FOR PROFESSIONAL CLIENTS/QUALIFIED INVESTORS BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY

Transcription

1 FOR PROFESSIONAL CLIENTS/QUALIFIED INVESTORS BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY

2 BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY

3 BACKGROUND The Basel Committee on Banking Supervision (BCBS) has revised the capital adequacy guidelines, known as Basel III, with the key goal of strengthening global capital and liquidity regulations in order to promote a more resilient banking sector. They also aim to improve the banking sector s ability to absorb shocks arising from financial and economic stress, which, in turn would reduce the overall risk of a spillover from the financial sector to the real economy. Basel III is based on three pillars with liquidity standards an additional component: CAPITAL REFORM Quality, consistency, and transparency of capital base RISK MANAGEMENT AND SUPERVISION Capital incentives for using CCP for OTC MARKET DISCIPLINE Off-balance sheet vehicles Capturing of all risks Higher capital for systemic derivatives Securitisation exposures Controlling leverage Higher capital for inter-financial exposure Calculation of regulatory capital ratios Buffers Contingent capital Capital surcharge for systemic banks LIQUIDITY STANDARDS Liquidity coverage ratio (LCR) Net stable funding ratio Principles for Sound Liquidity Risk Management and Supervision Supervisory monitoring These liquidity standards will have a direct impact on how banks view cash in the context of their capital and liquidity ratio. This paper is the first in a series, each designed to cover a different Basel III ratio. In this piece we will concentrate on the potential adverse impact the Liquidity Coverage Ratio (LCR) could have on the balance sheet and net interest margin of a bank. We will illustrate this later with a simplified numerical example. BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY [1]

4 THE LIQUIDITY COVERAGE RATIO (LCR) The LCR focuses on the short end of a bank s funding liability side (less than 30 days) and aims to ensure that banks have enough liquid assets to fulfill their short-term cash obligations under severe stress. Liquid assets are considered at market value, and then standardised haircuts are applied. Net cash outflows use a run-off factor, which expresses the likelihood of how much of the outstanding amount will be redeemed within the next 30 days. The LCR is comprised of two parts: 1. High Quality Liquid Assets (HQLA) 2. Total net outflows based on run-off factors applicable to bank liabilities The driver of the LCR is comprised of the run-off factors of the bank liabilities. Banks finance themselves with retail and wholesale deposits and other wholesale funding sources and Basel III defines and classifies them with run-off factors. The more stable the funding base (for example retail and small and medium enterprise deposits) the lower the run-off factor. The less stable the funding source, i.e. borrowing from financial institutions and/or nonfinancial institutions, the greater the adverse impact on the balance sheet and P&L, and the higher the run-off factor. TABLE 1 Bank s assets (HQLA) Haircut Cash and Central Bank Reserves 0% Government Bonds 0% Agencies 15% Corporate and Covered Bonds AA- 15% Corporate Bonds A+ to BBB- 50% 1 Unencumbered equities 50% 1 Residential MBS rated AA or higher 25% 1 TABLE 2 Bank s liabilities (outflows) Run-off factor Retail and SME deposits 5-10% Wholesale Funding Source Financials 100% Non-Financial Corporation 40% 1 Custody-Clearing 25% Secured funding with level 1 collateral 0% It is clear from tables 1 and 2 that a bank s approach to funding can have a negative impact on it s balance sheet and hence they need to make fundamental long term business decisions on which direction they would like to drive the business. Basel III also indicates what kind of assets banks would need to hold in order to ensure an adequate stock of unencumbered HQLAs. They need to consist of cash, or assets that can be readily converted into cash, in order to meet a 30 calendar day liquidity stress scenario. HQLAs are further comprised into Level 1 and Level 2 assets, with Level 2 assets being divided up further: TABLE 3 Levels % of total assets Permissible assets 1 60% Cash, Central Bank Reserves, certain marketable securities backed by sovereigns and central banks 2A 25% Certain government securities, covered bonds, corporate debt securities 2B 15% Corporate or Covered Bonds rated A+ to BBB For the HQLAs, the standardised general haircut rules that apply are: ` `Level 1 haircuts = 0% ` `Level 2A haircuts =15% ` `Level 2B haircuts: Qualifying RMBS rated AA = 25% Corporate or Covered Bonds rated A+ to BBB = 50% Qualifying Equities = 50% With the current regulations, banks need to make a business decision on the kind of deposits they are willing to take on their balance sheet. On the bank s liability side the run off factor, which can vary between 0%-100%, determines the amount of HQLAs the bank has to put aside for the respective deposit received. There is also a second level of consideration. If a bank has to deposit HQLAs in order to support a specific deposit (be it wholesale or retail), does this also have a direct impact on the net interest margin of a bank? This liquidity has to be put aside and cannot be used in any other form by the bank, i.e. lending, collateral etc. There is the possibility that net income may fall, having a direct impact on the Return On Equity (ROE) of a bank. This could have negative consequences for the bank s share price. 1 Newly introduced by BCBS on 6th January [2] BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY

5 NUMERICAL EXAMPLE We will assume a large non-financial corporation in Europe plans to deposit 1bn of its operating cash with a bank for a period of 30 days. Under Basel III, a 1bn deposit mandates a bank covering this 30-day deposit to hold 40% (see table 2) of the notional amount of the deposit or 400 mm in HQLAs, assuming the bank decided to hold the maximum mount of Level 2A and 2B assets possible. Due to the need to apply the aforementioned haircuts to the market value of each of the HQLAs, this creates the following issue: TABLE 4 Corporate deposit of 1bn run-off factor of 40%: Level % of total assets HQLA haircut HQLA after applied haircut Level 1 60% 240m 0% 240m 240m Level 2A 25% 100m 15% 15m 85m Level 2B 15% 60m 50% 30m 30m 400m 355m To depict the potentially adverse reduction on the bank s net interest margin, in order to comply with the nominal HQLA short fall, it is assumed that Level 1 HQLAs will be increased by 45m to a new total of 285m 3. `Ìn Europe, a major HQLA used to satisfy Level 1 HQLAs are German Bunds. At the end of 2012, 2-year German Bunds were yielding below 0.00% 4 `Àccording to the 2012 Annual Audited Statement of one of the largest banks in Europe, the estimated Average Yield on Earning Assets was 1.71% `Ìf one assumes that all 285m of Level 1 HQLAs in this example were 2-year German Bunds, the average yield on this 285m Level 1 HQLA reserve would be 0.00%. ``However, without the Basel III LCR, the bank could invest the 285m at the 1.71% average yield In summary, the bank in this example would have forgone interest income on an annualized basis of 4.87m 5. In order to close the 4.87m deficiency gap Level 2A and Level 2B need to achieve a theoretical return of 2.43% and 4.06%, respectively 6. After applying the haircut on HQLAs the bank would be short of 45m. Therefore, in order to comply with the LCR, the bank needs to hold a nominal amount of 445m 2. This shortfall of 45m means that the bank has to put more liquidity aside on a net basis. As noted in the introduction section of this paper, while Level 1 HQLAs are haircut free, due to their lower risk, the yield on these assets are often below those of Level 2A, 2B, and most other bank assets. Thus, the larger the carrying amount of these assets on the bank s balance sheet, the more sizable the adverse impact upon the bank s net interest margin, earnings, and ROE due to their lower yield m original deposit required + 45m shortfall m Level 1 original assets required + 45m shortfall from earlier example 4 2-year Bund on yielded % 5 285m * 1.71% 6 For Level 2A and Level 2B HQLAs the reference index ML AA Corporate Index and ML A-BBB Corporate Index was chosen. The yield on was 1.25% and 2.16% respectively. Since the bank is losing out on 4.87m ( 100m * 2.43%) + ( 60m * 4.06%) = 4.87m of average interest it has been calculated what the theoretical yield on Level 2A and Level 2B would need to be in order to neutralize the deficit. An even split in interest between Level 2A and Level 2B was assumed. For Level 2A the theoretical yield would need to be 2.43% and for Level 2B 4.06% respectively. This would be a yield gap of 1.18% and 1.90% respectively with respect to the above chosen indices. BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY [3]

6 HOW MONEY MARKET FUNDS CAN BE USED BY BANKS This paper illustrates the possible negative effects that accepting wholesale deposits under 30 days could have on a bank s balance sheet. Banks have to evaluate how they can off-set these negative impacts and look for a solution to deleverage without negatively impacting their business model. We propose the use of MMFs for wholesale funding under 30 days to effectively move the assets off balance sheet and therefore perserve the bank s net interest margin, earnings, and ROE. This way, the bank does not need to hold high levels of liquidity on its balance sheet, which effectively cannot be used for any other operations within the bank. BLACKROCK AND BASEL III As a leading provider of asset management, risk management and advisory services to institutional, intermediary, banks and individual clients worldwide, BlackRock is focused on assisting its clients in understanding regulatory changes wherever it impacts the financial market. With respect to Basel III, the impact will not come immediately but there will be a significant transition period until This should provide banks with enough time to adjust their structure, funding and to build the appropriate systems. We believe it is prudent to illustrate the potential adverse impact Basel III will have on a bank s balance sheet and discuss the alternatives that are available. In addition, the bank has the opportunity to generate extra income via a bank sponsored portal or a relevant distribution agreement with the MMF provider. This would put the bank in a position to offer its institutional client base an active solution for the current regulatory environment. [4] BASEL III AND ITS IMPLICATIONS FOR LIQUIDITY

7 WHAT S NEXT IN THE SERIES A CLOSER LOOK AT THE LEVERAGE RATIO (LR) The Leverage Ratio will mandate that all EU banks must allocate a minimum 3% of expensive Core Tier I Capital (i.e. common equity) against all on-balance sheet assets and a large percentage of off-balance sheet assets. Due to a bank s need to at least cover their weighted average cost of capital, banks will be incentivised to shed high quality, low risk assets which contradicts the spirit of the Basel III LCR which induces banks to hold a higher amount of HQLAs. The LR reporting has begun with bank level reporting to supervisors on 1st January 2013 and will proceed with public disclosure starting 1st January BASEL III: THE LIQUIDITY COVERAGE RATIO AND ITS IMPLICATIONS FOR LIQUIDITY

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