The Liquidity Coverage Ratio (LCR)
The Basel Committee has developed two standards for supervisors to use in liquidity risk supervision.
One standard, the Liquidity Coverage Ratio, addresses the sufficiency of a stock of high quality liquid assets to meet short-term liquidity needs under a specified acute stress scenario.
The complementary standard, the Net Stable Funding Ratio, addresses longerterm structural liquidity mismatches.
To raise the resilience of banks to potential liquidity shocks, the standards should be implemented consistently as part of a global framework.
To this end, most of the specific parameters used in these metrics are internationally harmonised, with specific and concrete values.
Certain parameters, however, will need to be set by national supervisors to reflect jurisdiction-specific conditions.
In these cases, the parameters should be transparent and clearly outlined in the regulations of each jurisdiction.
This will provide clarity both within the jurisdiction as well as across borders.
In addition, supervisors may require an individual institution to adopt more stringent standards or parameters to reflect its liquidity risk profile and the supervisor's assessment of the institution's compliance with the Committee's sound principles.
The liquidity coverage ratio identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute short-term stress scenario specified by supervisors.
The specified scenario entails both institution-specific and systemic shocks built upon actual circumstances experienced in the global financial crisis.
The scenario entails:
a significant downgrade of the institution's public credit rating;
a partial loss of deposits;
a loss of unsecured wholesale funding;
a significant increase in secured funding haircuts; and
increases in derivative collateral calls and substantial calls on contractual and noncontractual off-balance sheet exposures, including committed credit and liquidity facilities.
As part of this metric, banks are also required to provide a list of contingent liabilities (both contractual and non-contractual) and their related triggers.
Liquidity coverage ratio
This metric aims to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors.
At a minimum, the stock of liquid assets should enable the bank to survive until day 30 of the proposed stress scenario, by which time it is assumed that appropriate actions can be taken by management and/or supervisors, and/or the bank can be resolved in an orderly way.
The Liquidity Coverage Ratio (LCR) builds on traditional liquidity "coverage ratio" methodologies used internally by banks to assess exposure to contingent liquidity events.
Net cumulative cash outflows for the scenario are to be calculated for 30 calendar days into the future.
The standard would require that the value of the ratio be no lower than 100% (ie the stock of liquid assets should at least equal the estimated net cash outflows).
Banks are expected to meet this requirement continuously and hold a stock of unencumbered, high quality assets as a defence against the potential onset of severe liquidity stress.
Banks and supervisors are also expected to be aware of any potential mismatches within the 30-day period and ensure that sufficient liquid assets are available to meet any cashflow gaps throughout the month.
The scenario proposed for this standard entails a combined idiosyncratic and market-wide shock which would result in:
(a) a three-notch downgrade in the institution's public credit rating;
(b) run-off of a proportion of retail deposits;
(c) a loss of unsecured wholesale funding capacity and reductions of potential sources of secured funding on a term basis;
(d) loss of secured, short-term financing transactions for all but high quality liquid assets;
(e) increases in market volatilities that impact the quality of collateral or potential future exposure of derivatives positions and thus requiring larger collateral haircuts or additional collateral;
(f) unscheduled draws on all of the institution's committed but unused credit and liquidity facilities; and
(g) the need for the institution to fund balance sheet growth arising from non-contractual obligations honoured in the interest of mitigating reputational risk.
In summary, the stress scenario specified incorporates many of the shocks experienced during the current crisis into one acute stress for which sufficient liquidity is needed to survive up to 30 calendar days.
This stress test should be viewed as a minimum supervisory requirement for banks.
Banks are still expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct scenarios that could cause difficulties for their specific business activities.
Such internal stress tests should incorporate longer time horizons than the ones mandated by this standard. Banks are expected to share these additional stress tests with supervisors.
The proposed standard should be a key component of the regulatory approach, but must be supplemented by detailed supervisory assessments of other aspects of the bank's liquidity risk management framework in line with the Committee's Sound Principles.
The LCR consists of two components:
A. Value of the stock of high quality liquid assets in stressed conditions.
B. Net cash outflows, calculated according to the scenario parameters set by supervisors.
Stock of high quality liquid assets
The numerator of the LCR is the "stock of high quality liquid assets".
Under the proposed standard, banks must hold a stock of unencumbered, high quality liquid assets which is clearly sufficient to cover cumulative net cash outflows (as defined below) over a 30-day period under the prescribed stress scenario.
As supported by the Financial Stability Board in its September 2009 report to the G20, the LCR establishes a harmonised framework to ensure that global banks have sufficient high-quality liquid assets to withstand a stressed scenario (as set out in the LCR).
In order to qualify as a "high-quality liquid asset", assets should be liquid in markets during a time of stress and, ideally, be central bank eligible.
Characteristics of high quality liquid assets
The 2007-2009 crisis reinforced the need to examine carefully the liquidity of asset markets, and relatedly, the characteristics that allow some markets to remain liquid in times of stress.
Banks need to be careful not to be misled by the wide range of liquid markets during booms.
Assets are considered to be high quality liquid assets if they can be easily and immediately converted into cash at little or no loss of value.
The liquidity of an asset depends on the underlying stress scenario, the volume to be monetised and the time-frame considered.
Nevertheless, there are certain assets that are more likely to generate funds without incurring large fire-sales even in times of stress.
This section outlines factors which influence whether or not the market for an asset can be relied upon to raise liquidity when considered in the context of possible stresses.
During the consultative period and quantitative impact study, the Committee will analyse the trade-offs between the severity of the stress scenario and the definition of the stock of liquid assets which will be held to meet the standard.
The final calibration of the factors of the outflows and inflows, as well as the composition of the stock of liquid assets, will be sufficiently conservative to create strong incentives for banks to maintain prudent funding liquidity profiles, while minimising the negative impact of its liquidity standards on the financial system and broader economy.
As such, the Committee is assessing the impact of both a narrow definition of liquid assets comprised of cash, central bank reserves and high quality sovereign paper, as well as a somewhat broader definition which could also include a proportion of high quality corporate bonds and/or covered bonds.
The Committee will gather data on this defined range of asset classes to analyse the impact and trade-offs of various options involved in defining the stock of high quality liquid assets.
The text below describes the general characteristics of high quality liquid assets and outlines the specific instruments for which the Committee will collect data, along with information on haircuts currently associated with these assets in both normal times and periods of stress.
Low credit and market risk: assets which are less risky tend to have higher liquidity.
On the credit risk front, high credit standing of the issuer and a low degree of subordination increases an asset's liquidity.
On the market risk front, low duration, low volatility, low inflation risk and being denominated in a convertible currency with low foreign exchange rate risk all enhance an asset's liquidity.
Ease and certainty of valuation: an asset's liquidity increases if market participants are more likely to agree on its valuation.
A liquid asset's pricing formula must be easy to calculate and not depend on strong assumptions.
The inputs into those pricing formula must also be publicly available. In practice this should rule out the inclusion of any exotic product.
Low correlation with risky assets: the stock of high quality liquid assets should not be subject to wrong-way risk.
Assets issued by financial firms, for instance, are more likely to be illiquid in times of liquidity stress in the banking sector.
Listed on a developed and recognised exchange market: being listed increases an asset's transparency.
Active and sizable market: the asset should have active outright sale and repo markets at all times (which means having a large number of market participants and a high trading volume).
Market breadth (price impact per unit of liquidity) and market depth (units of the asset can be traded for a given price impact) should be good.
Presence of committed market makers: quotes will always be available for buying and/or selling the asset.
Low market concentration: diverse group of buyers and sellers in an asset's market increases the reliability of its liquidity.
Flight to quality: historically, the market has shown tendencies to move into some types of assets in a systemic crisis.
As outlined by these characteristics, the test of the "high quality" of assets is that by way of sale or secured borrowing, their liquidity-generating capacity is assumed to remain intact even in periods of severe idiosyncratic and market stress: indeed such assets often benefit from a flight to quality in these circumstances.
Lower quality assets fail to meet that test.
An attempt by a bank to raise liquidity from lower quality assets under conditions of severe market stress would entail acceptance of a large fire-sale discount or haircut to compensate for high market risk.
That may not only erode the market's confidence in the bank, but would also generate mark-to-market losses for banks holding similar instruments and add to the pressure on their liquidity position, thus encouraging further fire sales and declines in prices and market liquidity.
In these circumstances, private market liquidity for such instruments is likely to evaporate extremely quickly, as evidenced in the current crisis.
Taking into account the system-wide response, only high quality liquid assets meet the test that they can be readily converted into cash under severe stress in private markets.
High quality liquid assets should also ideally be eligible at central banks.
Central banks provide a further backstop to the supply of banking system liquidity under conditions of severe stress.
Central bank eligibility should thus provide additional confidence that banks hold a reserve of high quality liquid assets that could be used in events of severe stress without damaging the broader financial system.
That in turn would raise confidence in the safety and soundness of liquidity risk management in the banking system.
This stock of high quality liquid assets must be available for the bank's treasury to convert into cash to fill funding gaps at any time between cash inflows and outflows during the stressed period.
These assets must be unencumbered and freely available to the relevant group entities.
At the consolidated level, banks may also include in the stock qualifying liquid assets which are held to meet legal entity requirements (where applicable), to the extent that the related risks are also reflected in the consolidated standard.
The stock of liquid assets should not be co-mingled with or used as hedges on trading positions, be designated as collateral or be designated as credit enhancements in structured transactions, and should be managed with the clear and sole intent for use as a source of contingent funds.
The stock should be under the control of the specific function or functions charged with managing the liquidity risk of the institution.
A bank should periodically monetise a proportion of the assets in its liquid assets buffer through repo or outright sale to the market in order to test the usability of the assets.
While the LCR is expected to be met and reported in a common currency, supervisors and banks should also be aware of the liquidity needs in each significant currency.
The bank should be able to use the stock to generate liquidity in the desired currency and in the jurisdiction in which the liquidity will be required.
As such, banks are expected to be able to meet their liquidity needs in each currency and maintain high quality liquid assets consistent with the distribution of their liquidity needs by currency.