Basel 3 and its impact on liquidity measures

Index

1. Introduction

2. Developments in Basel III
2.1. Increasing Capital Requirements
2.2. Liquidity Coverage Ratio
2.3. Net Stable Funding Ratio
2.4. Monitoring Tools and Application of Standards

3. Initial Situation of Banks Regarding Liquidity Requirements
3.1. Quantitative Impact Study of the BCBS
3.2. European Quantitative Impact Study of the CEBS
3.3. Comparison of Results

4. Economic Impacts of the New Liquidity Requirements
4.1. Benefits of the New Liquidity Requirements
4.2. Costs of the New Liquidity Requirements
4.3. Evaluation of the Results

5. Impact of the Liquidity Requirements on Banks and their Business Segments
5.1. Changed Market Conditions
5.2. Impact on the Profitability of Banks
5.3. Impact on Business Segments
5.4. Impact on Central Banks
5.5. Overall Impacts on Banks and Business Segments

6. Evaluating the Liquidity Rules of Basel III
6.1. Static Nature of the Liquidity Measures
6.2. Are Wrong Incentives the Actual Causer?
6.3. Introduction of Basel III in Various Countries
6.4. Additional Comments

7. Conclusion

List of Abbreviations

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Figures

Figure 1: Phase-in arrangements

Figure 2: LCR of the Quantitative Impact Study conducted by the BCBS

Figure 3: NSFR of the Quantitative Impact Study conducted by the BCBS

Figure 4: LCR of the Europ. QIS

Figure 5: NSFR of the Europ. QIS

Figure 6: Long-run expected annual net economic benefits of Basel III requirements

Figure 7: Impact on the probability of crises

Figure 8: Impact on the reduction of output variability

Figure 9: Impact the on output level

Figure 10: Impact on the output level for different regions

Figure 11: Expected changes in product costs

Tables

Table 1: Summary of the results of the QIS of BCBS and CEBS

1. Introduction

On 6 September 2009 the Central Bank Governors and Heads of Supervision agreed on Basel III after the financial crisis proved that Basel II was not capable of preventing the global economy from such a crisis (BCBS, 2008). Basel III is the third version of the international regulatory framework for financial institutions published by the Basel Committee of Banking Supervision (BCBS) of the Bank for International Settlements (BIS) located in Basel, Switzerland (BIS, www.bis.org, 30.04.2011). In general it defines rules and measures ensuring that financial institutions do not take inappropriate risk and thus may endanger the savings of privates or even the economy of a country.

The financial crisis began with troubles in the United States (US) mortgage markets from 2004 to 2006. High risk loans were given to people with bad credit histories. Some could only barely procure their mortgage payments. These mortgages were packed to complex financial instruments sold to banks and investors all over the world. A fall in housing prices led to huge losses for different investment banks, mortgage associations and financial institutions in general. At the end of 2007 financial institutions began to realize how serious the situation was. Several central banks provided liquidity to the markets and cut their interest rates to prevent financial markets from collapsing. A huge bank run happened to Northern Rock after they received an emergency financial support from the Bank of England on 13 September 2007. Bear Stearns was later on taken over by JP Morgan Chase and several companies like AIG, Faennie Mae and Freddie Mac had to be rescued by the US government. Lehman Brothers went bankrupt and many other banks had severe big troubles (BBC News, 2009).

The enormous uncertainty about the condition of big financial institutions which were seen prior to the crisis as “too big to fail” caused a huge loss of confidence in financial markets. This nearly fully dried up the interbank market, which was the most important source of liquidity for many banks. The recent financial crisis has demonstrated the liquidity needs of financial institutions in times of losses, mistrust and economic downturn. The lack of liquidity may not have caused the crisis, but it intensified the trouble brought up with the subprime crisis, leading to a global financial crisis. Liquidity risk management did not have the relevance and priority as it should have had (BCBS, 2010c).

Prior to the crisis the focus of risk management was mainly on credit and interest rate risk. As a reaction to those events the rules of Basel II were tightened and newly published as Basel III to prevent another financial crisis in the future (ibid).

The public is always talking about the higher capital ratios phased in by Basel III and their enormous effects on banks and the economy. This bachelor thesis will focus on the publicly rather neglected impacts of the liquidity measures introduced under Basel III. It should highlight how significant and influencing these requirements are for the global financial system and also show that they are more significant than the majority is supposing!

This bachelor thesis should provide some deeper information about the impacts of the new liquidity measures. The impact of the standards on economy, financial institutions and their business segments is presented, after a detailed explanation of them. Concluding a comprehensive evaluation of the new requirements is done.

2. Developments in Basel III

The Basel frameworks are published by the BIS, an international organization with 56 central banks as its members. Those are meeting among others every two months in Basel at the regular meetings of Governors to discuss the newest changes in the world economy and financial markets. There are several committees of the BIS providing central banks with background information and policy recommendations (BIS, www.bis.org, 30.04.2011).

In 1988 the first version of the Basel framework called the Basel Capital Accord was introduced. In June 2006 the BIS already defined its framework of Basel II as three pillars, the minimum capital requirements, the supervisory review process and enhanced disclosure (Deutsche Bundesbank, www.bundesbank.de, 01.05.2011). They already claimed an appropriate capital and liquidity plan from financial institutions. Banks must have systems of measuring, monitoring and controlling liquidity risk in order to stay liquid under a period of stress. The liquidity situation of a bank under such a scenario should be assessed with stress tests appropriate to the banks trading activities and the liquidity of markets in which they operate. The test has to take some factors into account, for instance illiquidity respectively gapping of prices or shifting in correlations, were already determined. These formal guidelines for liquidity management were described in the second pillar of supervisory review processes in the chapter’s liquidity risk and market risk. The regulation of liquidity in Basel II was only formally or qualitative. Standardized measures are exact definitions were not introduced yet. This was changed with the announcement of Basel III introducing quantitative measures to evaluate, monitor and control liquidity risk (BCBS, 2006).

Prior to the announcement of the new Basel III framework the BCBS published the “Principles for Sound Liquidity Risk Management and Supervision” in September 2008. This publication replaced “Sound Practices for Managing Liquidity in Banking Organisations” of 2000 as a reaction on the financial turmoil in 2007. They adopted several principles ensuring an adequate liquidity risk management. The document consists of 17 principles in total which should be adhered by financial institutions (BCBS, 2008).

These principles are about the governance of risk management, the measurement, monitoring and controlling of liquidity risk, managing market access, stress testing, public disclosure and furthermore about the role of supervisors. Some important points picked out of these principles are the maintenance of an appropriate level of liquidity, incorporating liquidity costs in internal pricing and consideration of the legal, regulatory and operational limitations to the transferability of liquidity. In general banks must install a robust liquidity risk management framework which has significance for all business divisions (ibid.).

The BIS published two basic consultative papers in the context of Basel III. First, “A global regulatory framework for more resilient banks and banking systems” (BCBS, 2010c) concentrating on higher capital requirements and second, “International framework for liquidity risk measurement, standards and monitoring” (BCBS, 2010b) focusing on the new liquidity requirements. After the events during the financial crisis it was stated as a pure liquidity crisis. The rules of Basel II were adopted by liquidity requirements to prevent financial markets from another “liquidity bottleneck”. The main objectives of Basel III are to improve the banking sector’s ability to handle economic phases of stress, to improve risk management and to strengthen transparency and disclosure. This should be achieved by increasing the capital requirements and introducing liquidity ratios (BCBS, 2010c).

In this thesis I will concentrate on the second part consisting of two liquidity standards, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) and only give a short overview over the capital requirements, all in the next chapters.

2.1. Increasing Capital Requirements

Capital requirements already existed in Basel I and in Basel II and were adapted to the changed needs of financial markets. The minimum amount of common equity in Basel III is raised from 2% to 4.5% of Risk Weighted Assets (RWA), the Tier 1 capital requirements to 6% and the elements of capital structure are harmonized. There are two types of Tier 1 capital. Common Equity Tier 1 capital and Additional Tier 1 capital. Common Equity Tier 1 consists of common shares, stock surplus, retained earnings and accumulation of other incomes and disclosed reserves. Common shares can be issued by the bank or by consolidated subsidiaries meeting the criteria’s of common equity Tier 1 capital (BCBS, 2010c).

Stock surplus is a share premium resulting from the issue of common equity Tier1 instruments. Regulatory will finally adjust the common equity Tier 1 capital, for instance by reducing it at the amount of goodwill are the amount of investments in own stocks. This increase in Tier 1 capital is at the expense of Tier 2 capital remaining in total at 8% of RWA. The Tier 2 capital is composed of certain loan loss provisions and instruments in addition to stock surplus which is fulfilling the criteria for Tier 2 capital and not already included in Tier 1. It will also be adjusted by regulatory (ibid.).

In addition to Tier 1 and Tier 2 capital a capital conservation buffer med with common equity of 2.5% of RWA must be crafted in good times and can be degraded in periods of stress. Minimum capital conservation standards are defined to force financial institutions to “conserve” a percentage of its earnings. Below a common equity Tier 1 level of 4.5% of RWA all earnings must be retained, above 7% no earnings have to be retained (ibid.).

Furthermore according to national circumstances a countercyclical buffer within a range of 0 to 2.5% of RWA can be required. National authorities monitor credit growth, system-wide risk and so on. A countercyclical buffer can either be required for all banks in a country, for different banks which are affected by the same risky consumer group or for a single bank if the composition of their portfolio requires it. This buffer can consist of common equity or other fully loss absorbing capital. This could lead up to a 10.5% minimum requirement ratio of Tier 1 capital (BCBS, 2010c).

These higher capital ratios were introduced to ensure the ability of banks to compensate higher losses. To improve the liquidity situation of financial institutions two ratios were additionally introduced, presented in the next two chapters

2.2. Liquidity Coverage Ratio

As a result of the financial turmoil in 2007 the need for liquidity standards were recognized and therefore two liquidity measures were introduced in Basel III.

First, the short-term liquidity standard called LCR was defined by the BCBS in December 2009 as followed:

Source: BCBS, 2010b, p.5

“This metric aims to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors” (BCBS, 2010b, p.5) .

Main objective of the LCR is to ensure that the stock of high quality liquid assets is higher than the net cash outflows even during an acute short-term liquidity stress scenario over 30 days. The liquidity stress scenario would have results like a downgrading of the institution’s public credit rating at three levels, run-off of a proportion of retail deposits and increases in market volatilities. It is not yet exactly defined which assets will be eligible as a high quality liquid asset, but this will be done during the consultative period and quantitative impact study (BCBS, 2010b).

General characteristics at which the assets liquidity quality increases can be divided in fundamental and market-related. The fundamental ones can be described with a low credit and market risk, ease and certainty of valuation, low correlation with risky assets and listed on a recognized exchange market. The market-related characteristics are, being traded on an active and sizable market, presence of committed market makers, low market concentration and the flight to quality during a systemic crisis. Flight to quality means that the market showed a historical evidence to move into higher quality assets during crises. The attempt to raise liquidity from lower quality assets leads to high discount rates for those assets and a decrease of confidence in the market. Therefore only high quality assets meet the test and can be easily converted into cash during a period of stress. Ideally high quality assets should be eligible at central banks (ibid.).

A generally interesting fact about the eligibility of different assets is that the Swiss National Bank (SNB) has stricter requirements for pawnable securities as the European Central Bank. The SNB did not accept Greek and Portuguese securities already prior to the crisis. Now both do not accept them. Securities of financial institutions are also rejected by nearly all central banks because of their systemic risk (Mag. R., 2011).

As a result of these characteristics assets like cash, central bank reserves which can be drawn down in times of stress, marketable securities with guarantees from sovereign, central banks or other qualified institutions, and government or central bank debt are skilled as high quality liquid assets. Additionally corporate and covered bonds with haircuts by 20% or 40% of its market value will be added after testing their impact on the financial sector (BCBS, 2010b).

The second part of LCR that could be influenced is its denominator. This is the net cash outflow defined as the expected cash outflows minus expected cash inflows that are not encumbered for other purposes.

Cash outflows can be a retail deposit run-off, unsecured or secured wholesale funding run-off or additional requirements which are mainly increasing liquidity needs related to derivatives. A retail deposit is defined as a deposit from a natural person. They are divided in stable and less stable deposits. Stable deposits are weighted with a run-off factor of 7.5%, less stable deposits with a factor of 15%. A stable deposit is given when the depositor has other established relationships with the bank or the deposits are in transactional accounts. Wholesale funding are liabilities and obligations raised from non-natural persons. The secured ones are collateralized by legal rights, the unsecured are not. The ratios for wholesale funding are treated the same way as retail deposits (ibid.).

The net cash outflow is calculated by subtracting the cash inflows from the cash outflows. Cash inflows arise typically from retails, funding, lending or other liquidity needs. The bank should only consider loan payments which are fully performing (ibid.).

2.3. Net Stable Funding Ratio

Purpose of the second liquidity standard (NSFR) is to regulate the medium- and long-term liquidity situation of banks leading them away from short-term funding mismatches toward more stable, long-term funding. It should ensure that financial institutions have funded their assets with at least a minimum level of stable liabilities over a one-year horizon (BCBS, 2010b).

The metric of NSFR is defined by the BCBS in December 2009 as:

Source: BCBS, 2010b, p.20

Available Stable Funding (ASF) consists of the liabilities of the balance sheet, which are capital, preferred stocks and liabilities with maturities of at minimum one year, and deposits being expected to stay with the institution for a stress scenario period of one year. Significant decline of profitability, a potential rating downgrade or a material event which weakens the reputation of the institution could be part of a stress scenario. For the ASF different types of assets, like capital, deposits or funding are scaled into one of five categories each weighted with a different ASF factor between 0% and 100%. The more stable and certain (in providing liquidity) an asset is, the higher its ASF factor. For example the capital of an institution including Tier 1 and Tier 2 has an ASF factor of 100%, meaning it is suitable to provide liquidity in a stress scenario at 100%. The definition of stable assets is the same as for LCR, which is not yet defined. The sum of this weighted components results in the available amount of stable funding (ibid.).

The procedure for the required amount of stable funding is very similar. To determine this amount the asset side of the balance sheet is weighted with a Required Stable Funding (RSF) factor. Each type of asset has its own RSF factor. A low factor means the asset is very liquid and therefore does not have to be “secured” by stable funding. For instance, unencumbered marketable securities with a residual maturity greater than one year representing claims on a central bank have a RSF factor of 5%.

International active financial institutions are expected to meet both liquidity standards and to adhere to all the principles for “Sound Liquidity Risk Management and Supervision” (BCBS, 2008). National authorities have the justification to adopt the standards to higher minimum liquidity levels (BCBS, 2010b).

2.4. Monitoring Tools and Application of Standards

To ensure the compliance of LCR and NFSR and to have a complete view over the risk profile of a bank the BCBS introduced four monitoring tools. Those are contractual maturity mismatch, concentration of funding, available unencumbered assets and the market-related monitoring tool. The contractual maturity mismatch is measuring the gap between contractual liquidity inflows and outflows over a defined time horizon. The importance of funding according to the liquidity situation of a bank is identified by the tool concentration of funding. The available unencumbered assets provide supervisors with data and key characteristics of those assets. The market-related monitoring tool warns supervisors of potential liquidity problems of banks by providing high frequency market data with little time lag (BCBS, 2010b).

All standards presented above should be used to monitor and control risks and be met continuously. They should be calculated and reported at least monthly. Supervisors have the possibility to raise the frequency even to a daily reporting of standards in situations of stress. Basel III rules should be applied to all internationally active banks. The BCBS also points out the fact that banks should be aware of the availability of liquidity in different currencies during stress scenarios. All information about these standards has to be transparent and publicly disclosed (ibid.).

2.5. Overview of Basel III Introductions

On 1 January 2013 the introduction phase for the common equity requirements starts with lowered requirements until the final phase-in on 1 January 2015. The capital conservation buffer will be phased in between 2016 and the end of 2018 starting with 0.625% increasing every year (BIS, 2009a).

The observation period for LCR began in 2011 and the introduction will be in 2015. The observation period for NSFR starts in 2012, the final introduction will be in 2018. The impacts of actions taken by financial institution to fulfill the new requirements are observed and evaluated by supervisors during the observation period.

All effects of these standards could not be exactly calculated in advance. Therefore an accurate supervision is necessary. The last few outstanding issues of the newly standards will be defined during this period. All capital requirements will be fully effective on 1 January 2019. Figure 1 shows an overview of all introductions during Basel III. All dates are as of 1 January.

Overview of the Phase-in Arrangements during Basel III

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Figure 1: Phase-in arrangements (BIS, 2009a, p. 7)

3. Initial Situation of Banks Regarding Liquidity Requirements

The main question for a financial institution is how much has to be done or changed in order to fulfill the Basel III framework? How much additional capital or liquidity do they need?

Different studies occupy with those questions. The two probably most important studies for financial institutions in the Euro area are published by the BCBS and the Committee of European Banking Supervisors (CEBS).

3.1. Quantitative Impact Study of the BCBS

One of the Quantitative Impact Studies (QIS) was conducted by the BCBS after the announcement of the new capital and liquidity standards in 2009 to evaluate the degree of compliance with the new Basel III rules before the introduction phase has began. The study was scaled into two groups. First Group 1, consisting of 94 banks with Tier1 capital in excess of €3 billion. Group 1 banks are well diversified and internationally active. Group 2 consists of all other 169 banks. A full implementation on 31 December 2009 with the data of year-end 2009 was assumed without considering managerial interactions or the development of a bank in the future (BCBS, 2010d).

Main results from the QIS of the BCBS for LCR:

The average LCR for Group 1 banks of the QIS was 83%, for Group 2 banks 98%. Only 46% of all banks at the end of 2009 fulfilled the minimum LCR requirement and showed a shortfall of €1.73 trillion. It does only take the shortfall for banks below the 100% requirement into account and not those with liquidity surplus. Figure 2 shows a box plot of the results. The continuous red line is the required NSFR of 100%. The median result of Group 1 and Group 2 banks is each illustrated as a thin red line. For Group 1 banks (left box) it is clearly below 100%, at about 80%, whereas the median of Group 2 banks (right box) is slightly above the 100% level. The distribution of Group 2 must be skewed to the left, because the median result is greater than the average. It is not possible to evaluate the skewness for the distribution Group 1 results by just looking at Figure 2. The lower end of the thicker blue line shows the 25% quantile, the upper end shows the 75% quantile (ibid.).

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