Bank Liquidity Regulations

Background:

Basel III Minimum Liquidity Requirements

Liquidity Coverage Ratio

The LCR aims to ensure that a bank maintains a minimum level of high quality, unencumbered liquid assets to meet cash outflows under a severe liquidity shock scenario over a period of 30 days, entailing a combination of a partial loss of wholesale funding capacity or retail deposits and outflows due to credit downgrades or increased market volatilities which impact the quality of collateral and derivative positions.  There are two categories of eligible assets – “Level 1” and Level 2” assets. Level 1 assets are not subject to haircut, held at market value and are limited to cash or cash-like financial instruments, such as central bank reserves and marketable securities guaranteed by sovereigns or recognized international organizations. Level 2 assets are subjected to a minimum 15% haircut, capped at 40% of the overall pool of liquid assets and are limited to marketable securities guaranteed by sovereigns or recognized international organizations with a higher risk weight and non-financial corporate or covered bonds with a minimum of “AA-” credit rating. 

Net Stable Funding Ratio

The NSFR requires a bank to fund its long term assets with a minimum amount of stable liabilities to reduce short term funding mismatches. “Available stable funding” is defined as financial instruments that are expected to be reliable sources of funds over a one-year time horizon under conditions of extended stress. These include bank’s capital, preferred stock with at least one year maturity and liabilities with effective maturity of at least one year, but exclude borrowing from central bank lending facilities. “Required stable funding” (RSF) includes assets or off-balance-sheet items which could not be monetized easily in a liquidity event lasting for at least one-year period and will be quantified by RSF factors prescribed by the BCBS or national regulators (for off-balance-sheet items).   

Other Liquidity Metrics

In addition to the two minimum liquidity requirements, the BCBS also requires banks to monitor and report the following metrics to their supervisors: (i) contractual maturity mismatch, measured by the inflows and outflows from all on- and off-balance sheet items over various defined time bands; (ii) concentration of funding by significant counterparty, product or instrument and currency; (iii) available unencumbered assets; and (iv) LCR by significant currency.

UK Liquidity Regulation

The UK Financial Services Authority (UK FSA) was among the first major regulators to announce an overhaul of the liquidity regulation for all banks. Announced on October 5, 2009, the revised liquidity regulation aims to ensure that banks are adequately self-insured against liquidity stress events, so as to mitigate the severity and probability of future financial crises. The revised liquidity regulation covers four main areas: (i) overall adequacy of liquidity and self-sufficiency requirement; (ii) quantitative standards; (iii) systems and control requirements; and (iv) reporting requirements. Following a phase-in implementation approach, the UK FSA effected the qualitative and reporting requirements as of December 1, 2009 for most banks (except branches) and the quantitative requirements from June to November 2010. In a statement published on November 18, 2010, the UK FSA said that it will consider how best to incorporate the Basel liquidity framework into the UK liquidity regime once the relevant EU legislation for Basel III (Capital Requirements Directive IV) is finalized. 

Overall Adequacy of Liquidity and Self-Sufficiency Requirement

The UK liquidity regulation requires banks, including foreign branches, to be self-sufficient for its own liquidity needs. For branches, they are required to hold a local operational liquidity reserve, calibrated predominantly through analysis of the branch’s exposure to intra-group liquidity risk. Subject to the UK FSA’s equivalence assessment of the home supervisor’s liquidity regime, a firm may apply for a modified liquidity self-sufficiency requirement, in which case, the branch will no longer be subject to the quantitative standards and systems and control requirements while the day-to-day supervision of liquidity of the branch will be transferred to the home supervisor. The liquidity reporting requirements for the branch will be on a whole firm basis, at reduced frequency and granularity. The frequency of reporting will also depend on the significance of the branch to the UK markets -- more significant branch will need to report at least quarterly while for less significant branch, at least annually. According to the FSA, the rationale for allowing a modified liquidity requirement for foreign branches is to ensure that FSA forms a view on the overall soundness of the firm and not focusing solely on the UK entity’s position, as well as develop a joint understanding with home supervisors on liquidity matters.

Quantitative Standards

The UK FSA liquidity framework requires firm to conduct individual liquidity adequacy assessment (ILAS) at least annually. The quantitative requirements for each firm will be determined by the ILAS stress test, which will include three separate scenarios: idiosyncratic liquidity stress (e.g. loss of wholesale or retail funding, reduction of credit provision from counterparty, loss of access to foreign currency spot of swap market or rating downgrade), market-wide liquidity stress (e.g. uncertainty as to the asset valuation of the firm and its counterparties, widespread risk aversion or corporate defaults) and a combination of two. The stress test period should cover a short term period of at least two weeks and an extended period of three months. In addition, firms will also be subject to the UK FSA’s supervisory liquidity review process (SLRP) regularly, which will cover areas such as the most recent ILAS, systems and controls as well as contingency funding plan. Based on the SLRP, the UK FSA will form an opinion about the firm’s liquidity risk profile and issue guidance with respect to the sufficiency of the firm’s liquid asset buffer and funding profile, known as Individual Liquidity Guidance (ILG). Firms with relatively simpler business model or less reliance on wholesale funding may qualify for a simplified ILAS approach; in which case, the firms will need to prepare an annual ILAS and satisfy a standardized liquidity buffer ratio requirement, defined as liquid assets buffer over the sum of net outflow from wholesale, retail and SME deposits and undrawn credit facilities.

Systems and Control Requirements

The system and control requirements cover areas such as governance and management oversight of liquidity risk, measurement and management of liquidity risk, stress-testing, collateral management, funding diversification and access and contingency plan.

Reporting Requirements

Firms will need to provide FSA with granular liquidity data such as intra-day liquidity, mismatch and pricing, marketable assets, funding profile and concentration, and systems and controls with reporting frequency varying from daily to quarterly. 

US Liquidity and Funding Risk Management Guidance

The U.S. interagency guidance on liquidity and funding risk management framework, issued on March 17, 2010, outlines the process that depository institutions should follow in appropriately identifying, measuring, monitoring, and controlling their funding and liquidity risks. In particular, the guidance re-emphasizes the importance of cash flow projections, diversified funding sources, stress testing, a cushion of liquid assets, and a formal, well-developed contingency funding plan as primary tools for measuring and managing funding and liquidity risks. The guidance is applicable to both insured depository institutions and bank holding companies (including material non-bank subsidiaries). The Fed has yet to announce any proposal to implement the Basel III liquidity requirements. According to the press release on December 20, 2011, the Fed will issue proposals to implement the Basel III liquidity measures in the second phase.