Barbican Consulting Limited
Liquidity Risk Measures
Summary
Banks are required to measure the inflows and outflows of cash over a designated period (30 days). This is undertaken for business as usual and stressed conditions. To make stress testing relevant the scenarios are designed by the individual bank.
This analysis leads to banks holding High Quality Liquid Assets (HQLA). These are used to cover liquidity shortfalls in times of stress.
The Liquidity Coverage Ratio (LCR) is the key measure. It compares the HQLA held with the net cash outflows under stressed condition and thereby indicates whether the bank is sufficiently liquid.
By calculating the LCR banks undertake a detailed examination of their balance sheets. This involves evaluating all the factors that affect cash inflows and outflows. The process needs regular (at least annual) updating.
Regulators review and evaluate how a bank has undertaken the assessment. Should the assessment be insufficiently detailed a regulatory “add-on” may result.
The following explanation is high level and the rules and methods vary between different banks and different jurisdictions.
Background
Since 2008 greater emphasis has been placed on banks managing their short-term liquidity. This is because during the crisis many banks experienced cash outflows that greatly exceeded expectations. This led to the need for emergency funding from central banks.
The Basel Committee on Banking Supervision provided guidance on this topic in its 2013 document Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools. The approach has largely been adopted by regulators. The purpose is to ensure that banks hold sufficient liquidity in order to meet short term liquidity stresses.
Banks are required to continually monitor, manage and report their cash inflows and outflows. This requires a detailed understanding of the balance sheet and how instruments and counterparties behave. It means both quantitative and qualitative analysis. It also requires extensive regulatory reporting. This is used by the authorities to monitor the bank, compare it with its peer group and gain insight into systematic risks.
Liquidity Coverage Ratio (LCR)
The LCR the key metric that measures whether a bank holds sufficient liquidity.
To meet regulatory requirements banks are required to hold High Quality Liquid Assets (HQLA) to meet 100% of their potential cash outflows over a 30-day stressed period. The 30 days can be extended by the bank’s governing board or by regulators should they so choose.
A bank calculates the net cash outflow it would face under stressed conditions and compares it with the HQLA it holds.
For example, if the net outflow was £100m and the HQLA amounted to £130m the LCR ratio would be 130/100 = 130%. This would imply the bank can adequately meet any short-term cash outflows by liquidating the assets held for this purpose.
The LCR is being phased in so that banks have time to adjust. By 1st January 2019 banks will be expected to have a LCR that exceeds 100%.
During periods of stress it is recognised that a bank will need to call on its liquid resources and under these circumstances the ratio would fall below this threshold. However, should this happen regulators would require enhanced reporting and the expectation would be to correct the shortfall within a reasonable period.
High Quality Liquid Assets (HQLA)
HQLA are defined as being easily and immediately available to be converted into cash at no or little loss in value during times of stress by way of sale or repurchase. Ideally HQLA are central bank eligible. This means the central bank will accept them as collateral for borrowing facilities.
All HQLA should be unencumbered (not pledged or used as collateral). In some cases, assets held as collateral from reverse repurchase agreements can be included provided they cannot be withdrawn during the 30-day period. HQLA prepositioned with the central bank may also be included.
HQLA need to exhibit certain characteristics including:
Low risk: high credit standing, low duration;
Ease of valuation: transparent and widely agreed valuation processes;
Low correlation: Not subject to “wrong way risk” (for example bank issued securities whose value could deteriorate just when they are required for liquidity purposes exhibit wrong way risk);
Listing: on a recognised exchange;
An active sizeable market: low bid-offer spreads, high traded volumes, many market participants, robust market structures;
Low price volatility: evidenced by price data;
Flight to quality: typically, they are bought by investors in times of stress.
Some flexibility in the composition of HQLA is provided by designating HQLA as being Level 1, Level 2a or Level 2b.
The designation is complex and subject to regulatory interpretation. It is intended to give banks additional scope to use further assets for HQLA albeit haircuts apply. These haircuts impose a downward adjustment to the market value for purpose of inclusion in the HQLA calculation.
Level 1 assets: They include notes, coin, central bank reserves, marketable securities which are sovereign, central bank, BIS or ECB. They are all 0% risk weighted under Basel II and trade in a liquid market. A haircut does not apply.
Level 2a assets: They are marketable securities that are backed by sovereigns or central banks that have a 20% Basel II risk weighting. They must be traded in a liquid market and must not be issued by financial institutions. A haircut of 15% applies to the market value.
Level 2b assets: Corporate debt securities, including commercial paper and covered bonds not issued by the bank itself. Residential Mortgage Backed Securities may be included they cannot be self-issued and must have at least a AA rating. A 25% haircut applies. Corporate debt must have a rating higher than BBB-, there needs to be an active market and prices should not exhibit more than a 20% decline over any 30-day period. A 50% haircut applies. Equities provided they are not financial institutions, are a constituent of a major index and do not exhibit price declines of more than 40% over 30 days. A 50% haircut applies. (Note, the eligibility and haircuts may vary).
To meet the HQLA requirement Level 1 assets can be held without limit, Level 2a assets can constitute 40% of the total and Level 2b cannot make up for than 15% within the 40%.
It is also expected that banks periodically test the liquidity of their HQLA by way of sale or by repurchase.
From a commercial standpoint, the fact that HQLA offer very low returns will mean whilst reducing liquidity risk there is an associated cost. Therefore, engaging in activities that increase liquidity risk may reduce profitability.
Where are the HQLA?
The stock of HQLA should be held by the relevant control function. This is Treasury who should have continuous authority over the stock evidenced by a separate pool for the explicit use as a source of funding.
Total Net Cash Outflows
To determine the size of the HQLA, a bank needs to establish its total net cash outflows (expected inflows less expected outflows), during stressed conditions over 30 days.
Because individual bank balance sheets are different every bank needs to do its own calculations. These are then subject to regulatory scrutiny to determine whether the assumptions are appropriate.
To determine the outflows all sources of risk need to be assessed. They include but are not limited to the following “risk drivers”.
1. The retail deposit run-off: this depends on depositor type and includes demand and time deposits. Banks are expected to be able to differentiate between “stable” and “less stable” funding sources. Stable deposits are where the customer has a longstanding relationship with the bank or where the deposits relate to transactional cash. A run-off rate of 3%-5% for fully insured deposits is indicated. This percentage also depends on the public awareness of deposit insurance schemes and whether they are robustly maintained.
Deposits not covered by insurance schemes, deposits from sophisticated investors, internet accounts and foreign currency deposits are considered less stable. They therefore attract a suggested run-off rate of 10% or higher.
Deposits that exceed 30 days are excluded from the outflow calculation provided it can be demonstrated that the depositor has no legal right of early redemption or penalties for early redemption are onerous (loss of interest). Regulators may however assign a run-off rate to these deposits if they consider that a bank would allow early redemption to maintain its reputation.
2. Unsecured wholesale funding run-off: these are deposits from legal entities like small businesses (SMEs) that can mature or can be withdrawn within the 30-day period. Run-off rates of between 5%-10% are indicated. Being consistent with retail deposits.
BIS provides more detail on deposit run-off rates where the unsecured funds are from other sources. For example, operational deposits generated by clearing, custody and cash management activities: run-off 25%. Deposits in institutional networks of cooperative banks: run-off 25% to 100%. Unsecured wholesale funding provided by non-financial corporates and sovereigns, central banks, multilateral development banks, and public sector entities: run-off 20% to 40%. Unsecured wholesale funding provided by other legal entity customers: run-off 100%.
3. Secured funding run-off: The run-off rates depend on the counterparty and the assets used to secure the funding. Funding using Level 1 assets with the Central Bank provides a 0% run-off rate, Level 2 assets provide a 15% run-off rate. Lower quality collateral may be deemed to have run-off rates of 100%.
4. Derivative cash outflows: these typically arise from margin calls that result from changes in market value and need to be included in cash outflows.
5. Downgrade triggers: a bank that suffers a deterioration in credit rating may be contractually required to post additional collateral on transactions. To estimate this requirement banks are required to calculate and include the additional liquidity required for a 3-notch credit downgrade in the 30-day period.
6. Valuation changes of posted collateral: Posted collateral may itself change value. Where collateral consists of Level 1 assets no addition is required however if the collateral posted is below Level 1 then an additional 20% of its notional amount will need to be added to the stock of HQLA.
7. Loss of funding from secured funding programmes: This includes asset backed securities and covered bonds. 100% of the maturing amount over the 30-day period should be included in the HQLA.
8. Liquidity “guarantees”: Whereby a bank has a legal obligation to provide funding to conduits, special purpose vehicles or offers similar facilities should be included in the HQLA.
9. Drawdowns on committed credit: Undrawn portions should be included in the HQLA, guidance on this is dependent on the type of facility and the counterparty involved.
10. Other contingent obligations: This can include associations or linkages to products or services that may require liquidity support in times of stress. For example, customers, may expect a degree of liquidity during stressed conditions and the bank feels obliged to deliver this.
Cash inflows
The cash inflows are contractual inflows that are fully performing and are where there is no expectation of counterparty default. BIS caps total inflows. This means that a bank cannot just rely on cash inflows to meet its liquidity coverage.
The cap is 75% of total expected cash outflows. Therefore, a bank must hold HQLA that amounts at least to 25% of total cash outflows.
The regulatory requirements concerning the application of “haircuts” to cash inflows is not included in this document.
Monitoring Tools
Banks report liquidity data to regulators. This reporting is important because it is used to monitor the bank and the wider financial system. Banks also use monitoring tools to inform senior management about liquidity risk. The resources devoted to monitoring, its accuracy and timeliness, integration into risk reporting and overall understanding by management form part of the qualitative assessment of a bank’s ability to manage liquidity. Monitoring tools include the following.
Contractual Maturity Mismatch
This time banded report refers to the contractual cash inflows and outflows from all on and off-balance sheet instruments. The time bands may be daily, monthly and annually depending on the level of granularity required. In its basic format this type of report excludes behaviour, forecasts and changes in strategy. However behavioural assumptions, stresses and strategic plans can be overlaid to provide a useful discussion tool regarding the nature of liquidity risk.
Funding Concentration
This report helps determine how diversified the funding sources are (this can be difficult to ascertain from other reporting tools). It may include significant counterparties, the wholesale/retail mix, the maturity profile, currency amounts, instrument types and the secured/unsecured funding mix.
Unencumbered Assets
This report shows the percentage of assets already encumbered or pledged, the amount of assets that are eligible for Central Bank standing facilities and assets that can also be used to secure secondary market transactions like repo. This should include nominal amounts and anticipated cash values taking haircuts into account. It indicates how much capacity a bank has for further secured borrowing and also the ability to replenish shortfalls in funding. Although the behaviour of counterparties regarding haircuts and asset values is not taken into consideration.
LCR by Significant Currency
This report measures the stock of HQLA by significant currency against the stressed outflows for that currency over a 30-day period. Significant currencies are those which constitute more than 5% of total liabilities. This measure indicates whether a bank holds sufficient currency resources without the need to undertake foreign exchange transactions
Market Wide Monitoring Tools
This includes information on financial markets and the financial sector as well as specific information about the bank itself. It may include equity prices, money market rates and comparisons with central bank repo rates, credit default swap spreads, foreign exchange rates, funding rollover conditions and renewal rates, changes in funding maturities and sources of funds.
Glossary
High quality liquid assets (HQLA): Assets held by banks that are easily and immediately available to be converted into cash at no or little loss in value during times of stress by way of sale or repurchase. Ideally HQLA are central bank eligible. This means the central bank will accept them as collateral for borrowing facilities. They include central bank reserve accounts and high quality sovereign debt. These are referred to as Level 1 assets. There are also Level 2a and Level 2b assets. They too can count towards the bank’s liquidity however because they are not deemed to be of such high-quality haircuts apply to their valuation. HQLA should be unencumbered (not pledged or used as collateral). HQLA prepositioned (held with the central bank and not yet used as collateral) may also be included.
Liquidity Coverage Ratio (LCR): The LCR is a key metric that measures whether a bank holds sufficient liquidity under stressed conditions lasting 30 days. The bank calculates the net cash outflow it would face and compares this with the High-Quality Liquidity it holds.
For example, if the net outflow was £100m and the HQLA amounted to £130m the ratio would be 130/100 = 130%. From 2019 Regulators expect this ratio to exceed 100%.
Encumbrance: Assets used by banks to secure funding. This can take the form of pledge or repurchase. Encumbrance is increased by providing collateral. This may be the result of covered bond programmes, derivatives or repurchase agreements. A high encumbrance ratio (encumbered versus unencumbered assets) may adversely affect unsecured creditors. This may include deposit guarantee schemes. It may also increase the unsecured funding cost of a bank.
Run-off rate: The rate at which maturing deposits are not renewed. A 5% rate would imply that during stated period 5% of deposits are withdrawn and not redeposited. Run-off rates are used to determine the reliability of deposits and vary by investor behaviour.
Contractual maturity: The legal maturity date of a transaction. A contractual maturity mismatch report shows the inflows and outflows of cash in line with such maturity dates. However, it does not consider counterparty behaviour and contingent drawdowns on liquidity.
First Published by Barbican Consulting Limited 2017