less risky, and thus a more resilient financial system that supports strong and sustainable economic growth.^[11] The Financial Stability Board (FSB), consisting of a global group of regulators and central banks, started to

develop recommendations on regulatory reforms as early as the beginning of the

financial crisis.^[12] A wide array of reforms governing the global banking industry has been submitted in recent months in response to the excesses that became obvious in the global financial crisis from 2007 to 2008.^[13]

In December 2009, the BCBS published a consultation paper on the "International framework for liquidity risk measurement, standards and monitoring” and the con­sultation period closed in April 2010.^[14] The Basel Committee received plenty of feedback and recommendations from various market participants, interest groups and numerous other national banking associations.^[15] The BCBS has taken the feedback and the recommendations into account by creating the reform program to address the lessons of the crisis. Following endorsement of its proposed reforms of the Basel II framework at the G20 Seoul Summit in November 2010, the BCBS published the Basel III rules on 17 December 2010. The rules are contained in two separate documents:

(1) Basel III: A global framework for more resilient banks and banking systems and
(2) Basel III: International framework for liquidity risk measurement, standards and reporting.^[16]

Additionally to the Basel III rules the Basel Committee published a third paper, the "quantitative impact study” (QIS). This study measured the impact of the new standards on banks liquidity and equity and showed to which degree banks already meet the standard. A total of 263 international banks participated in the QIS exercise and were divided into two groups of banks with different characteristics. The study assumes a full implementation of the Basel III package and is based on year-end data from 2009.^[17] For further information and results see chapter 3.4.

1.3 Main contents of Basel III

The BCBS developed further reforms with Basel III to strengthen the global financial banking sector and make it more resilient.^[18] Compared to the existing Basel II regulatory framework the bulk of the Basel III can roughly be subdivided into two key elements of risks: the minimum capital standards and the minimum liquidity standards. The new rules are implemented in a transitional manner and must be completed in different steps until 2019.^[19]

With the new Basel Framework for the International Convergence of Capital and Capital Standards, the Basel Committee introduced international standards for bank capital adequacy requirements. The new capital standard is divided into three pillars: Pillar 1 defines the minimum capital requirements, which include capital requirements for credit risk, market risk and operational risk, Pillar 2 adds qualitative elements to the quantitative minimum capital requirements of Pillar 1, Pillar 3 defines the obligation to disclose information about a bank’s capital resources, capital requirements and the associated risks to the public.^[20]

The most significant aspect of the Basel III liquidity requirements is the setting of specific liquidity standards, which builds on prior work detailing how liquidity risk should be considered, measured and addressed. The first objective is to promote short-term resilience in the liquidity-risk profile by ensuring sufficient high-quality liquid resources to survive an acute stress scenario lasting for one month. The second objective is to promote resiliency over longer-time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis.^[21]

In interest of time and size of the given FOM standards for master thesis, the following chapters deal with the new liquidity standards and the implication for institutional banks.

2 The liquidity standard

2.1 General remarks on the new liquidity standards

One of the key problems of financial institutions during the financial crisis was the urgent liquidity need resulted from investment into illiquid assets and from a high degree of maturity mismatch. Investments in assets were made over a rather long horizon and could not sell without realizing large losses during the crisis. On the other hand, funding of these investments was often made at the short end and could not further extend to match the maturities and refinance the long-term maturity assets. The result was that banks needed to set up funding structures with a reduced reliance on short-term and unstable wholesale funding as well as build a buffer of high liquid assets which could be sold without large losses in times of stress.^[22]

The new Basel III liquidity framework proposes two internationally harmonized measures of liquidity risk exposure that aim to eliminate the investment/funding mismatch with improvements in banks resilience to acute (within 30 days) and medium/long-term (within 12 months) liquidity stress. The short-term metric is known as "Liquidity Coverage Ratio” (LCR) and introduces a specified stress scenario. It requires banks to maintain liquidity buffers sufficient to cover net cumulative cash outflows at all times during a 30-day period. The second objective, the structural funding metric with the name "Net Stable Funding Ratio” (NSFR) introduces minimum requirements for the use of longer-term and more stable funding sources to finance less liquid assets.^[23] Regarding the NSFR, the Basel Committee reaffirms its commitment to introduce the ratio as a longer-term structural complement to the LCR.^[24]

The liquidity framework includes furthermore a set of tools for the ongoing monitoring of liquidity risk exposures and information exchange among supervisors.^[25]

2.2 Liquidity Coverage Ratio

2.2.1 LCR objective and formula

The LCR is meant to ensure that banks maintain a stock of high quality liquid assets which is sufficient to meet short-term liquidity needs.^[26] The LCR objective in the official Basel III framework for liquidity risk measurement, standards and monitoring is: "The standard aims to ensure that a bank maintains an adequate level of unencumbered^[27], high-quality liquid assets that can be converted into cash to meet its liquidity needs for a 30 calendar day time horizon under a significantly severe liquidity stress scenario specified by supervisors. At a minimum, the stock of high quality liquid assets should enable the bank to survive until day 30 of the stress scenario, by which time it is assumed that appropriate corrective actions can be taken by management and/or supervisors, and/or the bank can be resolved in an orderly way.”^[28]

LCR standard builds on the traditional internal methodologies used by banks to assess exposure to contingent liquidity events and is defined in the following formula in figure 1.

illustration not visible in this excerpt

Figure 1: LCR formula

Source: ECB (2010): Strengthening the resilience of the banking sector: the Basel proposal for an international framework for liquidity risk, URL: http://www.ecb.int/paym/groups/pdf/mmcg/basel liquidity framework.pdf?48 010bf090fb57fa8b9ac919231e2d43, accessed 06.01.2011.

The relation of these positions must be at least 100 percent at all times.^[29] An example for LCR calculation can be found in the annex 1).

2.2.2 Meaning of: Stock of high quality liquid assets

The "stock of high quality liquid assets” is in the numerator of the LCR. The understanding of the standard is that banks must hold a stock of unencumbered high quality liquid assets to cover the total net cash outflows over a 30-day period under the described stress scenario in 2.2.4.^[30] The implementation of the definition is intended to favour those assets that are counted as liquid, and at the same time reduce incentives to hold assets that are considered less liquid.^[31] The Basel Committee has liberalized the definition of what counts as a liquid asset in their liquidity framework from December 2010. The high quality liquid assets can be divided into two categories:^[32]

Level 1 assets: These assets are limited to cash, central bank reserves which can be drawn down in times of stress and certain categories of government debt. Level 1 assets can comprise an unlimited share of liquid asset pool for the purposes of the LCR and are not subject to a haircut under the LCR.

Level 2 assets: These assets include certain categories of government debt and at least AA- rated corporate bonds (issued by non-bank issuer) and covered bonds which have a proven track record as reliable source of liquidity (repo or sale) in the capital market. Level 2 assets may not comprise more than 40 percent of the overall liquid asset pool for the purpose of the LCR and will have haircuts applied to their current market value. A minimum haircut of 15 percent must be applied to Level 2 assets.^[33]

illustration not visible in this excerpt

Figure 2: Two categories of high quality liquid assets

Source: Own illustration, following: BCBS, International framework for liquidity risk measurement, standards and monitoring, 2010, p. 7 ff.

2.2.3 Total net cash outflows

In the denominator of the LCR are the "net cash outflows”. The "net cash outflows over a 30-day time period” are determined by the total expected cash outflows minus total expected cash inflows and reflect the net amount of funding that may disappear within the 30 days under a stress scenario which is described in chapter 2.2.4.^[34] Total expected cash outflows are calculated by multiplying the outstanding balances of various types of liabilities and off-balance sheet commitments by rates at which they are expected to run off^[35] or be drawn down.^[36]

Figure 3: Total cash out- and inflow in detail

illustration not visible in this excerpt

Source: Own illustration, following: BCBS, International framework for liquidity risk measurement, standards and monitoring, 2010, p. 12 ff., 10.01.2011.

2.2.4 Assumptions of the stress scenario

The developed stress scenario involves many of the shocks experienced during the current crisis into one acute stress for which sufficient liquidity is needed to survive up to 30 calendar days.^[37] With the focus on stress testing, the new framework has prescribed principles that are aimed at reducing differences in methodologies to conduct stress testing.^[38] The factors of the stress scenario are: a three notch downgrade of the institution’s public credit rating, a run-off of a proportion of deposits, a loss of unsecured wholesale funding, a significant increase in secured funding haircuts, increases in derivative collateral calls and substantial calls on contractual and non-contractual off-balance sheet exposures, including committed credit and liquidity facilities. These stress factors are reflected in the percentages which are listed in figure 3.^[39]

2.2.5 LCR by currency

The International framework for liquidity risk measurement, standards and monitoring also explicitly defines the LCR by Currency ratio. This will make sure that there are no major currency mismatches in the LCR. The ratio will also only apply to currencies if aggregate liabilities in that currency make up more than 5 percent of banks total liabilities. This ratio will also be used by host supervisors to monitor whether cross-border firms have enough liquidity to handle the liquidity needs of the legal entity.

The BCBS recognizes that some jurisdictions will not have enough assets that qualify as level 1 or level 2 assets to make up the buffer and keep a deep active market. To determine which jurisdictions fall into this category, a prescriptive quantitative threshold will be developed during transition, with possibly qualitative criteria as well. Once the designation is made, there are three potential remedies. Banks can:

1) Set up committed liquidity facility lines with the central bank, with a fee to reflect a yield comparable to other liquid assets;
2) Use liquid assets denominated in a foreign currency; or
3) Allow Level 2 assets above the current 40 percent threshold, subject to additional haircuts. ^[40]

2.3 Net Stable Funding Ratio

2.3.1 NSFR objective and formula

The NSFR should promote short-term resilience over a longer period by creating additional incentives for banks to fund their activities with more stable funding on an ongoing basis. The idea is to require banks to hold a minimum amount of medium/long-term funding in relation to the underlying liquidity risk of assets.^[41] In the official Basel III framework for liquidity risk measurement, standards and monitoring is the definition of the NSFR objective: "This metric establishes a minimum acceptable amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon. This standard is designed to act as a minimum enforcement mechanism to complement the LCR and reinforce other supervisory efforts by promoting structural changes in the liquidity risk profiles of institutions away from short-term funding mismatches and toward more stable, longer-term funding of assets and business activities.”^[42]

The ratio is defined as:

Figure 4: NSFR formula

illustration not visible in this excerpt

Source: ECB (2010): Strengthening the resilience of the banking sector: the Basel proposal for an international framework for liquidity risk, URL: http://www.ecb.int/paym/groups/pdf/mmcg/basel liquidity framework.pdf?480 10bf090fb57fa8b9ac919231 e2d43, accessed 06.01.2011.

The NSFR ratio must equal or exceed 100 percent at all times. An example for LCR calculation can be found in the annex 2).

2.3.2 Available amount of stable funding

The "available amount of stable funding” (ASF) includes those types and amounts of equity and liability financing expected to be reliable sources with a maturity of more than one year under conditions of extended stress scenarios (see chapter 2.1.1). Each ASF factor is allocated between a range from 100 percent to 0 percent to the items on the liability side of the balance sheet depending on their availability in the extended firm-specific stress-scenario.^[43]

In calculating the ASF, a liquidity factor is associated with each category. The ASF is calculated as the weighted sum of the amounts by factors of liquidity. An overview over the different factors of liabilities gives the following figure 5.

Figure 5: ASF - types, amounts and allocations

illustration not visible in this excerpt

Source: Own illustration, following: BCBS (2010) International framework for liquidity risk measurement, standards and monitoring, p. 26 f., 10.01.2011.

2.3.3 Required amount of stable funding

The denominator of the NSFR is the "required amount of stable funding” (RSF). This factor is calculated as the sum of the value of assets which are held and funded by a bank. The RSF applies various haircuts or percentage reductions between a range from 0 percent to 100 percent, to various asset types which depend by their liquidity characteristics.^[44] The categories deemed more illiquid are assigned a higher weigh (see figure 6) so they require a higher amount of stable funds under the NSFR ratio. Illiquidity, according to this measure, is defined as the amount of a particular asset that could not be converted into cash through sale or use as collateral in a secured borrowing on an extended basis during a liquidity event lasting one year.^[45]

Figure 6: RSF - funding classes and haircuts

illustration not visible in this excerpt

Source: Own illustration, following: BCBS (2010) International framework for liquidity risk measurement, standards and monitoring, p. 28 ff., 10.01.2011.

2.4 Monitoring tools

Beside the calculation of the standardized liquidity risk measures the Basel Committee has listed a significant increase in the set of monitoring metrics that should be considered as the minimum types of information supervisors should use

in their monitoring activity.^[46] Banks will have to provide raw data to the supervisor to enable him to calculate at least the following metrics:

(1) Contractual maturity mismatch: a bank should report contractual cash and security inflows and outflows from all on- and off-balance sheet items. These flows have to be mapped to defined time bands based on their respective maturities.
(2) Concentration of funding: this type of information is the information of sources of wholesale funding whose withdrawal could trigger liquidity problems. This includes the funding liabilities sourced from each significant counterparty or product/investment as percentage of balance sheet as well as a list of asset and liability amounts per significant currency.
(3) Available unencumbered assets: the metric should provide supervisors with a list of available unencumbered assets that are marketable as collateral in secondary markets and/or eligible for Central banks standing facilities.^[47]
(4) LCR by significant currency: this metric is designed to capture currency mismatches as a result of consideration of foreign currency liquid assets. The foreign currency LCR is the stock of high quality liquid assets in each significant currency compared to total net cash outflows over a 30-day period in that specified currency.^[48] A currency is classified as “significant” if the aggregate liabilities denominated in that currency amount to minimum 5 percent of the banks total liabilities.^[49]
(5) Market-related monitoring tools: this monitoring tool is covering high frequency market data which can be used as early warning indicators in monitoring potential liquidity difficulties in the entire market, the banking sector and the individual institution.^[50] Tools could be e.g. bank-specific CDS spreads, equity prices as well as market-wide metrics such as liquidity of different assets and asset prices.^[51]

2.5 Transitional arrangements and jurisdiction

These standards should be implemented by the supervisors in each country. Both the LCR and the NSFR will be subject to an observation period beginning in 2011 which will be used to monitor the implications of these standards and address any unintended consequences.^[52] In order to give banking organizations time to develop their reporting systems, reporting to supervisors will for the first time be required by January 1, 2012. The LCR will be introduced on January 1, 2015 and the NSFR will become a minimum standard on January 1, 2018.^[53]

Most of the parameters which are used in the standards are internationally harmonized, but a few of the parameters contain elements of national discretion to reflect jurisdiction-specific conditions. In these cases, adjusted parameters should be transparent and clearly outlined in the regulations of each jurisdiction to provide clarity within the jurisdiction as well as international^. The liquidity standards will establish minimum levels for the banking sector; however, national authorities are free to require higher minimum levels of liquidity.^[54]

3 First results by measuring the proposed changes

3.1 Results from different institutions

The current Basel III requirements are much more demanding for institutional banks than the Basel II requirements. Especially the new liquidity standard, which were not in place in this form before, requires a completely new systematic. These requirements include the calibration of pressures on firms concerning liquidity needs and the assets eligible to be counted as liquid. The common changes will certainly have effects on the short-term and medium/long-term markets as well as change the market among banks for other banks paper, which are generally treated less favourable.^[55]

Banks, consulting companies and other established institutions analyzed the potential effects of the new banking regulatory framework and published their results. All these results are based only on assumptions which refer to available bank businesses. This includes that only banks are considered which were able to deliver the needed information. It is possible to get a good overview from established institutions which made an ongoing analysis over the level of achievement from the banks ratios. Beside the QIS from the BIS, which is the official analysis of the Basel Committee over the impact of the new requirements, the IMF and IIF also published impact reports.

3.2 Results from the IMF

The IMF report about the "Impact of regulatory Reforms on Large and Complex Financial Institutions” provides an illustrative analysis of the new liquidity requirements. The key objective of the analysis is to explore how banks and their business strategies are influenced by the proposed regulations. The calculation includes 20 countries with a total of 62 banks from Asia, Europe and North America and is based on 2[nd] Quarter 2010 data.^[56]

The general estimations from the financial industry is that most of the analyzed banks would meet the LCR requirements. For the few institutions which do not meet the LCR criteria yet, the liquidity gap may be limited and manageable. Due to the lack of publically disclosed information the LCR is not analyzed quantitatively. By using the liquid assets^[57] to total assets ratio as a comparison value for the liquidity coverage it can be shown that Asian and European banks have the best short-term liquidity positions. The Asian banks impress with their simple balance sheet structure concerning limited amount of complex securities and a stronger funding profile with the focus towards deposits.^[58]

Results in the IMF paper in case of suggestions for the LCR are only given with a view on special risk management. Especially banks with global activities may face additional funding challenges because of tighter liquidity requirements, which force every subsidiary/branch to meet LCR-criteria itself. Also the management of high quality liquid assets obtains a special importance in countries which have only few outstanding government debts. In these jurisdictions banks mainly manage their liquidity risk with assets beside government bonds. Therefore the LCR will be negatively affected because of less favourability of non-government assets. The result of the increased holdings of government securities to meet the LCR requirement may raise challenges in an environment of increased sovereign risk.^[59]

The IMF analysis of the NSFR illustrates a wide variation in banks ability to meet the required 100 percent level. On closer examination of the different countries it is for sure that European banks would be most affected by the NSFR requirements. The reason of this effect is reflected by large amounts of long-term lending on the asset side and a higher dependence on wholesale funding. Most of the North American and Asian banks meet the 100 percent NSFR requirements, whereby some Asian banks have a similar balance sheet structure like the European banks. Considering the average achievement in the analyzed countries, the minimum of 100 percent of the NSFR will be fully reached in two countries. The average NSFR for European banks is 89 percent for Asian banks 112 percent, and for North American banks 127 percent. The reason for the distinctive above average for banks in North America is the result of a high share in high quality liquid assets, and high share of deposits.

The IMF suggestions to meet the NSFR requirements are divided clearly into three separate options. Banks have to improve individually the banks funding mix by issuing medium/long-term senior unsecured funding, covered bonds, and raising more customer deposits. On the other hand is the IMF suggestion, to reduce banks assets investments with a high RSF factor.

The IMF reminds, however, that all this three options could have negative implications for the individual bank. At first the possible change in the funding structure towards medium/long-term debt. By issuing medium/long-term funding a bank has the effect that they always pay a term premium. Second, attempts to cover the funding shortage with deposits would intensify competition in local

deposit markets and raise difficulties and costs associated with building branch networks^[60]

3.3 Results from the IIF

3.3.1 Content of the IIF report

The IIF published the “Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework”. This report illustrates the impact of the requirements in the banking systems and the macroeconomic implications of the reform program. The IIF analyzed the impact on the United States, Euro Area and Japan as well as some smaller mature economies and larger emerging economies. The applied model is constructed of the net cumulative impact of the changes in the new regulation by running two different scenarios through 2020. The first scenario is the “base” scenario in which the IIF used neutral long-term assumptions about GDP and inflation, and a regulatory environment without significant changes beyond those introduced during the crisis. The second scenario is a "regulatory reform” scenario which considers a series of Basel III regulatory changes.^[61]

Some general key considerations are very important for the interpretation of the results. This model has the assumption that it is always possible for banks to issue more of common equity and medium/long-term debt and place it in the market, as long as they are willing to pay an appropriate price. Furthermore, the IIF also assumes fairly flexible bank product pricing.^[62]

3.3.2 Special LCR assumption and the calculation results

The IIF made special assumptions for the LCR calculation under regulatory change scenarios. They adjust the overall liquid asset ratio (the ratio of cash and government bonds held to total assets), to ensure that banks comfortably meet the LCR through the projection horizon. That scenario provides banks target a stable liquid asset ratio until 2014 and thereafter the scenario considered a continuous decline of 15 percent of liquid assets. The regulatory reform scenario suggests that the stock of high quality liquid assets increase to 22 percent in 2012 and 2013, followed by a reduction to 18 percent until 2020. The base scenario does not include the LCR as a binding constraint.

The IIF results in the two calculated scenarios show different developments which are illustrated in table 1. Between these three countries great differences in the ratios obtain. The Euro Area has by far the lowest ratios in both scenarios and the results in the following years maintain nearly at same differences. In the regulatory change scenario, the Euro Area reached their highest ratio with 81.3 percent in 2013, but is still far away from the minimum target of 100 percent. The IIF adds in its report that it was very difficult to set a plausible path for liquid assets that allows the banking system in the Euro Area to hit the LCR target through the projection horizon.^[63]

[...]

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^[1] Hofmann, G., (2010): Liquiditätsrisiko - alter Wein in neuen Schläuchen?, in: Bankinformationen - Das Fachmagazin der Volksbanken Raiffeisenbanken, no. 9, p. 32-33.

^[2] BCBS, (2010): Countercyclical capital buffer proposal, p. 2.

^[3] Pakravan, K., (2011): Banking 3.0 - financial regulatory systems made simple, in: The Banker, January, p. 8.

^[4] IMF (2010): Impact of Regulatory Reforms on Large and Complex Financial Institutions, p. 5, URL: http://www.imf.org/external/pubs/ft/spn/2010/spn1016.pdf, accessed, 27.01.2010.

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^[6] OECD (2010): Thinking Beyond Basel III: Necessary Solutions For Capital And Liquidity, p. 5 f., URL: http://www.oecd.org/dataoecd/42/58/45314422.pdf, accessed 28.12.2010.

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^[26] OeNB (2010): Financial stability report 20, p. 100.

^[27] "Unencumbered” is defined as "not pledged wither explicitly or implicitly in any way to secure, collateralize or credit enhance any transaction and not held as a hedge for any other exposure”.

^[28] BCBS (2010): International framework for liquidity risk measurement, standards and monitoring, p. 3.

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^[35] The run-off rate means the amount of funding maturing in the 30-day period that will not be rolled over.

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^[45] ECB (2010): Euro money market study, p. 19.

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^[49] BCBS (2010): International framework for liquidity risk measurement, standards and monitoring, p. 37.

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^[54] BCBS (2010): International framework for liquidity risk measurement, standards and monitoring, p. 2 f.

^[55] IIF (2010): Interim report on the cumulative impact on the global economy of proposed changes in the banking regulatory framework, p. 45, URL: http://www.ebf-fbe.eu/uploads/10- Interim%20NCI June2010 Web.pdf, accessed 30.01.2010.

^[56] IMF (2010): Impact of Regulatory Reforms on Large and Complex Financial Institutions, p. 13, URL: http://www.imf.org/external/pubs/ft/spn/2010/spn1016.pdf, accessed, 27.01.2010.

^[57] In this case: cash plus government securities.

^[58] IMF (2010): Impact of Regulatory Reforms on Large and Complex Financial Institutions,

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^[59] ibid., p. 22.

^[60] ibid., p. 18 ff.

^[61] ibid., p. 1 ff.

^[62] ibid., p. 7.

^[63] ibid., p. 54 f.