The Four Pillars of Post-Crisis Banking Regulations Pillar II: Liquidity and Funding

Transcription

1 The Four Pillars of Post-Crisis Banking Regulations Pillar II: Liquidity and Funding August 2015 Part 3 in the series: Yielding to a New Regulatory Reality-A Shifting Banking System and Its Impact on Cash Markets Another key lesson of the crisis, given the intense funding pressures experienced by many financial institutions during the period, is the importance of maintaining adequate liquidity that is, a stock of cash and unencumbered highquality liquid assets that can be converted easily into cash... banks of all sizes need to further strengthen their ability to identify, quantify, and manage their liquidity risks Ben Bernanke, 2013 The Four Pillars of Post-Crisis Bank Regulation Grappling with the implications of new regulations can be a challenging proposition, but for cash investors it is critical to understand the changes in the context of principal preservation, liquidity and yield. We have categorized new regulations into four main pillars: capitalization, liquidity & funding, resolution planning and complexity reduction. In this paper, we explore the practical implications of the second pillar liquidity and funding on banks and short-term markets. Figure 1: The Four Pillars of Post-Crisis Bank Regulation I. Capital III. Resolution Planning Regulatory Capital (CET1) Captial Buffers & AOCI Supplementary Leverage Ratio (SLR) Stress Testing II. Liquidity and Funding Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) Short-Term Wholesale Funding Capital Buffer Living Wills Orderly Liquidation Authority (OLA) Total Loss Absorbing Capacity (TLAC) IV. Complexity Reduction Volcker Rule Derivatives Reform Foreign Bank Organization Rule Risk Retention Rule (Securitization) Goal End Too Big to Fail, Strengthen Financial System, and Prevent De-Stabilizing Asset Fire Sales Impact Shifting Bank Business Models, ROE Pressures, Weaker Market Liquidity, Lower Supply of Short-Term Liquid Assets Source: SSGA 6/30/2015. Pillar II: Liquidity and Funding The financial crisis showed how disruptions to liquidity and funding conditions for banks (as well as other financial institutions) can have severe implications on the broader economy. 1 If capital is a bank s lifeblood, liquidity is its oxygen. To combat liquidity and funding risks in the future, the Basel Committee supplemented its revised set of capital standards with two new liquidity ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). Collectively, these ratios require that banks hold high levels of liquid assets and extend the duration of their funding profiles. In the US, the LCR is finalized while the NSFR is not.

2 Liquidity Coverage Ratio LCR = High Quality Liquid Assets Total Net Cash Outflows over 30 day Stress period 100% The purpose of the LCR is to ensure that banks maintain ample liquidity to withstand a stressed short-term funding scenario. To meet this goal, the LCR mandates that banks hold a predefined stock of unencumbered, high-quality liquid assets (HQLA) that are sufficient to meet modeled cumulative net cash outflows over a 30-day stress scenario. The ratio of liquid assets to net cash outflows must exceed 100 percent. In the US, the LCR is applicable to all banks above $50 billion in total assets, although systemically important banks with assets over $250 billion must abide by more onerous requirements. In the numerator, liquid assets are classified as Level 1, Level 2A or Level 2B. Level 1 assets, including cash, central bank reserves and direct US government obligations, are fully included in the LCR (i.e. 0% haircut). This favorable treatment resulted in strong demand for these assets as US rules were finalized in 2014 (see Figure 2). By comparison, assets characterized as Level 2A and 2B receive haircuts of 15 percent and 50 percent, respectively, and are of less value under the LCR. The outflow figure in the denominator reflects assumptions about the extent to which a bank s liabilities are prone to leave over a 30-day stress period, assigning a run-off factor by category. 2 Holding all else equal, a funding source that is deemed to be more stable is assigned a lower relative run-off factor. For example, as shown in Figure 3 a bank that funds its balance sheet exclusively with retail deposits will have to hold 3 5 percent of these funds in liquid assets as opposed to percent for unsecured wholesale funding. For this reason, liabilities maturing in greater than 30 days are preferred, as the effective run-off rate is 0%. Figure 2: US Banks Boost Treasury Purchases in 2014 $ % 450, , , , , , , , , Q1 Q1 Q1 Q1 Q US Treasuries $M (Left) Source: FDIC, January Implications YoY Growth (Right) The LCR increases the demand for high-quality liquid assets in the numerator and reduces the supply of short-term liabilities in the denominator. This acts as a double-edged sword in the market for short-term liquid assets as banks pile into Level 1 assets on one hand but seek to issue longer-term liabilities on the other. The latter makes banks less willing to issue high-quality debt instruments inside of 30 days including repurchase agreements (repos), certificates of deposit (CDs) and commercial paper (CP). Together, these dynamics raise the cost of liquidity for short-end investors. Another critical element of the LCR for short-end investors is how banks treat various classes of deposits. Deposits deemed to be operational that is, more based on Figure 3: Retail Deposits Favored in LCR Outflow Assumptions Retail Deposits Favored, Non-Operational Wholesale Funding is not. Lower Outflow Assumption Higher Outflow Assumption Retail Deposits % Unsecured Wholesale Funding % Secured Funding % Term Deposits with Residual Maturity > 30 Days 0 Small Business Deposits 5 10 Transactions with central counterparty or backed by Level 1 assets Stable Deposits 3 5 Operational Deposits (portion covered by deposit insurance) Less Stable Deposits 10 Operational Deposits (covered by clearing, custody and cash management activities) Unsecured wholesale funding from non-financial services sector (covered by deposit insurance) Unsecured wholesale funding from non-financial services sector (not covered by deposit insurance) All other unsecured wholesale funding including from financial services company or affiliate 5 Transactions backed by Level 2A assets, with any counterparty 25 Transactions backed by non Level 1/ non-level 2A assets, with any counterparty 20 Backed by RMBS eligible for inclusion in level 2B 40 Backed by other Level 2B assets All other secured funding transactions 100 Source: J.P. Morgan Securities LLC US Fixed Income Regulatory Update for 1Q15 May 26, Authors: Alex Roever Teresa Ho John Iborg. SSGA State Street Global Advisors 2

3 relationships are of greater value than non-operational deposits. In fact, some banks have recently begun to turn away wholesale deposits that are detrimental under the LCR, including deposits from financial institutions and their affiliates, as highlighted in Figure 3. 3 As rates rise, we expect aggressive price competition for retail deposits and for banks to be less willing to take on non-operational balances. The interplay between the LCR and the SLR presents a quandary for banks. Whereas the LCR requires banks to hold elevated levels of high quality liquid assets, there is a high capital cost of doing so under the SLR. Though both ratios reinforce the reduction of short-term wholesale funding, there is an inherent balancing act to optimize the balance sheet. The LCR also has implications on non-banks. For example, as the LCR discourages banks from providing credit and liquidity facilities for CP and asset backed commercial paper (ABCP), the cost for such arrangements will be higher. Similarly, as the LCR prefers that banks avoid wholesale deposits, the cost to non-financial corporates for holding cash in these accounts will increase. Net Stable Funding Ratio (NSFR) The NSFR measures funding that is deemed to be reliable over a one-year time horizon relative to less liquid assets. The purpose of the NSFR is to reduce maturity transformation risk. To be in compliance with the NSFR, a bank s available stable funding, the numerator in the ratio, must cover at least 100 percent of its required stable funding, the denominator of the ratio. Available Stable Funding NSFR = 100% Required Stable Funding The NSFR is negatively impacted when short-term liabilities fund long-term, less liquid assets. Figure 4 lists available and required stable funding factors under the NSFR. On the left side of the table, note how short-term funding is treated punitively compared to capital, long-term borrowings and retail deposits. Similarly, on the right side of the table, note how the most liquid Level 1 and Level 2A assets are preferred relative to both secured and unsecured loans, which require a much higher proportion of stable funding. Example: NSFR Impact on Bank Profitability Figure 5 illustrates the impact of the NSFR on bank profitability. Assume that a bank holds a $1 billion single-a rated corporate bond as an interest-earning asset on its balance sheet. Prior to the crisis, the bank could fund this corporate bond exclusively with short-term funding. As shown, doing so would hypothetically produce an annualized $17.6 million in after-tax income, or the equivalent return on equity of 35 percent (assuming a 5 percent SLR requirement). However, this funding model is not permitted under the NSFR. Under the NSFR, this asset would be assigned a required stable funding factor of 50 percent as a Level 2B security. To be NSFR neutral, the bank must utilize a funding source with at least a 50 percent available stable funding factor. Given that shortterm funding of less than 6 months has a ASF factor of 0%, as highlighted in the left column of Figure 4, a bank cannot fund this bond with short-term funding of less than 6 months and maintain a NSFR of 100 percent. Figure 6 illustrates three approaches to fund this corporate bond under the NSFR. While long-term funding is clearly preferred by regulators, it can be expensive. For example, Figure 4: Simplified Basel NSFR Requirements Banks Must Hold Long-Term Funding for Long-Term Assets Available Stable Funding (Higher Weight = Stronger Funding Source) % Required Stable Funding (Higher Weight = Requires More Stable Funding ) % Capital 100 Securities (Level 1 i.e. US Government) 5 Long-Term Borrowings ( 12 months) 100 Securities (Level 2A i.e. US Agency) 5 15 Retail and Small Business Deposits (Current, Savings, Time) Securities (Level 2B i.e. Corporate Bonds, Equities) Deposits from Corporate Customers 50 Unsecured/Secured Funding (i.e. loans) to Financial Institutions < 6 months Other Deposits & Short-Term Borrowings (6 months 12 months) 50 Unsecured/Secured Funding (i.e. loans) to Financial Institutions 6 months 1 Year Other Deposits & Short-Term Borrowings ( 6 months) 0 Unsecured/Secured Funding (i.e. loans) to Financial Institutions > 1 year 100 Deposits from Financial Institutions (i.e. bank deposits) 0 Unsecured/Secured Funding (i.e. loans) to Non-Financial Firms < 1 year 50 Trading/Pension Liabilities 0 Unsecured/Secured Funding (i.e. loans) to Non-Financial Firms > 1 year Other Assets *Reflects Basel III NSFR rule finalized September State Street Global Advisors 3

4 Figure 5: Pre-NSFR Funding Model Annualized ROE from Funding in Short-Term Markets Asset to Fund Total ($) RSF Factor RSF Needed Yield Revenue ($) High Quality Corporate Bond (Level 2 Security) 1, % 30.0 Funding Preference Pre-Crisis ST Funding <6 months via Repo Markets Total ($) ASF Factor ASF Rate Interest Cost ($) 100% Short-Term Funding < 6 Months 1, % -3.0 Total Funding 1,000 NIBT 27.0 * Asset Yield and Funding Costs Estimated. * Tax Rate Assumed to be 35%. Annual Taxes -9.5 ROE NIAT % Figure 6: Post-NSFR Funding Options Terming-Out Funding is More Expensive, Especially Under a 5% SLR Requirement Asset to Fund Total ($) RSF Factor (%) RSF Needed ($) Yield (%) Revenue ($) High Quality Corporate Bond (Level 2 Security) 1, Funding Option Under NSFR Option 1: Long-Term Funding Total ($) ASF Factor (%) ASF ($) Rate Interest Cost ($) 100% Long-Term Funding >12 Months 1, , % Total Funding 1, ,000 NIBT 7.0 Annual Taxes -2.5 ROE NSFR = $1000/$500 = 200% Net Income % Option 2: Laddered Funding Total ($) ASF Factor (%) ASF ($) Rate Interest Cost ($) 50% Long-Term >12 Months % % Short-Term Repo Funding <6 Months % -1.5 Total Funding 1, NIBT 17.0 Taxes -6.0 ROE NSFR = $500 / $500 = 100% Net Income % Option 3: Short-Term Funding 6 12 Months Total ($) ASF Factor (%) ASF ($) Rate Interest Cost ($) 100% Short-Term Funding 6 12 Months 1, % -4.5 Total Funding 1, NIBT 25.5 Taxes -8.9 ROE NSFR = $500 / $500 = 100% Net Income % * Asset Yield and Funding Costs Estimated. * Tax Rate Assumed to be 35%. State Street Global Advisors 4

5 funding this bond exclusively with debt maturing beyond 12 months generates an ROE of 9.1 percent. Although other combinations of funding sources will produce stronger returns in an NSFR-neutral manner, they nevertheless fall short of the pre-crisis funding model shown in Figure 5. Moreover, we would expect these economics to worsen as the the short-end of the yield curve steepens. Implications The NSFR guards against mismatches between assets and liabilities, encouraging banks to extend the duration of their funding book by reducing short-term wholesale funding and non-core deposits. Banks with higher proportions of short-term funding, most notably investment banks with limited retail deposit balances, are naturally more impacted by the rule. The NSFR hampers the ability of large dealers to intermediate between leveraged investors on the asset-side of the balance sheet (i.e., hedge funds and mortgage real estate investment trusts) and cash lenders on the liability side of their balance sheet (i.e., money market funds and securities lenders). This is because loans made to primary dealer clients such as a reverse repo or another secured lending agreements could require higher funding costs under the NSFR. Given that much of what is funded in the repo market is government/agency collateral, forcing these trades to be funded longer-term could hurt liquidity for these assets. To some extent, higher funding costs from the NSFR are likely to be passed along to investors via transaction costs and liquidity premium. As the NSFR incentivizes funding to extend at least beyond six months in duration (and preferably over one year), banks must charge more for their services in order to maintain profitability. As industry data suggest, many of the largest global banks are better situated to address the LCR than the NSFR, and the NSFR could be more a binding constraint moving forward. 4 Short-Term Wholesale Funding Surcharge In late 2014, the Fed released a proposal for calculating risk-based capital surcharges for systemically important US banks, or the G-SIB buffer. Whereas the G-SIB buffer under Basel proposals ranges up to 3.5 percent for the largest and most complex banks, under US rules the buffer can reach up to 5.5 percent. The US methodology for calculating this surcharge takes into account five equally-weighted factors, one of which is short-term wholesale funding. The inclusion of this factor, which examines daily short-term wholesale funding usage over the preceding calendar year, is a core difference between US and Basel rules. Implications Banks will have to factor this surcharge into their capital allocation decisions, which could result in an incentive to pursue only the most profitable short-term funding. For example, as categories of wholesale funding are weighted in similar manner as the LCR, non-operational deposits are treated punitively and negatively impact the G-SIB score. This presents yet another incentive to reduce these liabilities. In Part 4 of this series, we will examine Pillar III- Resolution Planning. 1 William C. Dudley, President and CEO, Federal Reserve Bank of New York, May 20, There are two versions of the LCR in the US one for banks with over $250 billion in consolidated assets and another less stringent rule for banks between $50 billion and $250 billion in assets. 3 Wall Street Journal, Banks Urge Clients to Take Money Elsewhere, December 7, Basel Committee on Banking Supervision, Basel III Monitoring Report, March Figure 7: US G-SIFI Buffer Includes Weighting for Short-Term Wholesale Funding Reliance Weight Size Cross-Jurisdisdictional Activity Interconnectedness GSIB Maps to CET1 Ratio Surcharge of 0% 5.5% Complexity Short-Term Wholesale Funding State Street Global Advisors 5

6 ssga.com For institutional use only. Not for use with the public. State Street Global Advisors Worldwide Entities Australia: State Street Global Advisors, Australia, Limited (ABN ) is the holder of an Australian Financial Services Licence (AFSL Number ). Registered Office: Level 17, 420 George Street, Sydney, NSW 2000, Australia. T: F: Belgium: State Street Global Advisors Belgium, Chausse de La Hulpe 120, 1000 Brussels, Belgium. T: , F: SSGA Belgium is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Canada: State Street Global Advisors, Ltd., 770 Sherbrooke Street West, Suite 1200 Montreal, Quebec, H3A 1G1, T: and 30 Adelaide Street East Suite 500, Toronto, Ontario M5C 3G6. T: Dubai: State Street Bank and Trust Company (Representative Office), Boulevard Plaza 1, 17th Floor, Office 1703 Near Dubai Mall & Burj Khalifa, P.O Box 26838, Dubai, United Arab Emirates. T: +971 (0) F: +971 (0) France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number: Registered Office: Immeuble Défense Plaza, rue Delarivière-Lefoullon, Paris La Défense Cedex, France. T: F: Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D Munich. T: +49 (0) F: +49 (0) Hong Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. T: F: Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number: Member of the Irish Association of Investment Managers. T: +353 (0) F: +353 (0) Italy: State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano) is a branch of State Street Global Advisors Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA ), with a capital of GBP , and whose registered office is at 20 Churchill Place, London E14 5HJ. State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano), is registered in Italy with company number R.E.A and VAT number and whose office is at Via dei Bossi, Milano, Italy. T: F: Japan: State Street Global Advisors (Japan) Co., Ltd., Japan, Toranomon Hills Mori Tower 25F, Toranomon, Minato-ku, Tokyo, T: +81 (0) Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345) Membership: Japan Investment Advisers Association, The Investment Trust Association, Japan, Japan Securities Dealers Association. Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-3, 1066 JR Amsterdam, Netherlands. T: +31 (0) State Street Global Advisors Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Singapore: State Street Global Advisors Singapore Limited, 168 Robinson Road, #33-01 Capital Tower, Singapore (Company Registered Number: D). T: F: Switzerland: State Street Global Advisors AG, Beethovenstrasse. 19, Postfach, CH-8027 Zurich. T: +41 (0) F: +41 (0) United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered Number: VAT Number: Registered Office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. T: F: United States: State Street Global Advisors, One Lincoln Street, Boston, MA T: Investing involves risk including the risk of loss of principal. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. The views expressed in this material are the views of the Global Cash Credit Team through the period ended August 26, 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA s express written consent State Street Corporation. All Rights Reserved. State Street Global Advisors ID4439-GCB Exp. Date: 08/31/20166