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Basel III and liquidity management in banks

Filed Under: Basel, Liquidity Risk

The Basel Committee on Banking Supervision has been mentioned often in the media both during and after the financial crisis. This Committee provides a much-needed forum for regulators to meet at regular intervals and discuss cooperation on banking supervisory matters such as the management of capital under the Basel III capital accord. The aim of the committee is to enhance the understanding of key supervisory issues such as liquidity risk and capital management.  In so doing, they strive to improve the quality of banking supervision worldwide.

It is important for banks to monitor the thinking and upcoming policy publications of this committee because it is a very good indicator of what is on the horizon. Local in-country regulators generally follow the guidance issued by the Basel Committee and then apply the standards to banks that operate within their jurisdiction.

The Basel Committee objectives extend to the following

  • Exchange information on supervisory issues.
  • Share approaches and techniques used in supervisory processes.
  • Promote a common understanding of supervisory standards.

What the Basel Committee is best known for

  • International standards on capital adequacy
  • The Core Principles for Effective Banking Supervision
  • Concordat on cross-border banking supervision

The Basel Committee’s management are located at the Bank for International Settlements (“BIS”) in Basel, Switzerland. The management is made up mainly of professional supervisors who are seconded from member institutions.

The Committee does not operate in a vacuum, it encourages members to develop relationships with other regulators and cooperate on issues where there may be a common goal. It also circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. If you are looking for papers and documents published by the Basel Committee, they are easily downloaded by the public.

New liquidity risk measures under Basel III

Natural disasters are inevitable even man-made like the financial market crisis. The question is whether we have the power to make sure that disasters do not become unnatural tragedies.

According to a recent report released by the World Bank and the United Nations, an ounce of prevention in planning for disasters is worth a pound of cure. So prevention pays, if done right and that means getting incentives right.

The pending roll-out of Basel III does not replace Basel II but rather improves upon the older Basel II requirements. Whether these measure will be effective when applied to liquidity risk management in practice, will still be up for detailed assessment.

The Committee published a paper in December 2010 known as the International framework for liquidity risk measurement, standards and monitoring. It introduced the liquidity coverage ration and the net funding stability ration.

Liquidity coverage ratio

Basel III introduces a new instrument for liquidity risk measurement, the liquidity coverage ratio. The measurement is intended to ensure the following.

  • Maintenance of an adequate level of unencumbered, high-quality assets.
  • The assets held must be easily converted into cash.
  • Cash from assets should meet liquidity needs for a 30-day period.
  • The liquidity risk management standard requires that the ratio be no lower than 100%.
  • Liquidity standard must be achieved under an acute liquidity risk stress scenario.

Net funding stability ratio

The net funding stability ration will be put into place to make sure that a bank maintains a minimum amount of stable liabilities in relation to their liquidity risk profile. A banks liquidity risk profile may be made up of activities such as investment banking inventories, off-balance sheet exposures, securitization pipelines and other assets.

The net funding stability ratio is the ratio of available stable funding divided by the required amount of stable funding and this standard similarly to the liquidity coverage ratio, must be no lower than 100%.

Report: Liquidity Coverage Ratio and Net Funding Stability Ratio

The European Banking Authority published on 4 April 2012 its first report on the results of the Basel III monitoring exercise. A key outcome was its findings on the two Basel III liquidity risk standards namely the Liquidity Coverage Ratio and the Net funding Stability Ration.

A total of 157 banks participated in the liquidity risk monitoring exercise. The reporting period of the review was end-June 2011.

Participating banks reported an average liquidity coverage ration of only 70%. The required ratio in terms of the Basel III requirement is 100%. This shortfall of liquid assets is in money terms about €1.2 trillion, which represents 3.7% of the approximate €31 trillion total assets of the sample.

The net funding stability ration reported by participating banks was an average 90%.

To fulfil the minimum standard of 100%, banks would need stable funding of about €1.9 trillion.

The saving grace for banks in Europe is that both liquidity standards are subject to an observation period. This observation period includes a review clause that has been put into place to allow for adjustments to cover any unintended consequences before implementation.

Both these ratios proposed by the Basel Committee continue to be widely criticised. The main concern raised is that very large capital reserves will be concentrated in the liquidity reserve. The Basel Committee being influenced by this criticism has couched its requirements for the ratios and their usage in relatively vague terms. In addition, these ratios will be implemented only in 2018.

The main challenges

  • Banks that operate across multiple jurisdictions will be faced with different national discretion and variations for the new liquidity risk rules. The result will be various kinds of liquidity risk regulatory reporting templates in different electronic formats per jurisdiction.
  • Banks will be challenged to put into place robust automated reporting solutions. Regulators will require reports to be submitted for their review at least monthly, with the ability when required to deliver information weekly and under stress conditions daily.
  • It is highly likely that national regulators will increase the quality and quantity of data included in their national regulatory reports.
  • There are still many banks who are not Basel II compliant and plan to move from Basel I directly to Basel III. This creates an interesting situation because Basel II is the building block for Basel III.
  • It is also possible that some banks stay on Basel I with no intention of moving to either II or III. This complicates the regulatory environment that banks and their regulators will work under.

Basel III a reality

Filed Under: Basel, Supervision

Introduction

The global economic crisis has provided regulators with an opportunity to fundamentally restructure the approach to risk and regulation in the financial sector.

The international members of the Basel Committee on Banking Supervision have collectively agreed on reforms to “strengthen global capital and liquidity rules with the aim of promoting a more resilient banking sector”.  This is what is generally known as Basel III.

One striking feature of the transition to Basel III is the extended period allowed for implementation.  Some features of Basel III may only be fully implemented by 2019 and some features such as the steps intended to be taken to minimise risks relating to systemically important financial institutions i.e. the To Big to Fail issue, may never be implemented.

What is the reality of Basel III

Initially, national regulators from various jurisdictions disagreed on many aspects of the implementation of Basel III.  In the end the basic principles were agreed upon but not without some compromise.

During the discussions, regulators in the West were focused on the need for increased buffers for both capital and liquidity.  While in the East, more focus was placed on the need for comprehensive risk management, enhanced stress testing and alignment of risk and capital management with the core part of a firms strategy.

The result of these differences is “supervisory discretion”.  This implies that some jurisdictions may apply a more detailed and rigid interpretation of the requirements of Basel III than in other regions.  Some regions may not ever implement the full suite of Basel III requirements.

Will there be an uneven playing field in the regulatory space going forward, most definitely.

What are the key differences and how will it impact strategy

Some banks set ambitious deadlines to achieve compliance with Basel III.  Early implementation is seen by many as a competitive advantage, a way to demonstrate soundness to regulators as well as the market.  These banks see potential reputation risk at play and if perceived as to slow to implement the requirements of Basel III they may be viewed as unsound.

Under the new Basel III framework, common equity requirements are in some instances more than double than before.  This leads to a significant reduction of available capital required by a bank to do business.  In addition, increased charges for the risk weighted assets of a bank may further restrict the extent to which they may do business.  Therefore, the combination of additional capital requirements as well as higher charges for the risk inherent in the assets created by banks, will in due course impact on the return on equity (ROE) by banks.  The extent of this impact is uncertain but it will be due to the roll out of Basel III and depend on the operating models of each bank.

The riskier a banks business or the assets it creates, as perceived by regulators, the greater the capital requirements will be under the Basel III regime and the higher the costs incurred by a bank will be.  In response, banks business models will be reshaped by these more stringent requirements.  As the business models of banks adapt to the impact of Basel III they may have to revert to a regime similar to one that operated over a century ago.  This is a model under which there was limited competition that resulted in much less innovation in financial services.

This adaptation by banks may however open up opportunities for competition from an unlikely source.  The shadow banking sector and its ability to innovate may fill in the gaps arising in the market left by banks.  This innovation is already clear in the retail sector as retailers such as Tesco create Tesco Bank and Walmart enter the pre-paid card market.  As major retailers enter the market for financial services previously occupied exclusively by banks, the question arrises whether consumers should avail of their services because these retailers are of course unregulated and do not need to abide by the provisions of Basel III.  As more consumers switch to avail of these services, it is unclear whether its a lower cost choice or if its because they are disgruntled and no longer trust banks.  Either way, it is more competition for banks who may end up loosing customers and revenue if they do not innovate.

Alongside the proposal for increased regulation in the areas of capital and liquidity is a debate around the degree of intensity of supervision that supervisors will apply under the Basel III framework.  Enhanced supervisory practices are expected to be a major focus going forward as Basel III is implemented.  In addition, the choice of regulator to effect change in banks business models as a way to drive structural change in the industry or to enhance their supervisory efforts to make sure that economic failures are contained are expected to have a huge impact upon each institution.

Amidst all the debate around Basel III, it’s worth noting that the fundamental approach to determining credit risk-weighted-assets has not changed.  The approach by regulators remains a risk-based capital regime.  Therefore, regulators will continue to focus on risk management and governance as key requirements to underpin a robust financial sector.

Conclusion

Clearly, market consensus is that Basel III will not be the answer to all the problems experienced since the financial market crisis blew up the world.  It does however go a long way in addressing excessive risk taken on by banks.  It follows that institutions that are affected by the implementation of Basel III must keep a flexibility about themselves to accommodate years of fine tuning and still more future reforms.  Banks earnings will diminish if they do not become more creative and markets that are deserted will be occupied by competitors from unlikely industries who are unrestrained by Basel III.

Banks should be weary of competition in the financial sector particularly as the higher cost of being regulated as a bank kicks in as Basel III rolls out.  Retailers who begin to offer services in competition with banks should note that it’s only a matter of time before regulators step in and begin to regulate their activity with similar constraints as banks.

Liquidity risk levels upgraded under Basel III

Filed Under: Basel, Liquidity Risk

The Basel Committee on Banking Supervision has been mentioned often during and after the financial crisis. This Committee provides a forum for regulators to meet at regular intervals and discuss cooperation on supervisory matters relating to banks. The purpose is to enhance the understanding of supervisory issues such as liquidity risk management and to improve the quality of banking supervision globally.

In jurisdictions where bank regulators are party to the Basel process, the banks supervised by these regulators  should closely monitor the thinking and policy development.  For example, publications by this committee are  a very good indicator of what is on the horizon. Local in-country regulators generally follow the guidance issued by the Basel Committee and then apply the standards to banks that operate within their jurisdiction.

The Basel Committee objectives

  • Exchange information on supervisory issues.
  • Share approaches and techniques used in supervisory processes.
  • Promote a common understanding of supervisory standards.

What the Basel Committee is best known for

  • International standards on capital adequacy
  • The Core Principles for Effective Banking Supervision
  • Concordat on cross-border banking supervision

The Basel Committee’s management are located at the Bank for International Settlements (“BIS”) in Basel, Switzerland. The management is made up mainly of professional supervisors who are seconded from member institutions.

The Committee does not operate in a vacuum, it encourages members to develop relationships with other regulators and cooperate on issues where there may be a common goal. It also circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. If you are looking for papers and documents published by the Basel Committee, they are easily downloaded by the public.

New liquidity risk measures

Natural disasters are inevitable even man-made like the financial market crisis. The question is whether we have the power to make sure that disasters do not become unnatural tragedies.

According to a recent report released by the World Bank and the United Nations, an ounce of prevention in planning for disasters is worth a pound of cure. So prevention pays, if done right. And that means getting incentives right.

The pending roll-out of Basel III does not replace Basel II but rather improves upon the older Basel II requirements. Whether these measure will be effective when applied to liquidity risk management in practice, will still be up for detailed assessment.

The Committee published a paper in December 2010 known as the International framework for liquidity risk measurement, standards and monitoring. It introduced the liquidity coverage ration and the net funding stability ration.

Liquidity coverage ratio

Basel III introduces a new instrument for liquidity risk measurement, the liquidity coverage ratio. The measurement is intended to ensure the following.

  • Maintenance of an adequate level of unencumbered, high-quality assets.
  • The assets held must be easily converted into cash.
  • Cash from assets should meet liquidity needs for a 30-day period.
  • The liquidity risk management standard requires that the ratio be no lower than 100%.
  • Liquidity standard must be achieved under an acute liquidity risk stress scenario.

Net funding stability ratio

The net funding stability ration will be put into place to make sure that a bank maintains a minimum amount of stable liabilities in relation to their liquidity risk profile. A banks liquidity risk profile may be made up of activities such as investment banking inventories, off-balance sheet exposures, securitization pipelines and other assets.

The net funding stability ratio is the ratio of available stable funding divided by the required amount of stable funding and this standard similarly to the liquidity coverage ratio, must be no lower than 100%.

Report on Liquidity Coverage Ration and Net Funding Stability Ratio

The European Banking Authority published on 4 April 2012 its first report on the results of the Basel III monitoring exercise. A key outcome was its findings on the two Basel III liquidity risk standards namely the Liquidity Coverage Ratio and the Net funding Stability Ration.

A total of 157 banks participated in the liquidity risk monitoring exercise. The reporting period of the review was end-June 2011.

Participating banks reported an average liquidity coverage ration of only 70%. The required ratio in terms of the Basel III requirement is 100%. This shortfall of liquid assets is in money terms about €1.2 trillion, which represents 3.7% of the approximate €31 trillion total assets of the sample.

The net funding stability ration reported by participating banks was an average 90%.

To fulfil the minimum standard of 100%, banks would need stable funding of about €1.9 trillion.

The saving grace for banks in Europe is that both liquidity standards are subject to an observation period. This observation period includes a review clause that has been put into place to allow for adjustments to cover any unintended consequences before implementation.

Both these ratios proposed by the Basel Committee continue to be widely criticised. The main concern raised is that very large capital reserves will be concentrated in the liquidity reserve. The Basel Committee being influenced by this criticism has couched its requirements for the ratios and their usage in relatively vague terms. In addition, these ratios will be implemented only in 2018.

The main challenges

  • Banks that operate across multiple jurisdictions will be faced with different national discretion and variations for the new liquidity risk rules. The result will be various kinds of liquidity risk regulatory reporting templates in different electronic formats per jurisdiction.
  • Banks will be challenged to put into place robust automated reporting solutions. Regulators will require reports to be submitted for their review at least monthly, with the ability when required to deliver information weekly and under stress conditions daily.
  • It is highly likely that national regulators will increase the quality and quantity of data included in their national regulatory reports.
  • There are still many banks who are not Basel II compliant and plan to move from Basel I directly to Basel III. This creates an interesting situation because Basel II is the building block for Basel III.
  • It is also possible that some banks stay on Basel I with no intention of moving to either II or III. This complicates the regulatory environment that banks and their regulators will work under.