On Thursday, the Basel Committee on Banking Supervision (BCBS) of the Bank for International Settlements announced a series of proposals designed to strengthen the resilience of the banking sector and create an international framework for liquidity risk management, standards and monitoring.

Proposals to Strengthen Resilience of Banking Sector

The BCBS cited the build up of excessive on- and off-balance sheet leverage, accompanied by a gradual erosion of the level and quality of the capital base, as one of the main reasons the financial crisis became so severe. To address this and other market failures revealed by the crisis, the BCBS proposes a number of reforms to the international regulatory framework designed to strengthen bank-level regulation and help improve the resilience of individual banking institutions to periods of stress. The proposed reforms also have a system-side focus, addressing risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.

The banking sector proposals announced Thursday are in intended to implement the mandate of the Governors Heads of Supervision handed down in September to strengthen global capital and liquidity regulations and promote a more resilient banking sector. The BCBS’s proposals cover the following areas:

  • Raising the quality, consistency and transparency of the capital base, in order to ensure the banking system is in a better position to absorb losses on both a going concern and a gone concern basis.
  • Strengthening the risk coverage of the capital framework, designed to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities.
  • Introducing a leverage ratio as a supplementary measure to other risk-based frameworks to limit the build-up of excessive leverage in the banking system.
  • Introducing a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress to contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks.
  • Introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. The framework also includes a common set of monitoring metrics to assist supervisors in identifying and analyzing liquidity risk trends at both the bank and system wide level.

In order to avoid any negative effects on bank lending activity that could impair the economic recovery, the BCBS is initiating a comprehensive impact assessment of the capital and liquidity standards in the proposals. The impact assessment will be carried out in the first half of 2010. Following the assessment, the BCBS will then review, and potentially revise, the proposed regulatory minimum level of capital and other proposed reforms. According to the BCBS, the final set of standards will be developed by the end of 2010 to be phased in as financial conditions improve and the economic recovery is assured, with the aim of implementation by the end of 2012.  

Proposals to Create International Liquidity Risk Management Framework

The BCBS also issued a series of proposals to strengthen liquidity risk management. In reviewing the global financial crisis which began in mid-2007 with the failure of several credit-based hedge funds and intensified in September 2008 with the failure of Lehman Brothers and the federal bailout of AIG, the BCBS maintains that financial institutions previously did not scrutinize liquidity risk management during the previous periods of ample liquidity and that the global financial crisis showed how quickly liquidity and credit can evaporate. It stated that a key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk. In November 2008, the BCBS urged that the recommendations contained in its report issued in September 2008 be put into practice. In announcing its new proposals, the BCBS reiterated the need to implement those recommendations to provide consistent supervisory expectations on the key elements of a robust framework for liquidity risk management at banking organizations.

The liquidity risk management elements that the BCBS advocates are:

  • Board and senior management oversight;
  • Establishment of policies and risk tolerance;
  • Use of liquidity risk management tools, such as comprehensive cash flow forecasting, limits and liquidity scenario stress testing;
  • Development of robust and multifaceted contingency funding plans; and
  • Maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs.

In promoting these elements in its proposal, the BCBS said that it reviewed:

  • A proposed adoption of two measures of liquidity risk exposure, as described below;
  • Common monitoring metrics used by liquidity risk management supervisors, and a proposed set of metrics to be used; and
  • Application issues for the new ratios and metrics faced by supervisors.

The BCBS proposes the adoption of two measures of liquidity risk management: a liquidity coverage ratio and a net stable funding ratio. The liquidity coverage ratio would identify the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute short-term stress scenario. The net stable funding ratio would measure the amount of longer term stable sources of funding employed by an institution relative to the liquidity profiles of the assets funded and the potential for contingent calls on funding liquidity arising from off-balance sheet commitments and obligations.

The BCBS advocates the adoption of the liquidity coverage ratio and the net stable funding ratio, but acknowledges that certain parameters in calculating the ratios would need to be set by national supervisors to reflect certain jurisdictional-specific conditions. Supervisors might also require an individual institution to adopt more stringent standards or parameters to reflect that institution’s liquidity risk profile and the supervisor’s assessment of the institution’s compliance with BCBS standards.

The BCBS noted that liquidity risk supervisors at financial institutions currently use a wide range of quantitative metrics to monitor liquidity risk profiles, cataloging more than 25 different metrics and concepts used globally. To introduce more consistency, the BCBS has developed a set of common metrics that should be considered as the minimum types of information which supervisors should use in monitoring the liquidity risk profiles of supervised entities. The metrics proposed by the BCBS include:

  • An assessment of contractual maturity mismatch between a financial institution’s assets and liabilities;
  • Analyzing concentrations of funding provided by specific counterparties, instruments and currencies;
  • Measuring the available unencumbered assets of a financial institution to be used as collateral for secured funding from central bank facilities; and
  • Utilizing marked-based data as a supplement to the other measurement tools.

Regarding the metrics recommended for adoption, the BCBS notes that these metrics capture specific information related to a bank’s cash flows, balance sheet structure, unencumbered collateral and certain market indicators. It acknowledges that supervisors may need to supplement this framework by using additional tools and metrics tailored to capture elements of liquidity risk specific to their jurisdictions. Supervisors should take action where potential liquidity difficulties are signaled or where a deteriorating liquidity position is identified, or where the absolute result of the metrics identifies a current or potential liquidity problem.

The comment period for the BCBS proposals ends on April 16, 2010.