Tailored to Small Markets: Implementation of Basel III Liquidity Requirements Christopher h Wilson Financial Supervision and Regulation Division Monetary and Capital Markets Department October 2015
Outline Motivations for Basel III liquidity reforms Overview of Basel III liquidity framework Implementing LCR in small markets Examples from IMF TA 2
Motivations for the Basel III liquidity reforms Benign liquidity conditions leading up to the crisis allowed banks to take on excessive leverage Recognition that liquidity risk not being properly managed Need for greater attention by supervisors 3
Prior to the crisis, benign liquidity conditions allowed banks to grow balance sheets Risk premia in the interbank market (bps) 250 Repo haircut index corporate and structured finance securities (%) 50% 45% 200 40% 35% 150 30% 25% 100 20% 15% 50 10% 5% 0 0% 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1 2008Q3 2009Q1 2009Q3 2010Q1 2010Q3 2011Q1 2011Q3 2012Q1 2012Q3 2013Q1 2013Q3 2014Q1 2014Q3 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Sources: Bloomberg; BIS; and IMF staff calculations. 4
Prior to the crisis, complacent about liquidity risks Regulatory overkill is identified as the greatest risk facing the financial sector for the second year running PWC Banking Banana Skins 2006 1. Too much regulation 2. Credit Risk 3. Derivatives 4. Commodities 5. Interest rates 6. High dependency on technology 7. Hedge funds 8. Corporate governance 9. Emerging markets 10... 5
Lapses in liquidity risk management contributed to the crisis The crisis exposed banks inadequate liquidity risk profile management and inaccurate liquidity risk pricing through: Heavy reliance on short-term t funding HBOS Too much reliance on external financingi Insufficient liquidity buffers to survive a disruption in funding markets
Example of liquidity not being properly managed - HBOS 2001 2008 CAGR ( bn) ( bn) (%) Group Customer Loans 201.0 435.2 12.6 Customer Deposits 140.5 222.3 7.8 Total Assets 274.7 630.9 12.6 Tangible Shareholders Equity ( m) 9,823 17,792 10.4 Loans/Deposits Ratio (%) 143 196 Wholesale funding < 1 year 89.88 119.4 Leverage (Assets/TSE) (x) 28 35 Retail Customer Loans 132.1 255.3 9.9 Customer Deposits 102.0 143.7 5.0 Corporate (including Business Banking in 2001) Customer Loans 55.1 123.0 14.4 Customer Deposits 22.2 38.5 10.5 International Customer Loans 14.4 61.0 29.5 Customer Deposits 3.7 6.6 29.6 Liquidity Ratio Loans / deposits ratio of 196 in 2008 Funding Mix Rising short-term wholesale funding and leverage Retail Business Avg. loan growth ~2x avg. deposit growth Treasury Deposits 12.6 33.5 15.0 Corporate Business Avg. loan growth ~1.5x Insurance & Investment G l I (G W i P i ) ( ) 1064 1 799 78 avg. deposit growth General Insurance (Gross Written Premiums) ( m) 1,064 1,799 7.8 Investment Sales 7.8 11.2 5.3 Source: Parliamentary Commission on Banking Standards, 2013, An Accident Waiting to Happen : The Failure of HBOS, HL Paper 144 HC 705. 7
Global liquidity regulations -historical perspective 1988 Basel 1 Capital Accord 2000 2013 Sound Practices for Managing Liquidity in Banking Organizations 2008 Sound Practices for Liquidity Risk Management LCR 1996 Market Risk Amendment to Capital Accord 2004 Basel 2 Capital Accord 2010 Basel 3 2014 NSFR 8
Examples of country-by-country liquidity regulations prior to Basel 3 South Korea U.S.A. U.K. Sterling Stock floor, scenario analysis LDR ratio 100%, Current Assets/ Current Liabilities (100%) Coverage ratio Japan No quantitative ratio, scenario analysis Australia 9% HQLA/total liabilities & 5 day name crisis 9
Basel III is a comprehensive liquidity framework Short-term t Resilience LCR Risk Management Principles for Sound Liquidity Risk Management NSFR Long-term Resilience
BIII: Principles for Sound Liquidity Risk Management Published in 2008, revised and strengthen the BSBC practice guidance (2000) LCR Principles for sound liquidity risk management Principles for Sound Liquidity Risk Management NSFR 13 principles for banks 4 principles for supervisors
Basel III Liquidity Framework: LCR Objective is to promote short term resilience, 30 day time horizon LCR Principles for sound liquidity risk management High level of prescription regarding HQLA eligibility LCR NSFR Based on stressed assumptions Categories of liability structure
Basel III Liquidity Framework: NSFR Objective to promote longer term resilience, 1 year time horizon Principles for sound liquidity risk management Encourages greater matching of assets and liabilities NSFR NSFR Factors applied to assets and liabilities
Principles for Sound Liquidity Risk Management and Supervision, BCBS 2008 Severe stress scenarios Liquidity risk tolerance Adequate liquidity cushion Allocate costs, benefits and risks Contingency funding plan Identify & measure full range of liquidity risks Intraday liquidity risk and collateral BCBS 2008 Market discipline Detailed guidance on the risk management and supervision of funding and liquidity risk 14
The new Basel III metrics Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NFSR) Two complementary metrics with different time horizons Stock of High Quality Liquid Assets Net cash out over 30-day period under stress > 100% Available Amount of Stable Funding Required Amount of Stable Funding > 100% LCR: to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted dinto cash to meet liquidity needs for a 30-day time horizon under an acute liquidity stress scenario NSFR: a full balance-sheet metric, compares an estimate of reliable funding sources to an estimate of required stable funding over the 1 year horizon, under more prolonged but less acute stress than in the LCR 15
LCR in detail Main features Stock of HQLA Estimation of stressed outflows 30 day time horizon Promote short term resilience 100% threshold Idiosyncratic and marketwide stress Stressed assumptions for both assets and liabilities l Three categories of HQLA Segment and categorize liability structure t Calibration of run-off rates 16
LCR harmonized the definition of HQLA Level 1 Level 2A Level 2B HQLA HQLA HQLA Cash Securities issued or guaranteed by sovereigns or CBs with 20% RWA (15% haircut) RMBS with AA and better ratings (25% haircut) CB reserves Non-financial i corporate debt securities with ratings between A+ and BBB- (50% haircut) Securities issued or guaranteed by sovereigns or CBs 0% RW or domestic currency Non-financial corporate debt securities and covered bonds with AA- and better ratings (15% Haircut) Non-financial common equity shares included in a major stock index (50% haircut) Total Level 2 HQLA can constitute up to 40% of total HQLA Level 2B HQLA can constitute up to 15% of total HQLA 17
To be eligible as HQLA, assets need to meet three tests Fundamental characteristics Low risk Ease and certainty of valuation Low correlation with risky assets Listed on a developed and recognized exchange Market characteristics Active and sizable market (historical evidence of market breadth and depth) Low volatility Flight to quality Operational requirements 18
Estimating cash outflows Retail deposits 3% to 10% depending on the stability of deposits Unsecured wholesale funding Small business customers: 5% to 10% Other: 5% to 100% depending on the nature of funding and characteristics of customers Secured funding 0% to 100% based on the counterparty and assets backing the transaction Other Undrawn committed credit and liquidity facilities: 5% to 100% Other contingent funding liabilities: national discretion, but 0-5% for trade finance 19
Estimating cash inflows Maturing secured lending transactions 0% to 100% depending on the collateral (mostly equal to haircut ratio for HQLA) Credit or liquidity facilities/operational deposits at other banks 0% Other inflows 50% for retail and non-financial wholesale counterparties (50% roll-over assumed) 100% for financial institutions and CBs Net derivative cash inflows 100% 20
Net Stable Funding Ratio RSF Assets Cash Short term Long term Available Amount of Stable Funding Required Amount of Stable Funding > 100% Introduction as a minimum i requirement: 2018 ASF is a weighted sum of funding sources according to their stability features (liabilities) RSF is a weighted sum of uses of funding sources according to their liquidity (assets) ASF Liabilities Demand Short Term Long term No maturity 21
NSFR: ASF and RSF factors Available Stable Funding (liabilities) Tier 1 - Tier 2 capital, preferred shares in excess of Tier 2, and other liabilities with residual maturity > 1 y Availabili ty factor Required Stable Funding (assets) 100 Cash, securities and non-renewable loans to financials with maturity < 1y; short-term t actively traded d instruments Require d factor 0 Stable deposits from retail and Small business customers with residual maturity < 1 y Less stable deposits from retail and Small Business customers with residual maturity < 1 y 90 Unencumbered debt issued or guarantee by sovereigns, CBs or IFIs, with remaining maturity > 1 y and rating > AA 80 Unencumbered corporate bonds and covered bonds with an effective maturity o 1y, rated at least AA, traded in deep, active and liquid markets, and have demonstrated to remain liquid in a stressed market environment. 5 20 Wholesale funding by non-financial corporates, 50 Loans to non-financial corporate with residual maturity 50 sovereigns, central banks, MDBs with residual <1y. maturity < 1 y Unencumbered equity securities listed on a major exchange and included in a large capital market index and unencumbered corporate bonds or covered bonds rated AA- to A- with maturity of 1 y, which are traded in deep, active and liquid markets and have demonstrated to remain liquid in a stressed market environment. Gold All other liabilities and equity not included above 0 Mortgages 65 Loans to retail with residual maturity <1y 85 All other assets 100 Undrawn amount of committed credit and liquidity facilities 5 22
Liquidity: LCR and NSFR a stylized example > 1 Year Balance Sheet Bank A Bank B RSF Factors Assets: 30days Liquid short-term assets 5 30 0% Loans (retail > 1 year) 85 35 85% Mortgages g (> 1 year) 10 35 65% Total 100 100 Required Stable Funding Run-off rates ASF Factors Liabilities: Stable retail deposits 25 75 3% 90% Interbank (unsecured) 75 25 100% 0% Equity 10 10 0% 100% Available Stable Funding Liquidity Coverage Ratio Net Stable Funding Ratio LCR (1) Liquid assets 5 30 (2) Net 30-day cash outflow 76 27 Required: Ratio (1) / (2) 7% 110% 100% NSFR (1) Available stable funding 33 78 (2) Required stable funding 79 53 Required: Ratio (1) / (2) 41% 148% 100% 23
Phase-in Arrangements Capital Phases 2013 2014 2015 2016 2017 2018 2019 Parallel run 1 Jan 2013 1 Jan 2017 Migration to Leverage Ratio Disclosure starts 1 Jan 2015 Pillar 1 Minimum Common Equity Capital Ratio 3.50% 4.00% 4.50% 4.5% Capital Conservation Buffer 0.63% 1.25% 1.88% 2.5% Minimum common equity plus capital conservation buffer 3.50% 4.00% 4.50% 5.13% 5.75% 6.38% 7.0% Phase-in of deductions from CET1* 20% 40% 60% 80% 100% 100% Minimum Tier 1 Capital 4.50% 5.50% 6.00% 6.0% Minimum Total Capital 8.00% 8.0% Minimum Total Capital plus conservation buffer Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital 8.00% 8.63% 9.25% 9.88% 10.5% Phased out over 10 year horizon beginning g2013 Liquidity L Liquidity coverage ratio minimum requirement Net stable funding ratio * Including amounts exceeding the limit for deferred tax assets (DTAs), mortgage servicing rights (MSRs) and financials. transition periods 60% 70% 80% 90% 100% Introduce minimum standard 24
Implementation of BIII liquidity : challenging but business models are adjusting Lower risk business models Holding greater amounts of HQLA Funding structures improved, competition for deposits Loan to deposit ratios moderating Risks Over-crowding of certain assets Interaction between liquid assets, RoE and asset quality Adjustments not uniform across banks and regions Shortage of HQLA, shallow markets 25
Liquidity Regulation post crisis BCBS MEMBERSHIP Internationally Active Banks Non-Internationally Active Banks Argentina Australia Belgium Brazil Canada China European Union France Germany Hong Kong India Indonesia Italy Japan Korea Luxembourg Mexico Netherlands Russia Saudi Arabia Singapore South Africa Spain Sweden Switzerland Turkey United Kingdom United States NSFR LCR Risk Management LOCAL RULES Risk Management Compliance with Basel Core Principles
Implementing LCR major questions Appropriate supervisory framework? Qualitative guidance for liquidity risk management Availability of HQLA? Breadth and depth of markets (limited price decline or increase in haircut even during stressed market conditions) Level 2 HQLA liquid enough? Central Bank reserves? Stability of deposits? Ability to categorize liabilities into the LCR definitions Historical data Calibration lb of run-off rates 27
Making an assessment of whether a transition to Basel III liquidity makes sense where to start? Step 1: Assess the pre-conditions for the applicability of the LCR Can be made by looking at the money market conditions and the liquidity of government securities. Does a repo market exist for government securities? Is the market for government securities liquid (look at bid-ask spread, volumes, price volatility, etc). Does the market exhibit different liquidity at different maturities? Are there other liquid markets? Step 2: Consider evaluating assumptions for the LCR Particularly in the cases of crisis countries, with somewhat unstable banking systems, the appropriateness of the assumptions used for the LCR could be usefully reviewed in light of the current country s experience. Step 3: Assess the current level of the banks short term liquidity position Can be made by looking at a number of ratios. Liquid Assets to Total Assets is a commonly used but not fully appropriate measure as it does not provide information about the adequacy of a given stock of liquid assets. More in line with the rationale of the LCR is the ratio of Liquid Assets to Short Term Funding (where deposits should not or should only partially be included). Loans to Deposits ratio can also provide some useful insight with high values calling for more in depth analysis. Step 4: Assess the banks structural liquidity position and the possible impact of the NSFR Requires an evaluation of fbanks k maturity mismatch. hthe banks k reliance on short term wholesale funding should be investigated. The ratio of such funding to total liabilities (excluding equity) should also be determined. At aggregate level, a large external debt can be a signal of potential vulnerability. A proxy impact of the NSFR can be assessed at bank level if adequate data is disclosed using methodology proposed by IMF WP/14/106 28
Implementing LCR practical steps QIS Conduct a QIS Understand composition of assets and liabilities Identify liquidity situation based on a standardized LCR calibration National Discretion Look into stability of liabilities (e.g., deposits) and liquidity of assets (e.g. Level 1 & 2A & 2B assets) Consider use of national discretion to modify certain aspects of framework ALA treatment See how much bank HQLA will be needed and whether it would be practical to expect banks to increase their HQLA holding Consider use of ALA treatment, carefully examining pros and cons of each option 29
Treatment for jurisdictions with insufficient HQLA - alternative liquidity approaches (ALA) Option 1: Contractual committed liquidity facilities (CLF) from CBs with a fee Option 2: Foreign currency HQLA to cover domestic currency liquidity needs Option 3: Additional use of Level 2A HQLA with higher haircut (minimum 20%) 30
Implementing LCR ALA pros and cons Option 1: CLF Option 2: Use of foreign currency HQLA Option 3: Additional use of Level 2 assets Useful for jurisdictions with a deep and well- developed capital markets Does not change banks asset and liability characteristics Suited for banking systems with already high levels of liquid foreign assets Difficult to design and calibrate lb fees and haircuts to provide right incentives Could introduce higher h foreign exchange risk Need careful assessment of fliquidity of these assets during times of stress 31
Integrate BIII into routine supervision LCR Monitoring Tools Market-related monitoring tools LCR by significant currency Contractual maturity mis- match Available unencumbered assets Concentration of funding Apply the Supervisory Principles (principles 14-17) 1. Regularly perform a comprehensive assessment of a bank s overall liquidity risk management framework 2. Regular monitoring 3. Intervene to require remedial action to address deficiencies 4. Communicate with other relevant e supervisors so s 32
1 st Country example Situation Recommendation Desire to strengthen liquidity rules Liquidity regime was fit-forpurpose: healthy buffers Excess system liquidity, conservatively invested HQLA, but no deep and liquid market Banks mainly deposit funded Qualitative guidance in place LCR QIS conducted, but with limited details and data variability Offered tailored advice Developed a 3 year road map for improving liquidity regime Logical sequencing of initiatives Consider modifications to LCR framework to take account of local conditions Conduct a follow-up QIS, uniform template, detailed guidance, engagement with industry 33
1 st Country example: 3 year strategic plan Static coverage ratio 2013 - Establish a project team - perform stock take from QIS Hold targeted discussions with industry 2014 - Issue draft guidance outlining main LCR definitions - Conduct follow up QIS - Assess results, consider main policy questions - Calibration crucial 2015 - Engage with industry - Issue final regulations -Consider transition arrangements, parallel run, phase-in etc Basel III LCR, NSFR to come 34
2 nd Country example Situation Recommendation Desire to strengthen liquidity rules Simple liquidity ratio Regulation last updated in 2004 No qualitative guidance for risk management Developed risk management standards to be implemented as a priority Revised liquidity ratio to be more closely aligned with LCR, modified to take account of local conditions: Scarcity of HQLA Run-off assumptions Currency differentiated LCR mandatory 35
2 nd Country example Existing rule Recommended amendments to liquidity rules Standard coverage ratio Minimum threshold h for compliance 50% Broad definition of liquid assets 30 day time horizon Off-balance sheet items not included No distinction between encumbered and unencumbered assets Minimum threshold increased to 100% 30 day time horizon Based on stressed assumptions of assets and liabilities Definition of HQLA aligned with LCR Off-balance sheet items defined and included Distinction between encumbered and unencumbered 36
Summary B3 reforms comprehensive regulatory framework for liquidity significantly strengthen resilience of banks to liquidity shocks, disruptions to funding markets Binding for internationally active banks Changed business models, almost there Liquidity regulation for non-internationally active banks Sound Principles, Basel Core Principles and local prudential ratios Basel III desirable on a time line that makes sense, takes into consideration local characteristics, TA proved effective at identifying issues, helping transition 37
Questions? Contact: t cwilson@imf.org 38
Key resources Liquidity Risk: management and supervisory challenges, BCBS, February, 2008 Liquidity Stress Testing: a survey of theory, empirics and current industry and supervisory practices, BCBS, October 2013 Comptroller s Handbook: Liquidity, OCC, June 2012 Principles for Sound Liquidity Risk Management and Supervision, BCBS, 2008 Managing Liquidity Risk, Swift, June 2011 39