Corresponding author: Alette Tammenga ( alettetammenga@hotmail.com ) Academic editor: Chris D. Knoops
© 2020 Alette Tammenga, Pieter Haarman.
This is an open access article distributed under the terms of the Creative Commons Attribution License (CC BY-NC-ND 4.0), which permits to copy and distribute the article for non-commercial purposes, provided that the article is not altered or modified and the original author and source are credited.
Citation:
Tammenga A, Haarman P (2020) Liquidity risk regulation and its practical implications for banks: the introduction and effects of the Liquidity Coverage Ratio. Maandblad Voor Accountancy en Bedrijfseconomie 94(9/10): 403-412. https://doi.org/10.5117/mab.94.51137
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Following the financial crisis, quantitative liquidity risk regulation was introduced by means of the Liquidity Coverage Ratio (LCR). This literature study aims to investigate whether the introduction of the LCR leads to better liquidity risk management in banks. It elaborates on the drivers and definition of liquidity risk as well as the history, benefits and goals of this regulation. It also delves into the exact composition of the ratio and the assumptions used. The impact on bank lending as well as banks' business model and risk management is addressed, as well as the interaction with monetary policy operations and capital regulation. This paper then describes the operational differences that were observed after the implementation, and behavioral aspects. We also address the Net stable Funding Ratio (NSFR) and the discussion on interaction between the two indicators and possible redundancy. We have found that the introduction of the LCR leads to better management of liquidity risk for most financial institutions, but more harmonious implementation throughout the sector could reduce liquidity risk even further.
bank, bank regulation, risk management, financial risk management, liquidity risk, LCR, NSFR
One of the most important additions to bank regulations since the financial crisis of 2007–2008 was the introduction of quantitative requirements regarding liquidity risk. This paper will mainly go into the effects of the Liquidity Coverage Ratio (LCR) and will also discuss the Net Stable Funding Ratio (NSFR), to assess whether these regulatory additions actually lead to better management of liquidity risks in banks and which consequences their implementation might have brought about.
Following the financial crisis in 2007–2008, a significant amount of additional regulation was introduced. One of the most important additions was the introduction of new regulatory requirements regarding liquidity risk. Among others, the Liquidity Coverage Ratio (LCR) was introduced. This paper will address the rationale behind this ratio and its effects by means of a literature study. It will try to answer the following questions:
1. How is liquidity risk defined and what are drivers for liquidity risk?
2. Why was the LCR introduced eventually?
3. How is the LCR defined?
4. What are the effects of the LCR on banks, also combined with the NSFR requirement?
This will lead us to answering the main question:
Does the introduction of the LCR lead to better management of liquidity risk for banks?
The paper is structured as follows: In section 2, the definition and drivers of liquidity risk will be addressed. Section 3 gives an overview of the history of liquidity risk regulation. Section 4 addresses the introduction and perceived benefits of the LCR ratio and NSFR. Section 5 gives details on the composition of the LCR ratio. Section 6 is the main part of this paper and will address the effects and consequences of the LCR ratio. Section 7 addresses the Net Stable Funding Ratio, its effects as well as possible interaction between the two liquidity indicators and possible redundancy. The paper ends with a conclusion in section 8.
The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk. Liquidity is defined by the Basel committee as the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. Every transaction or commitment of a bank has an impact on its liquidity. Cash flow obligations are often uncertain, because they are affected by external events such as clients withdrawing their money (Basel Committee 2008).
As identified by
Funding liquidity is defined as the bank’s ability to pay its financial obligations upon request. “Funding liquidity risk is the risk that the firm will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm” (Basel Committee 2008). The classic example of a bank being illiquid due to a bank-run is expressed in terms of funding liquidity; when customers (en masse) choose to withdraw their deposits the financial obligations of the bank rise and the bank may, at some point, not be able to cash out anymore.
“Market liquidity risk is the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption” (Basel Committee 2008). Such was the case during the financial crisis, when many large institutions held mortgage-backed securities which were marketable at first, but demand vanished and the market dried up, creating illiquidity for those institutions who held on to these securities.
By definition of market liquidity, determinants of liquidity risk are embedded in the market conditions of the bank, the operating countries and the marketability of the assets. This is exemplified in crisis, when assets may be sold in a ‘fire sale’ to provide short-term funding while generating large losses on the expected value of the assets. Academics have found several drivers of liquidity risk (
(
In the Netherlands, specific liquidity regulation was already introduced in 2003. Banks were at all times required to have a ‘Liquidity Balance’ greater than or equal to zero. The Liquidity Balance was defined as:
Where Available liquidity is defined as the weighted stock of liquid assets plus the weighted cash inflow scheduled within the coming month (
In 2004, further study into liquidity risk management was initiated by a Joint Forum consisting of BCBS, the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). Their report in 2006 concluded that a centralization was ongoing in liquidity risk management and that firms seemed to have improved their ability to provide quantitative indicators of liquidity risk. The most common measures used at that time were liquid asset ratios, cash flow projections and stress tests. Since most indicators only referred to idiosyncratic stress, the Joint Forum suggested that supervisors should explore the reasons why firms did not consider market-wide shocks (Basel Committee on Banking Supervision 2006). The Institute of International Finance (IIF) also worked on liquidity risk. They published recommendations regarding the governance and organizational structure for managing liquidity risks, the monitoring and stress testing. Harmonization was considered positively, but based on qualitative approaches, not by setting prescriptive, quantitative measurements. In 2008, an updated version of the 2000 BCBS paper containing sound practices was published (
1. the lack of supervisory momentum;
2. the view that capital also addresses liquidity risks, and
3. the interaction of liquidity regulation and monetary policy implementation.
These will be addressed in more detail in section 4 and 6.
The financial crisis has shed a new light on the perceived obstacles mentioned above. As described in the preamble of the Delegated Regulation (European Commission 2015): “During the early ‘liquidity phase’ of the financial crisis that began in 2007, many credit institutions, despite maintaining adequate capital levels, experienced significant difficulties because they had failed to manage their liquidity risk prudently. Some credit institutions became overly dependent on short term financing which rapidly dried up at the onset of the crisis. Such credit institutions then became vulnerable to liquidity demands because they were not holding a sufficient volume of liquid assets to meet demands to withdraw funds (outflows) during the stressed period. Credit institutions were then forced to liquidate assets in a fire-sale which created a self-reinforcing downward price spiral and lack of market confidence triggering a solvency crisis. Ultimately many credit institutions became excessively dependent on liquidity provision by the central banks and had to be bailed out by the injection of massive amount of funds from the public purse. Thus it became apparent that it was necessary to develop a detailed liquidity coverage requirement whose aim should be to avoid this risk by making credit institutions less dependent on short-term financing and central bank liquidity provision and more resilient to sudden liquidity shocks.” As
In 2009, the BCBS started working on the Basel III regulation. By lack of an existing global standard, as was present for capital, a more theoretical approach was chosen for liquidity regulation compared to capital regulation. In 2010, the international framework for liquidity risk management was introduced, including proposals to introduce the LCR and the Net Stable Funding Ratio (NSFR). Being the first quantitative regulations for liquidity risk management, these regulations were expected to have a large impact on banking activity and financial markets. In January 2013, the Committee published a final document with the new Basel III Liquidity Coverage Ratio (Basel Committee on Banking Supervision 2013). The final NSFR standard was published in October 2014. The NSFR was introduced because of similar reasons to the LCR but implementation has lagged throughout several countries. The formal implementation in the European Union laws will take place as part of the revised Capital Requirements Regulation (CRR2), which was published in June 2019 and is expected to come into force as of June 2021. Section 7 will further address the NSFR.
In their report on liquidity measures, the European Banking Authority (
The externality of individual banks’ liquidity problems, e.g. the risk that this is shifted to the public balance sheet is, according to
According to
The floor for liquidity risk contributes to avoiding excessive loan growth and therefore helps to reduce the underlying growth factors for another possible bubble or financial crisis (
The LCR is a short-term buffer providing liquidity to banks in distress while maintaining independent from central bank or government assistance. The LCR was created with the emphasis on short term liquidity and the ability to withhold from a fire sale. The LCR formula is fairly simple;
The LCR is designed to indicate liquidity by requiring the Liquidity Buffer, defined as HQLA, to be larger than the short term net outflows of the bank. The 30-day time period allows additional measures to be taken by supervisory authorities, if the stress scenario holds.
The main assumptions for determining the LCR are:
• Deposit flights; The run-off by depositors in fear of a collapse or closure might lead to the actual collapse of the bank, an example of the classic bank-run.
• Non-renewal of market and unsecured interbank refunding; Markets and other banks will not renew loans towards the institution in fear of a collapse.
• Increase in drawdown of committed funding in favor of clients; clients with committed credit lines draw to the maximum amount of the line.
• Continuation of credit production; Credit production is not stopped but continued in the same way as in a non-stress situation.
• Non resort to Central Bank (as last resort) except for liquidity lines; For as long as the bank is independent and out of trouble, it will try not to resort to the Central Bank for liquidity support.
As is shown in Figure
Therefore, it is worthy to note that the LCR should not be considered too strictly by investors or depositors as a reflection on the value or potential security of (assets in) a bank. The LCR is considered to reduce the impact of liquidity risk as banks are encouraged to hold HQLA and academics have argued this leads to a higher investor confidence (
The Liquidity Buffer is comprised of HQLA. HQLA should be liquid even in stress scenarios as the value of HQLA depends on the price in private markets during these stress scenarios. The HQLA is categorized into three main groups (including types and haircut percentages):
– Level 1 High quality assets (covered bonds 7%, sovereign bonds 0%, cash 0%)
– Level 2A Good quality assets (other assets 15%)
– Level 2B Good quality assets (RMBS 25%, ABS 25%, SME ABS 35%, and Corporate Debt Securities 50%)
The haircuts associated with the types of assets are instrumental to the application of the LCR and the banks’ portfolio of HQLA. An example of this is the work of
The Net Outflow is further formulized:
The denominator represents the net amount that the institution would have to disburse if it would face a normalized liquidity stress, which are called the net outflows. As a buffer, inflows taken into account are limited to 75% of outflows.
Liquidity outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down. They include e.g. the current outstanding amount for stable retail deposits and other retail deposits, the current outstanding amounts of other liabilities that become due, the maximum amount that can be drawn down during the next 30 calendar days from undrawn committed credit and liquidity facilities (European Commission 2015).
The inflow should be assessed over a period of 30 calendar days. They shall comprise only contractual inflows from exposures that are not past due and for which the credit institution has no reason to expect non-performance within 30 calendar days. This comprises of e.g. monies due from central banks and financial customers, securities maturing within 30 calendar days and also monies due from positions in major indexes of equity instruments. All of these to an inflow rate of 100%.
50% inflow rate to be applied to e.g. monies due from non-financial customers.
In this section, we address the effects of the LCR on banks.
The effect of liquidity regulation on bank lending is a topic of debate among scholars and regulators. It is argued that banks’ demand in liquid assets and maturities of wholesale liabilities increase, which leads to a larger lending spread. Banks’ demand for long-term funding increases, which is expected to increase the yield curve of the overnight rate, deeming it less applicable for monetary policy (
On the contrary, it is argued that a higher LCR leads to a more stable financial system, thereby less disruptive credit flows to the real economy, ultimately leading to a positive effect on the real economy (
Based on these academic results, we argue that the first implication of LCR on lending results in a higher lending spread due to higher demand for long-term funding, which reduces over time as argued by
The effect of liquidity regulation on banks’ operations and business model diversification is one of the focal points of the LCR, as the regulation implies the diversification of the asset portfolio for banks and a reduced dependency on short-term wholesale funding. The LCR is specifically designed to encourage an increase in deposits versus (short-term) wholesale funding and HQLAs versus less stable assets (
It is expected by regulators that the LCR will have a negative effect on the financial performance of banks, specifically through the reduction of earnings (
Based on these findings, we conclude that the LCR implementation has a slightly negative effect on financial performance in the short term but may prove beneficial for the economy as a whole when banks face distress and require aid on a less-frequent basis.
Legislators have expected that the LCR implementation within banks results in a discouragement of risk taking with regards to the risk appetite, loan-to-deposit ratio and a reduction of Return on Equity (
Risk appetite (and attitude) could also change when the financial system is under duress, as argued by
As mentioned in Section 3, some interaction was expected between capital and liquidity regulation. In this section we will further investigate this interaction and the different views on capital versus liquidity regulation that can be observed. EBA Banking Stakeholder Group (2012) states in an opinion paper that to some extent, capital can be viewed as a substitute for liquidity requirements. They state that higher capital ratios could reassure depositors and make a bank run less likely and that therefore, the economic costs of capital and liquidity buffers should be assessed jointly.
Another interesting study by
In our view, the potential interaction between capital and liquidity regulation does not provide sufficient grounds to the view that liquidity regulation would be redundant given the current capital regulation, also based on what was observed in the financial crisis. We strongly argue for specific measures to mitigate liquidity risk while realizing a consistent and sufficiently clear regulatory framework. Section 7.2 will address interaction between the two liquidity indicators LCR and NSFR.
In addition, their analysis shows that the LCR requirement can substantially alter the effect of a central banks’ open market operations (OMO) on equilibrium interest rates. “When there is no LCR requirement, the overnight interest rate is determined by the total quantity of reserves supplied by the central bank. In such an environment, only the size of an OMO matters for interest rates; the details of the operation (assets used, counterparties, etc.) are irrelevant.”
“Once an LCR requirement is introduced, this result no longer holds. The structure of an OMO determines its effects on bank balance sheets and, hence, on the likelihood of a bank facing an LCR shortfall. This likelihood, in turn, affects banks’ incentives to trade in interbank markets. For some types of operations the overnight interest rate becomes more responsive to changes in the supply of reserves than in the standard model, while for others it becomes unresponsive. Similarly, the equilibrium LCR premium increases when the central bank adds reserves with some types of operations, but decreases for others. The magnitude of these effects depends on a variety of factors, some of which may be unknown to the central bank when the operation takes place.” (
As
Further study into the interaction between liquidity regulation and monetary policy implementation was done by
In monetary policy operations, central banks should be aware of the effects that the LCR regulation has on the effectiveness of the operations, it becomes more difficult as more factors play a role. The LCR may hamper their ability to perform such operations in the way it was done before the introduction of the LCR due to the effect that LCR requirements may have on both short- and long-term interest rates, e.g. by means of an ‘LCR premium’ that fluctuates. It could prove a fruitful path for researchers to fully investigate the relationship between monetary policy and banks’ decisions at different LCR levels.
The EBA has observed differences in the application of the LCR Delegated Regulation (
Article 23 of the Delegated Act (European Commission 2015) addresses a “leftover category” for outflows of products not covered by earlier articles. For this category, no specific outflow percentages are prescribed: institutions can use their own methodology for assigning an appropriate outflow. As part of this assessment, institutions need to assume combined idiosyncratic and market-wide stress and they need to take into account material reputational damage that could result from not providing liquidity support to the products and services. This is a somewhat subjective assessment, which could offer incentive to downplay potential outflow (De Nederlansche Bank 2018).
The LCR is implemented in the EU and like other EU regulation, the implementation has been carried out by national supervisors with a material number of discretions. As stated by the Basel Committee on Banking Supervision, national authorities have discretions regarding deposit run-off rates, derivative recognition and funding (
Next to the operational differences, there may also be some unintended consequences connected to the LCR implementation. Before implementation, there were fears of a negative effect on GDP growth through lending to the real economy, a higher encumbrance of assets and increasing possible losses for bond holders. Reports from
There may also be a time dimension towards the calculation of the LCR as some end-of-month/quarter/year payments may be made, influencing the LCR. This could lead to a much better reported LCR as compared to the actual LCR over time, which undermines the effectiveness of the regulation altogether. EBA requires additional analysis to be done by supervisors regarding intramonth versus end of month LCR figures and express that they expect banks to apply a prudent approach in case of differences. Also, in times of distress banks may occur an inability to match their liabilities with respects to different currencies, as banks during times of distress may not be able to swap or hedge currency risks perfectly, creating significant currency mismatches. Only a reporting requirement for material currencies (>5%) is in place at the moment, requiring banks to report LCR levels for material currencies. But no formal requirement of an LCR >100% is in place for these currencies. This could be a risk in times of stress and requires banks to manage this in a prudent way. EBA is working on the LCR by significant currency (
Where regulation is applied, it is always interesting to also look at the behavioral view. Even though the LCR does not specifically aim to alter behavior in the financial sector, there might be caveats in the application of supervision. Banks with an LCR close to or under 100% threshold might be inclined to alter their LCR at the time of reporting through the structure of payments (inflow or outflow). Currently, it is not proven that banks are actively managing this regarding LCR but an institution under duress might be inclined to do so. It reminds the authors of Lehman’s application of ‘Repo 105’ (
In this section, we review the definition and effects of the NSFR and its interaction with the LCR in the application by banks.
In addition to the LCR, the NSFR was introduced under the Basel III accords. The NSFR aims to promote stable funding over a medium horizon of 1 year, as opposed to the short-term goal of the LCR. The NSFR is focused on stable funding to reduce the effect of funding shocks on the financial stability of individual banks and the sector as a whole. In combination with the LCR, the NSFR (and liquidity regulation as a whole) is aimed at the prevention of the liquidity stresses that were experienced during the Financial Crisis.
The NSFR is constructed as follows:
The Available Stable Funding (ASF) is comprised of funding sources such as debt and equity with appropriate factors to reflect the long-term and prudent nature of the funding. The Required Stable Funding (RSF) is comprised of all assets for which funding is required and applied with factors based on liquidity and nature of the assets. It follows instinctively that an institutions equity is calculated with a high ASF factor and that cash money is calculated with a very low RSF factor.
The NSFR is calculated based on a 1-year horizon, as opposed to the 1-month horizon of the LCR, to ensure banks are capable of withstanding prolonged liquidity stress (
Discussion has been taking place regarding the impact of liquidity regulations ever since the publication of quantitative measures in 2013 (LCR) and 2014 (NSFR) by the Basel Committee. In a keynote speech from the head of the European Banking Federation in 2017 (
In a simplified framework using stylized balance sheets of banks by
In our view, these interactions should be a topic for continuous study going forward but at this moment, both of the liquidity requirements serve a specific purpose and neither of them is perceived as redundant.
The LCR was introduced in the Basel III accord to aid regulators in curtailing liquidity risk in the financial system. The LCR requirement encourages banks to hold assets such as cash, bonds and high quality securities relative to the expected outflow in the next 30 days. At the time of introduction, The Netherlands was already familiar with liquidity regulation through application of the Liquidity Balance. However, because of the change in momentum in the regulatory landscape due to the financial crisis, quantitative, harmonized liquidity requirements were introduced, reducing national differences. Among the perceived benefits of quantified liquidity regulation such as the LCR are an increase in economic welfare, improving the soundness of the banking sector and preventing excessive loan growth.
The requirement for banks to increase their assets (HQLA) is expected to decrease their ability and willingness to lend. The impact of these requirements should decrease over time. Initial results confirm these expectations. In line with a reduction in lending, the LCR is expected to have a negative effect on the short-term financial performance of banks, especially when banks hold an LCR close to or below the 100% threshold. This could result in an increase in risk appetite of banks, searching to compensate for the lesser financial performance. However, through initial findings of
Although some interaction seems to exist between capital and liquidity regulation, this interaction does not provide sufficient grounds to the view that liquidity regulation would be redundant given the current set of capital regulation and including what was observed in the financial crisis. In monetary policy operations, central banks should be aware of the effects that the LCR regulation has on the effectiveness of the operations, it becomes more difficult as more factors play a role. The LCR may hamper their ability to perform such operations due to the effect LCR requirements may have on both short- and long-term interest rates, e.g. by means of an ‘LCR premium’ that fluctuates. One of the goals with the LCR is to harmonize liquidity regulation. To a certain degree, this has been achieved. However, we also find that there are a number of unintended effects and operational differences observed. The behavioral aspect of LCR reporting could be one of the serious attention points, as institutions may find it optimal to structure their balance sheet to increase LCR and deter regulators’ suspicions. Finally, the LCR may have had a positive effect on the attractiveness of shadow banking, especially for institutions with a higher risk appetite.
We therefore argue that the introduction of the LCR leads to a better management of liquidity risk for most financial institutions. We do want to note that liquidity risk in the financial sector as a whole might be reduced even more when the consistency of the LCR is further improved by clarifying the regulations. Doing so is expected to increase comparability between banks and to aid in really achieving its perceived benefits. Apart from monitoring this single ratio, it will remain important to consider the wider area of liquidity risk management in an integral way.
The increase in risk appetite, systemic risk, and shadow banking is a concern not limited to liquidity risk but should definitely be in scope for regulators regarding improvements on the stability and resiliency of the financial system. The Basel committee and an EBA working group are working on the monitoring of the LCR and on the assessment about whether the intended effects have been achieved and whether perceived benefits materialized. Results of these exercises could be relevant input for further study. A specific point of interest could be whether the funding costs of banks actually decreased, as was expected in 2013. Going forward, it is expected that more clarity will be provided by regulators regarding topics in the regulation that can be interpreted in multiple ways.
Since this paper was a literature study, no research in banks was performed. This could be an interesting addition to the study of liquidity regulation in banking. Once the NSFR has been implemented, this might be grounds for further research into (unintended) consequences as well. Additionally, this paper focused on the implementation in the EU and it could be interesting to analyze the implementation in other jurisdictions such as the USA.
There is a lot to be researched in terms of the effectiveness of quantitative liquidity risk regulation. Hopefully this will be achieved before the next crisis hits, and will show whether the new regulation is indeed able to limit the depth and consequences of the new crisis.
A.Z. Tammenga MSc. is working as a consultant at Transcendent Group Netherlands and is also a student in the Postgraduate program “Risk management for Financial Institutions” at VU Amsterdam.
P.A.J. Haarman MSc. works as a senior consultant at EY Consulting and is also a student in the Postgraduate program “Risk management for Financial Institutions” at VU Amsterdam.