Stand out for the right reasons Financial Services Risk and Regulation

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1 Stand out for the right reasons Financial Services Risk and Regulation FS Risk and Regulation Briefing Liquidity Coverage Ratio in the EU: getting ready to launch The Liquidity Coverage Ratio (LCR) is a regulatory requirement designed by the Basel Committee for Banking Supervision (BCBS) to improve the level of insurance against liquidity risk in the banking sector. This ratio requests firms to maintain a buffer of highly liquid assets against liquidity outflows in a stress scenario defined by the regulators and featuring retail and wholesale funding outflows over a 30 day period. The LCR was published by the BCBS in January 2013 but the EU implementation took almost two years to finalise. The CRR was published in June 2013 but did not include the detailed specifications for the LCR. On 10 October 2014, the EU Commission issued its Delegated Regulation (DR) on the Liquidity Coverage Ratio for credit institutions, which was originally expected at the end of June. This act now gives banks clarity and detailed guidance on the scope and timeline of implementation, calculation of the ratio, the assets that can be included in the Liquid Asset Buffer (LAB), and percentages for the different types of inflows and outflows. The final LCR is generally good reading for the banks as it allows a wider range of instruments in the liquid asset buffer and it offers clarification and simplification on a number of areas. This briefing summarises the key takeaways from the regulatory text and considers the likely implications for banks. The key changes compared to the BCBS and CRR text are: Exclusion of investment firms from the scope of detailed LCR until the EU Commission s review expected in 2016 A wider and more user-friendly definition of the liquid asset buffer Simplified and/or less onerous requirements for certain types of deposits More favourable treatment for certain intragroup and specialised credit institutions inflows.

2 A wider and more userfriendly definition of the liquid asset buffer Compared to the BCBS definition of the LCR, the following areas have been changed in the respect of the LAB. The LAB includes a wider range of securitisations in addition to residential mortgage backed securities (RMBS), such as auto loans, consumer credit and Small and Medium Enterprises (SME) loans. Regarding operational requirements, the DR indicates that liquid assets do not necessarily need to be in a separate pool under the control of the liquidity management function (LMF), if internal systems and controls are in place for the LMF to access the assets at any point during the 30 day stress period. It clarifies that the ability to monetise assets through repo agreements equates to the power to liquidate. The text provides a definition of the stress scenarios under which a firm may use its liquid asset buffer. It also states that the valuation of liquid assets should be their market value net of any haircut. Finally, it is worth noting that the DR clarifies potentially confusing terminology, indicating that extremely high liquidity and credit quality assets and high liquidity and credit quality assets correspond to level 1 and level 2 assets as used in the BCBS text, and it uses the latter terminology in the rest of the text. The following assets can be included in the LAB: Level 1 assets (assets not included in the BCBS definition are marked with *) Coins and banknotes Exposures to or guaranteed by the ECB or a Member State (MS) s central bank Exposures to or guaranteed by centrals banks if they or central government rated External Credit Assessment Institution (ECAI) 1 Exposures to MS Public Sector Entities (PSEs) and to central or regional governments, local authorities of MS and of ECAI 1 rated third countries Exposures to or guaranteed by central government or central bank of third country not ECAI 1 rated if to cover outflow incurred in same currency or in jurisdiction where liquidity risk is taken Assets issued by credit institutions if institution guaranteed by MS local or central government or if institution is promotional lender subject to additional criteria* Certain ECAI 1 rated covered bonds which must meet additional criteria including a 500m size, a 2% overcollateralization and a 7% minimum haircut. Those are also subject to a cap at 70% of the total liquid asset buffer.* Level 2 assets (assets not included in the BCBS definition are marked with *) Level 2A assets These can make up to a maximum of 40% of the liquidity buffer and are subject to a minimum 15% haircut. They include: Third country government bonds and bonds issued by public entities with a 20% capital risk weight EU covered bonds with an ECAI 2 rating, which must meet additional criteria including a minimum 250m issue size, and a 7% overcollateralization * Non-EU covered bonds rated ECAI 1 with a 7% overcollateralization Corporate bonds rated ECAI 1 with minimum issue size of 250m and maximum initial maturity of 10 years. Level 2B assets These can make up to a maximum of 15% of the liquidity buffer and are subject to a minimum haircut varying between 25 and 50% dependent on risk profile and volatility. They include: High quality securitisations for RMBS and auto loans, subject to a 25% haircut High quality securitisations for SME and consumer loans subject to a 35% haircut* Corporate bonds rated at least ECAI 3, with minimum issue size of 250m and maximum initial maturity of 10 years Unrated high quality covered bonds, subject to a 30% haircut* Shares that are part of a major stock index Restricted-use central bank committed liquidity facilities Deposits in cooperative and institutional protection schemes, subject to a minimum 25% haircut, unless the central institution holds or reinvests the deposits in liquid assets of a higher level*. PwC Page 2 of 4

3 Finally collective investment undertakings (CIUs) are subject to a look-through approach for the underlying liquid assets with minimum haircuts for each category of asset. Operational deposits made simpler The determination of what constitutes an operational deposit is key for firms as they attract a lower outflow rate of 25%. Requirements in order to identify those deposits have been significantly simplified. In particular, an established operational relationship is now defined as meeting all the following criteria: Pricing at least 5 bp below prevailing rate Deposit is priced without economic incentives to maintain funds in the account The account sees material transactions on a frequent basis The relationship with the depositor has existed for at least 2 years or the deposit is used for at least 2 active services such as payment services, security trading or depository services. And most importantly, the requirements for evidence that operational functioning would be compromised in case of fund withdrawal have been removed. Retail deposits outflows redefined In agreement with the Basel text, the Delegated Act now allows firms to apply a 3% outflow factor to retail deposits covered by a national deposit guarantee scheme provided this scheme: Has upfront funding Can sustain a large call on its reserves Ensures a seven working day repayment period. The onus on firms to come up with higher retail deposits outflow rates is reduced, as the delegated Act now prescribes outflow rates with two risk buckets: 10-15% and 15 to 20%, depending on the number of risk factors met by the deposit balance in question, such as size, remuneration, depositor residence/currency, and distribution channel. Special treatment for intragroup inflows and specialised credit institutions inflows As in the Basel text, there is a cap on inflows equal to 75% of expected outflows. However, there are a number of exceptions that are specific to the EU: There is a full exemption (no cap applied) for inflows from banks belonging to the same group or the same institutional protection scheme. And there is a full exemption for all inflows from specialised credit institutions engaged in leasing and factoring, with the caveat that a 90% cap on auto and consumer leasing inflows applies. Scope and timeline This detailed LCR will apply to banks on a solo and consolidated basis. The Regulation also states that the detailed LCR does not apply to investment firms. The EBA will prepare a report on the application of the LCR to investment firms by the end of The Commission will then report on the issue to the Parliament and the Council, with a legislative proposal if deemed necessary. As required by the CRR, the LCR ratio is phased-in, rising from 60% in 2015 to 100% in National authorities may apply a higher ratio until the LCR is fully phased-in. Finally, given the time for legislative consideration and industry preparation, the proposal suggests a 1 October 2015 implementation. What s next? This more detailed guidance was an important missing piece of the regulatory puzzle that banks needed to get on with their implementation of the LCR in the EU. Now what is left for regulators to do is three-fold: The European Banking Authority (EBA) will need to revise its reporting templates according to the new detailed rules and banks will have to adjust their reporting accordingly; PwC Page 3 of 4

4 The CBI will need to crystallize those changes and clarify the steady state liquidity regime for banks, especially regarding what will happen to the liquidity reporting process under the earlier regime. What is the impact on banks? Although this DR does not contain any new challenges, it is nevertheless essential for banks to assess the impact of the finalised ratio on their liquidity management and whether they need to adjust their liquidity reserves or funding model ahead of the phased-in implementation. Banks have to watch out for the revised EBA reporting templates and make sure those are embedded in their reporting systems as soon as possible. International banks must prepare for additional complexities as the EU LCR requirement, as well as the US implementation, differ from the Basel requirement. They will have to report different numbers to local supervisors, and be ready to consolidate all the local requirements into a consolidated LCR, making sure the strictest rules at local level are reflected in the consolidated number. What do firms need to do now? Firms have already been working on their LCR implementation for a while. Now that the ratio is finalised, they need to revisit their LCR implementation plan including: Define policies for classifying assets, inflows and outflows and calculating the actual ratio Banks will also need to embed the new liquidity ratio into their liquidity risk management framework, for example in the definition of risk appetite, in the MI used to monitor the liquidity position of the firm and in their funds transfer pricing methodologies. The next 12 months are going to be key for banks as they need to make sure they accurately capture the data required and compute the ratios with the appropriate degree of confidence to communicate them to both supervisors and the public. Contacts Update the assessment of the quantitative impact on their balance sheet of the finalised LCR Adjust their risk appetite and risk management framework to reflect the new regulatory requirement Adjust collateral management to the new definition of the liquidity pool Revise the liquidity transfer pricing regime in order to be consistent with the LCR Update their reporting systems once the revised EBA templates are out. Garvan O Neill John Bligh Kaustuv Banerjee E: garvan.oneill@ie.pwc.com E: john.bligh@ie.pwc.com E: kaustuv.banerjee@ie.pwc.com T: T: T: PwC Page 4 of 4

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