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On the Revisions to Basel III’s Liquidity Requirements

On the Revisions to Basel III’s Liquidity Requirements

So the Basel Committee finally released its revisions to the all-important Liquidity Coverage Ratio (LCR), which I have written about at length. Most of the press coverage has painted the revisions as weakening the LCR, and it’s true that some of the revisions weaken the LCR, but after delving into the document, I find more of a mixed bag. The bottom line (for those who don’t want to read some of the gory details) is that while there were unfortunately more losses than wins, the core of the LCR is absolutely still intact, and the implementation of the first liquidity regime for major banks will undoubtedly be a huge upgrade to the financial regulatory framework.

Here are some of the major wins and losses, in my opinion, in the revised LCR.

Losses

First, the losses.

Liquidity Facilities to Non-Financial Corporates

The worst change in my opinion is the reduced outflow rate for liquidity facilities that banks have extended to non-financial corporates. Under the original LCR, the outflow rate for these liquidity facilities was 100%. The revised LCR reduces that to 40%. These liquidity facilities are predominantly commercial paper backstop facilities, which corporations will arrange with banks if they finance enough of their day-to-day operating costs by borrowing in the commercial paper market. The revised standard greatly clarifies the definition of a “liquidity facility,” and basically says that the size of a liquidity facility will be equal to the amount of debt that the corporation has outstanding that is maturing in the coming 30 days. This makes sense, and it’s much simpler than trying to distinguish between liquidity and credit facilities by examining the parties’ intent.

But why reduce the outflow rate to 40%? If the commercial paper market shuts down — which it did during the 2008 financial crisis — then companies won’t be able to replace any of their maturing commercial paper debt, which means the outflow rate on the liquidity facilities should be 100%. Why is the Basel Committee assuming that companies will be able to replace 60% of their commercial paper funding during a financial crisis? I think that’s highly unrealistic, even if you’re basing the LCR on funding conditions that prevailed during the 2008 crisis (which, as I’ve said before, is a remarkably stupid idea).

Liquidity and Credit Facilities for Prudentially-Regulated Banks

The revised LCR also reduces the outflow rate on both liquidity and credit facilities extended to banks that are subject to prudential supervision, from 100% to 40%. The original LCR treated prudentially-regulated banks the same as “financial companies” such as securities and brokerage firms. Now, I’m actually okay with prudentially-regulated banks being treated as more reliable than other financial companies — after all, prudentially-regulated banks will be subject to the LCR, and will therefore be better-prepared to meet their liquidity needs during a financial crisis.

That said, I think that reducing the outflow rate on liquidity facilities for these banks from 100% to 40% is, well, imprudent. Any future financial crisis that I can envision will disproportionately impact the big, prudentially-regulated banks that are subject to the LCR (since they sit at the center of virtually all financial markets). Trouble at any of these big banks could have large knock-on effects for the financial system. Given that reality, wouldn’t it be far more prudent to require these banks to pre-fund the majority (i.e., 75–80%) of the liquidity facilities that they’ve extended to each other? Yes, I thought you might agree.

Rehypothecated Collateral on Derivatives

I’m also not wild about the paragraph in the revised LCR (paragraph 117) that allows banks to assume that any high-quality liquid assets (HQLAs) that have been posted to them as collateral on derivatives trades can be rehypothecated to generate cash inflows. The way the paragraph is worded, it appears that banks will be able to simply assume that the HQLAs can be rehypothecated, and will be able to count those cash inflows whether or not they actually rehypothecate the HQLAs.

The obvious reason I don’t like this is that it would allow banks to count cash inflows which may or may not exist. But the other reason I don’t like this is that during a financial crisis, banks will almost certainly not be able to rehypothecate many of the “Level 2A” and “Level 2B” HQLAs (e.g., covered bonds, some equities). Now, it’s true that these kinds of assets are typically not posted as collateral on derivatives trades; however, if banks are allowed to count hypothetical cash inflows from rehypothecating these assets in their LCR calculations, then they might start to allow counterparties to post these assets as collateral on derivatives. Either way, this can be fixed by simply clarifying that banks can only count cash inflows from actual, existing rehypothecations in their LCR calculations.

Wins

Now, some of the wins.

Periodic Monetization

The revised LCR requires banks to “periodically monetise a representative proportion of the assets” in their stock of HQLAs, “in order to test its access to the market.” Here the Basel Committee is taking a page from the Fed’s proposed “enhanced prudential standards” rule, and I’m glad they did. This is a good idea for a variety of reasons. In terms of ensuring that banks have the operational capability to actually monetize their HQLAs during a crisis (an under-appreciated risk), practice will make perfect.

Also, as the Basel Committee notes, requiring periodic monetization will “minimise the risk of negative signalling during a period of actual stress.” Some banks have complained about this requirement in the Fed’s proposed rule by arguing that the market will misinterpret these required periodic monetizations as evidence that the bank is in trouble. Yes, it’s true that the first couple of times, some investors may misinterpret the required monetizations as evidence that the bank is in trouble; but after those investors freak out and scream about how the bank is failing or something, and other market participants respond that no, the monetizations were actually required by law, then the market will no longer consider those monetizations as a signal of trouble. Which will be extremely useful during a real crisis.

In-the-Money Options

In the paragraph on derivatives cash outflows, the revised LCR adds that “[o]ptions should be assumed to be exercised when they are ‘in the money’ to the option buyer.” This is a good example of how the rulemaking process for financial regulations can be beneficial (even though this was not a formal rulemaking). The original LCR didn’t count the cash outflows that would occur from counterparties exercising their in-the-money options. I didn’t think about these cash outflows either — and I thought pretty hard about how cash flows around derivatives would be treated under the original LCR. It was clearly not the Basel Committee’s intent to exclude those cash flows; they just didn’t think about in-the-money options.

But someone (probably someone who works with options) obviously did realize that this was a source of cash outflows that the original LCR did not clearly address, and questioned how these outflows would be treated. As a result, the Basel Committee added the clarification about in-the-money options, which captures a real liquidity drain and makes the LCR more effective. This kind of beneficial clarification occurs rather frequently in the US rulemaking process, although when regulators revise proposed rules to clarify how the rule will apply more situations, they are almost invariably attacked for making the rule more “complex,” or for adding more “loopholes.” But I digress.

Diversification of the Stock of HQLAs

This is a provisional win. The revised LCR states that the stock of HQLAs must be “well diversified within the asset classes themselves” (except for sovereign debt, obviously). This is an important requirement, and will guard against banks overloading their liquidity buffers with, say, corporate bonds in one particular industry. But the strength of this diversification requirement will depend on how national regulators define “well diversified,” and on the compliance regime they implement to maintain this diversification. That’s why this win is still provisional in my mind. So we’ll see how the Fed handles this in their rulemaking. Still, the fact that a diversification requirement was included at all is a win.


In sum, I think there were both wins and losses in the revised LCR. The losses probably outweigh the wins, but all of the changes were on the margin. As I said before, however, the core of the LCR is definitely still intact, which is a very good thing.

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