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Basel III - Amendments to the Liquidity Coverage Ratio

March-20-2013

Area Structured Finance and Derivatives

Summary

On January 6, 2013, the Group of Governors and Heads of Supervision (the “GHOS”), which oversees the Basel Committee on Banking Supervision (the “Basel Committee”), announced it would be amending the Basel III liquidity coverage ratio (the “LCR”).  In connection with the announcement, Mervyn King, chairman of the GHOS and governor of the Bank of England, stated that for the first time in regulatory history, there will be a truly global minimum standard for bank liquidity.

In particular, (i) a phased timetable to introduce the LCR, and (ii) reaffirmation that a bank’s liquid assets are available in times of stress, will help ensure the new liquidity standard does not hinder the global banking system’s ability to finance a recovery.

History

The LCR standard was first published by the Basel Committee at the end of 2010, as part of the Basel III regulatory standards. Basel III supplemented the existing international Convergence of Capital Measurement Document (Basel II) which came into effect in 2008 across the European Union and in many other jurisdictions.  At the time of Basel III’s publication, it was anticipated that the new measures would help strengthen the regulation and facilitate the supervision and risk management of the banking sector as a whole. However, critics have argued that the Basel III 2010 LCR standard was too onerous, and that it adversely affected lending activity when many financial systems were under stress.

Revisions to the LCR

The LCR is an essential component of the broader Basel III reforms. The revised standard builds on traditional liquidity coverage ratio methodologies used internally by banks to assess exposure to contingent liquidity events.  It has two components: (i) the value of the stock of unencumbered high quality liquid assets (“HQLA”) in stressed conditions, and (ii) total net cash outflows.

The revised LCR was developed as a way to promote short-term resilience of a bank’s liquidity risk profile by ensuring it has sufficient HQLA to survive a significant stress scenario lasting 30 calendar days.  The LCR reflects the ratio of a bank’s HQLA to its net cash outflows over the next 30 calendar days.  In its press release dated January 6, 2013, the Basel Committee stated that the amendments would help prevent central banks from becoming ‘lenders of first resort’.

The revised ratio loosens some limitations of the original LCR, primarily by expanding the assets eligible to be treated as liquid assets and by altering the predicted outflow and inflow rates to more accurately reflect real-world scenarios.  As it is less onerous than the original formulation, the revised LCR is expected to be welcomed by the banks.

Highlights of the amendments to the LCR standard include:

  • revisions to the definition of HQLA and net cash outflows;
  • a timetable for phase-in of the standard to be introduced on January 1, 2015 in stages, with an initial 60% liquidity requirement rising annually by 10% to 100% by 2019;
  • a reaffirmation of the availability of a bank’s liquid assets in periods of stress, including during the transition period in which banks may fall below the required LCR thresholds; and
  • an agreement for the Basel Committee to conduct further work on the interaction between the LCR and the provision of central bank facilities.

Once the phase-in arrangements are complete, the amended standard will require that, absent a situation of financial stress, the value of the LCR must be no lower than 100% (i.e., the value of HQLA should at least equal total net cash outflows).  Banks are expected to meet this requirement on an ongoing basis and hold unencumbered HQLA as a defence against the potential onset of liquidity stress. During a period of financial stress, however, banks may use their HQLA (causing the LCR to fall below 100%).

Canadian Perspective

In Canada, the Office of the Superintendent of Financial Institutions (“OSFI”) is the national authority charged with implementation of Basel III, and has recently joined the growing group of international regulators committed to implementing Basel III in their domestic regulatory frameworks.  OSFI has made concerted efforts to accelerate the implementation of Basel III in Canada on a basis that makes sense for Canadian institutions.

OSFI stated it is confident that over time these initiatives will help foster public confidence in the implementation of Basel III, and demonstrate that the promises made by G20 countries, such as Canada, are being matched by actions. Much remains to be accomplished, but OSFI stated publicly that the end result will be a safer, more resilient financial system in Canada.

Referring to the LCR, the Assistant Superintendent of OSFI was recently quoted as saying OSFI will need to fully examine how its existing liquidity monitoring tools should be used in conjunction with the new international standards.

Much like in other jurisdictions, the changes are anticipated to be well received by Canadian banks, not only because the LCR standard has been eased, but also because they will now have more time to comply with the rule.  The Bank of Canada Governor, Mark Carney, has stated that it will prove to be competitively advantageous for the Canadian banking system.

Some jurisdictions have not, however, completed the migration from the original Basel I to Basel II, much less implemented Basel III.  OSFI recognizes that if countries do not follow through, there is a risk that countries, like Canada, that do implement Basel III could find their banks at a disadvantage in international markets. Canadian banks may even confront unfair competition from foreign banks domestically.  These challenges will need to be addressed as OSFI works towards implementing Basel III.

For further information on the amendments to the Basel Committee’s LCR, please contact any member of our Structured Finance and Derivatives Group.