Basel III liquidity options

It is generally accepted that the forthcoming introduction of liquidity requirements as part of Basel III poses significant issues for Australian banks. In particular, there is a shortage of government debt available to be held to enable compliance with the Liquidity Coverage Ratio (LCR) requirement. The proposed “Australian solution” to this problem changes the approach to ensuring liquidity crises are avoided in a subtle, but significant, way, and may have broader implications for system-wide cash management arrangements. The Net Stable Funding Ratio (NSFR) requirement also has the potential to affect the structural development of Australian financial markets, given the current high reliance on overseas wholesale debt markets.

The Basel III LCR and NSFR requirements have been introduced as one response to the Global Financial Crisis experience in which banks, worldwide, experienced liquidity crises. Holdings of marketable private sector securities turned out to be not very marketable, and lines of credit and short term funding dried up. A vicious cycle of asset sales to meet funding shortages led to asset price declines, inducing collateral and margin calls and further funding problems.

That experience demonstrates the third of the problems associated with liquidity. The first problem is that liquidity is hard to define, although most analysts would point to a liquid asset as being one which can be converted into cash (the ultimate liquid asset) quickly and without risk of significant loss of market value. Second, it is even harder to measure. And third, it is likely to disappear just when it is needed most. It is not an inherent, immutable property of a financial asset, but one subject to the fallacy of composition. An asset may be liquid for any individual holder, but not if all holders are attempting to use that property simultaneously.

The Basel Committee has defined bank liquidity as follows: “Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses.” Such liquidity risk arises from the key role of banks as liquidity providers by funding longer-term assets with shorter-term (often at call) liabilities.

Their approach has been to announce the gradual introduction of two minimum requirements, one aimed at short-term crisis situations and the other focused on longer term funding. After an observation period commencing in 2011, the LCR would apply from 1 January 2015 and the NSF from 1 January 2018.

Although not strongly emphasized, the former focuses primarily on system wide liquidity crises (reflected in the use of a stressed scenario involving “a combined idiosyncratic and market-wide shock” and the latter on individual bank difficulties involving “an extended firm-specific stress scenario”.

The LCR Requirement

The LCR requires banks to hold an amount of high quality liquid assets (HQLA) sufficient to enable the bank to cope with fund outflows over a one-month stress period. The scenario envisaged for cash outflows draws on the experience of the Global Financial Crisis, and assigns varying “run-off” factors to different classes of funding, allows for limited inflows of funds (such as from contractual repayments on loans), and assumes limited outflows of funds associated with the need to maintain some level of lending and credit extensions. Given the complexity of bank operations, including collateralised funding, off-balance sheet activities and derivatives transactions, there is a long list of categories of transactions for which quantitative assumptions about run-off factors to derive the denominator of the LCR must be made.

Because avoiding asset price fire-sale declines is critical, only assets whose price is not sensitive to credit risk concerns are suitable for inclusion in HQLA (the numerator of LCR). The Basel Committee adopts a two-tier approach to the LCR with level one assets (essentially sovereign debt and Central Bank liabilities) being required to account for at least 60 per cent of HQLA. Level two assets can include highly rated (AA- or better) corporate (non-financial institution) and covered bonds and some other assets (with a 15 per cent haircut to market value applied).

The Basel Committee also suggests that HQLA should be eligible for use as collateral in accessing Central Bank liquidity facilities. Because of the system-wide stress scenario used, securities issued by other banks or financial institutions are not included in HQLA because these would be likely to be facing losses in market value.

Ultimately, these criteria for eligibility mean that Australian government and semi-government debthave been designated by the Australian authorities as the only currently available assets meeting the LCR. While the Reserve Bank accepts residential mortgage backed securities as collateral for repurchase agreements, these are issued by other financial institutions. Similarly, despite a large Kangaroo Bond market (AUD securities issued in Australia by foreign entities), the depth of the secondary market in these securities, and demonstrated resilience, is deemed inadequate. While the Federal Government has recently announced plans to allow limited issuance of covered bonds, it will (hopefully) be some time before there is any evidence of how prices of such securities will cope in a time of stress (and their consequent suitability as level two HQLA).