The Basel III regime requires a significant departure from the established thinking and practices of banking regulation. Its signature feature, arising as a direct response to the experience of the recent global financial crisis, is the priority placed on liquidity management. Setting an adequate standard for liquidity, and gauging compliance with that standard, requires new tools, new calculations, and a new, conservative attitude on the part of regulated financial institutions to assets and products which, while secure from a creditworthiness perspective, require a liquidity commitment. The new regulatory burden is lighter for Canadian banks, having avoided the worst of the financial crisis, than for their European and American cousins. The government-backed security of Canadian mortgage debt, for instance, and the highly concentrated nature of the banking sector in Canada somewhat reduce the need for rigorous liquidity oversight. Notwithstanding this, we can anticipate that domestic banks will try to cut operating costs, increase their focus on term deposits and other liquidity-friendly products in their personal and commercial business lines, and possibly reconsider the prominent role ETFs have played in bank-branded investment strategies.
Liquidity Oversight as a Central Tenet of Basel III
The Basel Committee on Banking Supervision (the BCBS) made clear their intentions to strengthen liquidity management oversight as early as 2008, when it published Principles for Sound Liquidity Risk Management and Supervision (“Sound Principles”), a paper that reviewed the then-received wisdom on liquidity control and risk mitigation.
Liquidity Standards (NSFR and LCR)
To complement the principles expressed in Sound Principles, the BCBS developed two minimum standards for funding liquidity the Net Stable Funding Radio (NSFR) and the Liquidity Coverage Ratio (LCR). The LCR is envisaged as encouraging short-term resilience of a bank’s liquidity position, such that the bank can survive a stress scenario for a period of one month. The NSFR contemplates a year of liquidity pressure, and provides a maturity structure for assets and liabilities. Adherence with the two standards, and with the principles of sound liquidity risk management, is set out as the minimum standard of liquidity for internationally active financial institutions.
The introduction of the two new liquidity risk management ratios, while original, form one of three major areas of emphasis in the overall Basel III programme. The remaining two aspects of Basel III focus on the traditional concern of the BCBS capital adequacy (as in, the withholding by banks and other deposit-taking institutions of sufficient capital assets, valued according to risk factors pertaining to each asset class, in relation to the bank’s lending profile).
Leverage Ratio v. Assets-to-Capital Multiple
In Canada, two calculations are used to establish a bank’s capital adequacy: the assets to capital multiple and a risk-based capital ratio. The multiple is a longstanding OSFI requirement, designed to establish the overall sufficiency of a bank’s capital. It is effectively replaced by the latter ratio, which is one of the hallmarks of the
Basel regime. The Risk-based capital ratio weighs assets according to their relative vulnerability to credit risk, operational risk, and market risk. The specific ratios applicable to various assets are set out, and tightened, in each Basel iteration.
To promote transparency of a bank’s risk profile on an international level, there is limited scope for domestic variance to the specific risk-weighted ratios of the various capital classes. Instead, a standardized approach to valuation and risk assessment is used, although the overall permissible minimum risk-based capital ratio can be tightened by the imposition of domestic rules by national regulators.
The assets to capital multiple is calculated by dividing an institution’s consolidated total assets both on- and off-balance sheet by the total of its adjusted net Tier 1 Capital and adjusted net Tier 2 Capital. OSFI’s final version of its Capital Adequacy Requirements Guideline, which came into effect on January 1, 2013, prescribes (with some permitted exceptions) a minimum ratio of assets being no more than twenty times capital.
Basel III introduces a leverage ratio to complement the assets to capital multiple outlined above and, subject to its permanent implementation globally, OSFI will require Canadian banks to be actively using the leverage ratio by 2018. The leverage ratio is not an enhancement from the traditional risk-weighting calculations, but rather is a different and arguably simpler measure designed to provide an overall metric for risk modelling and ease of assessing the aggregation of leverage in a particular bank. The leverage ratio is calculated by dividing a bank’s Tier 1 capital by the actual value of its average consolidated total assets; the minimum Basel requirement (to be supplemented by national regulators) is the continuous maintenance of a leverage ratio in excess of 3 percent. Unlike the liquidity aspects of Basel III, the longstanding existence of the assets to capital multiple in the Canadian capital adequacy framework has prepared Canadian financial institutions for the operational aspects of the leverage ratio.
Changes to Capital Requirements
Basel III also introduces a series of changes to the capital requirements. As of January 1, 2015, a bank will be required to hold common equity valued at 4.5 percent of its risk-weighted assets. Tier 1 Capital will be required to be 6 percent of a bank’s risk-weighted assets. The total regulatory capital position (Tier 1 and Tier 2 capital together) will remain at 8 percent of a bank’s risk-weighted assets. Tier 3 capital, which included various subordinated and unsecured instruments and was limited to 250 percent of a bank’s Tier 1 capital, will be phased out altogether.
The theme of the LCR - being an increased concern over the durability of financial institutions in periods of stress - is echoed in other Basel III reforms. A capital conservation buffer has been introduced, with the objective of using equity to absorb or minimize sudden losses in a time of stress. By January 2019, banks will be required to have an additional 2.5 percent of common equity Tier 1 capital, in surplus to the prescribed 4.5 percent minimum, equalling a 7 percent common equity requirement and a comparatively high 10.5% minimum total capital ratio.
In addition, OSFI has nominated the six largest banks in Canada (The Royal Bank of Canada, the Bank of Montreal, the Canadian Imperial Bank of Commerce, the Bank of Nova Scotia, the Toronto Dominion Bank, and the National Bank) as “domestic systemically important banks” or DSIBs. As such, they will be subject to a 1 percent risk-weighted capital charge in addition to the standard common equity Tier 1 requirement.
A criticism of the risk-based approach of the Basel II regime was the potential for increased capital adequacy controls to be pro-cyclical1. In other words, the measures discourage the availability of capital at a time when it is most needed. As a consequence of risk-weighting, banks are required to increase capital ratios as risks increase. This might result in less lending at a time of an economic downturn, when easier access to credit may
be an ingredient in a recovery.
Basel III does not respond to this criticism, but recognizes in principle the benefits of counter-cyclical regulatory measures from the “upside” perspective as in, when the credit markets are perhaps too liberal. Basel III creates a counter-cyclical buffer requirement, enabling national regulators to permit, either continuously or in periods of protracted aggregate or high credit growth, an additional 2.5 percent (or less) common equity Tier 1 capital holding requirement, in addition to the other capital requirements to which banks are subject.
The whole regime comprising a tightening of the capital requirements, the leverage ratio, and the short-term and long-term liquidity requirements is targeted at systemic risk. The lessons learned in the financial crisis are fully on display in Basel III, with its emphasis not solely on risk-based assessments, as was the theme of Basel II, but also on pragmatic controls to limit leverage, encourage ready access to liquid resources, recognize systemically-important institutions, and provide for a countercyclical buffer to react to potential credit balloons. Many of these were features, or at least objectives, of the Canadian banking regulatory framework prior to Basel III the assets to capital multiple being a prime example. The confidence of OSFI that Canadian financial institutions will be Basel III compliant in a timely manner is therefore warranted. However, from a Canadian perspective, the liquidity requirements arguably the hallmark of the Basel III programme are novel (as they are for most major capital markets). The LCR in particular, with its earlier implementation and focus on a 30-day crisis period, may pose new challenges to Canada’s deposit-taking institutions.
Liquidity Coverage Ratio
Business Options for Basel III Compliance: Understanding Liquidity Regulation
The BCBS unveiled the specific parameters of the NSFR and the LCR in Basel III: International framework for liquidity risk measurement, standards, and monitoring, a major publication released in December 2010. Major revisions to those parameters, largely a response to comment by market participants and national regulators, were released in January 2013. The revisions, described below, consist of a slight relaxation of the original requirements. In summary, they (i) permit a greater variety of assets to be considered “high-quality” for the purposes of liquidation in a stress period; (ii) ease certain run-off assumptions banks must use in calculating net cash outflows, and (iii) enable banks to fall below the LCR requirement if necessary and while submitting to regulatory supervision. What, precisely, the enhanced regulatory supervision will entail is yet unclear, and is likely to be highly dependent on the circumstances of the individual institution.
- For instance, M. Gordy and B. Howells, Procyclicality in Basel II: Can we Treat the Disease Without Killing the Patient?, a paper for the Board of Governors of the Federal Reserve System, May 2004.
Liquidity Coverage Ratio: Basel III Timeline
The BCBS anticipates banking regulatory supervisors in Basel-compliant jurisdictions (in Canada, OSFI) to fully implement the LCR on January 1, 2015.
Liquidity Coverage Ratio: Basel III Requirement
The LCR requires a bank to carry a minimum ratio of unencumbered high-quality liquid assets (“HQLA”) that meets or exceeds 100 per cent. of its total net cash outflows for the 30 day stress period. For a comparative perspective, according to a 2012 BCBS Basel III impact study, as of December 2011, the weighted average LCR for the then-existing “Group 1” banks (internationally active banks with Tier 1 capital assets greater than 3 billion euro) participating in the study would have been 91%. All other banks participating in the study had a weighted LCR average of 98%. Thus, the imposition of the LCR requirements is material; the study strongly suggests that most major banks will have to rebalance their holdings to account for it.
Liquidity Coverage Ratio: HQLA
The LCR standards provide detailed guidance on both sides of the ratio calculation: first, the standards specify what instruments may be considered HQLA; secondly, liquidity “run-off” rates are standardized to determine a bank’s total net cash flows.
The specified HQLA are divided into two levels: Level 1 Assets and Level 2 Assets. Level 1 Assets represent the most liquid and easily convertible assets -- for instance, cash, sovereign-guaranteed securities, and certain central bank reserves. Level 2 Assets are relatively riskier, and permit the inclusion of well-rated private-sector securities. Level 2 Assets are discounted according to prescribed discounts and in the aggregate cannot account for more than 40% of a bank’s total HQLA. Under the original (December 2010) HQLA standards, private-sector Level 2 Assets were limited to senior corporate debt securities with a rating of AA- or higher. The BCBS revisions in January 2013 have changed the standards for Level 2 Assets, permitting another division. Level 2 Assets are grouped in Level 2A Assets, which follow the original Level 2 requirements, and Level 2B Assets. Level 2B Assets are a further declension in the overall scheme they are subject to a larger discount, and can account for no more than 15% of the bank’s total HQLA, yet they permit high-rated mortgage-backed securities, exchange-traded common stock, and certain lesser-rated corporate debt securities that may not meet the Level 2A Assets test. None of the corporate debt or common equity in Level 2 may be issued by a financial institution. Given the diverse holdings and business lines of Canadian banks, it is unlikely that the Level 1/2A/2B classification of HQLA will pose particular compliance problems in this jurisdiction.
The January 2013 revised standards, which permitted riskier and potentially less liquid assets to contribute, at Level 2B, to a bank’s HQLA portfolio, may have been (in part) a response to the Eurozone sovereign debt crisis. At the time of Basel III’s original unveiling, in late 2010, the crisis within the euro area was in its infancy. After encountering initial (and largely political and structural) roadblocks, the institutions of the Eurozone responded with liquidity relief and currency stabilization, preventing a wholesale loss of confidence in sovereign creditworthiness and preserving government securities as a bedrock of certainty (and certain liquidity). Nevertheless, the “close-call” of the crisis, particularly with respect to Greece and, to a lesser extent, Cyprus and Portugal, may have motivated the BCBS to diversity the HQLA asset pool. In light of recent political events
surrounding the raising of the so-called “debt ceiling” in the United States, this diversification may prove prescient.
Liquidity Coverage Ratio: HQLA “Unencumbered”
All HQLA (at any level) must be “unencumbered.” The LCR standards define unencumbered as being free of security or contractual restriction, and also free of any legal or regulatory impediment to the bank’s ability to sell, transfer, or assign the asset. The aim is for the HQLA to effectively retain liquidity in the market during a stress period, and be available to secure emergency support to a bank, if needed. Assets received by a bank as collateral in reverse repurchase (repo) agreements, securities financings, or derivatives transactions may be included in the bank’s HQLA portfolio, provided the collateral is available (legally and contractually and in the case of physical or bearer instruments, functionally) for the bank’s use. The goal being short-term liquidity in a crisis, the creation of future obligations to debtors or counterparties arising from the use or alienation of collateral is immaterial to the LCR calculation.
Savings Products and Credit Facilities
The “best” HQLA, and the easiest to monitor, are cash and monetary instruments. Cash holdings are Level 1 Assets for HQLA purposes (and, coincidentally, contribute to a healthy Tier 1 regulatory capital position under the exigencies of Basel II). A bank’s treasury position, and its depositors, are the key sources of cash holdings. Fixed-term deposits are treated relatively favourably in the “run-off” discount standards set for the purpose of calculating a bank’s net outflows, particularly if the deposits are protected by an effective deposit-insurance scheme, as they are in Canada.
The LCR requirements might incentivize banks to encourage long-term deposits and savings products. Traditional savings bonds (offered, as opposed to brokered, by the bank), which virtually guarantee returns after a period of illiquidity for the customer, serve the purpose of improving the bank’s liquidity position. Participation in savings schemes at the retail level may be incentivized by better interest rates and creative marketing. A common lure for retail-level customers are lower service fees. From a liquidity perspective, lower fees are a “double-edged sword”. Fees discounts may encourage retail business, but they are also a source of (cash) revenue for the bank’s treasury. Nevertheless, one might expect banks to improve their offerings to ordinary savers with liquidity for the bank in mind.
Liquidity Coverage Ratio: Net Cash Outflows
The total net cash outflows of a bank is, simply, the difference between the bank’s total expected cash outflows and inflows during the 30-day period. The preferred mechanism for calculating and comparing cash outflows, labeled the “NCCF” (Net Cumulative Cash Flow), will become a mandatory compliance tool with OSFI’s promulgation of comprehensive liquidity guidance, expected in final form this year (the draft guidance is discussed in detail below). The calculation is performed by multiplying the outstanding balances of certain liabilities by their presumptive draw-down (“run-off”) rates during the stress period. Inflows are calculated by multiplying the balances of certain receivables by rates at which their payers are presumed to make payments during the stress period. Inflows cannot exceed 75% of outflows. The presumptive run-off rates are set out in the LCR standards according to instrument and receivable types (i.e. retail term deposits (i.e. savings products with
fixed terms and no liquidity for the bank’s customer, government secured lending, corporate credit facilities), and have the virtue of being, generally, unilaterally imposed across all of the Basel member states. There is very little room for national variance.
The January 2013 revisions eased a number of liquidity run-off assumptions. A few examples of such run-off assumptions includes retail term deposits, for which the original run-off rate for stable deposits benefitting from a public insurance scheme (such as the Canadian Deposit Insurance Corporation) was 5 percent. OSFI, under the revisions, has been given the power to lower this figure to 3 percent; a significant change in the context of the value of such assets. Another example relates to inter-bank credit and liquidity facilities.
Liquidity Coverage Ratio: 100%, Most of the Time
Originally, the LCR standards required an assumption that banks would experience drawdowns the maximum available amounts they have provided by means of such facilities in a stress period. This has been amended to a 40 percent drawdown assumption for interbank credit and liquidity facilities, with the full 100 percent drawdown assumption remaining in place for liquidity facilities provided to non-bank financial institutions. If the liquidity facility is provided to non-bank, non-financial institution counterparties (corporate customers, central banks, and sovereigns, for instance) the 100 percent drawdown assumption has been reduced to 30 percent. Interestingly, this change is not mirrored on the inflow side of the equation: banks are not entitled to assume they will be able, in a stress period, to draw down any amount on liquidity or credit facilities provided for the benefit of the bank.
In addition to increased participation in saving, a bank might seek to encourage its existing wealth management clients, who may have invested in various asset classes and securities through the bank’s fostering or brokerage, to transfer or convert such investments to term deposits. Equally, discouraging certain types of highly-liquid debt finance, particularly for corporate borrowers, will have the effect of reducing net outflows in the stress calculation. To encourage flexibility, small and medium-sized enterprise borrowers could be migrated to credit products with shorter maturity periods, moving away from long-term credit facilities and programmes. This can be a difficult course for the bank to chart, as interest on corporate lending is a significant source of revenue. Nevertheless, in the aggregate, large facilities for corporate borrowers have the potential, in a stress period, to weigh heavily on a bank’s outflows and worsen its LCR from the denominator-end of the calculation.
OSFI Will Require High Standards
In January 2012, the BCBS issued a statement advising that, in times of unusual systemic stress (much like the global experience of late 2008), banks and financial institutions could fall below the 100% threshold of HQLA holdings, subject to supervision from their respective national regulator. The statement reflects a conundrum of liquidity risk management -- to maintain liquidity, a bank must hold a high number of liquid assets at the very moment (the stress period) when demands on the bank’s most liquid facilities would be greatest. The BCBS might retort that this, precisely, is the point of the LCR requirement, and it is a problem faced by every financial institution with a capital adequacy requirement of any kind to some degree. It remains for national regulators to respond to a bank’s LCR falling below 100%. In such a scenario, one might expect OSFI and its equivalents to consider the matter on a case-specific basis and thereby avoid the imposition of the most rigid decision-making in a time of crisis.
Liquidity Management and the Leverage Ratio in Canada
The “crisis” contemplated by the LCR standards involves a number of likely sources of liquidity pressure, many of which took place in the events of 2007-2008. Such pressures include the possibility of significant draw-downs on credit facilities combined with withdrawals in deposits and cash holdings, the need for greater collateral in the event of downward pressure on the bank’s external credit rating, a tightening of available credit in the interbank market, and general volatility in the debt and equity capital markets, including with respect to the bank’s own issued securities.
Canadian banks have the oft-mentioned benefit of being well-capitalized and conservatively managed. The Canadian banking regulatory scheme is sophisticated; the Canadian capital markets are generally stable and not prone to shock. Canada has not experienced the crisis in confidence in sovereign debt that continues to impact the Eurozone and certain developing economies. For these reasons perhaps, OSFI, despite requiring early and complete compliance with the timelines of Basel III, is not yet opting to use its discretion for jurisdictional variance to impose measurably stricter leverage or liquidity ratios on regulated institutions. For example, the leverage ratio will respect the 3 percent figure set by the Basel Committee. Higher leverage ratios
(i.e. tighter rules) are permitted; the Federal Reserve announced in July 2013 that the leverage ratio in the United States would be 6 percent; it is unknown what share of US banks could meet that requirement now. Again, the security of the Canadian mortgage market is the primary disincentive for encumbering the Banks with a higher ratio, and constant monitoring will, if properly conducted, give OSFI some warning of institution-specific liquidity hazards on the horizon.
Latest Developments in the Implementation of Basel III
OSFI has recognized that, despite the requirements set in January of last year that the use of the LCR and the NCCF, coupled with its own liquidity supervisory obligation, be fully implemented by January 2015, no comprehensive liquidity guideline has been released. On November 29, OSFI published a draft guideline to formally reflect the BCBS guidance with amendments for domestic variation. Banks and financial institutions could comment on the draft guideline until January 24, 2014. The final guideline has yet to be released, but given that (i) the obligation for regulated bodies to meet the 100 per cent LCR minimum requirement, and the related reporting mechanism, are to be fully in force from the outset, without a phase-in period, the need for comprehensive guidance is timely.
Net Cumulative Cash Flow
Much of the draft guideline directly parrots the BCBS’ guidance, with minor adjustments for Canadian parlance. Of particular interest, however, is Chapter 4, which focuses on the NCCF. The NCCF itself does not yield a maximum or minimum cash flow or exposure. It is a measurement tool, designed to give financial institutions a proven mechanism for evaluating incongruence between their receivables and liabilities. From a regulatory perspective, the use of the NCCF by each bank gives OSFI a comparative tool, which is useful in assessing both the relative health of the Canadian bank sector and the success of Basel III implementation in contrast to other jurisdictions.
The NCCF is a “horizon metric”; it measures anticipated cash inflows and outflows in weekly increments, stretching into the future for one month, then monthly increments stretching forward for one year, then a final time band for anticipated flows over the one-year horizon. Financial institutions will report their NCCF on a consolidated basis, with separate calculations also undertaken for Canadian currency flows and those of major foreign currencies. The draft guideline sets out, in detail, the treatments of particular types of inflows and outflows, such that the NCCF calculation could be undertaken by financial institutions now.
The November 2013 guideline also sets out in detail the required frequency and reporting of the LCR calculation. OSFI envisages the LCR will be reported monthly, with the operational ability (in a stress event) for regulated institutions to report with greater frequency, including the prospect of daily reporting. The data used must not be greater than 14 calendar days old, which is consistent with the BCBS’ January 2013 guidance. The regular reporting requirement supplements the obligation to report an LCR shortfall should it occur.
The NSFR remains “under observation”; OSFI foresees its implementation in 2018, and has not yet contemplated the reporting and calculation requirements for regulated institution’s NSFR compliance. The NSFR mechanism, while an important part of the Basel III regime, is clearly a secondary implementation priority.
Business Options for Basel III Compliance: Additional Considerations
Capital-Light Operating Models
Aside from a return to emphasizing savings products, banks can opt for changes to business practices in lending which may have the effect of protecting liquidity. A particular example is the pursuit of collateral, particularly in forms which will enable the bank to alienate or assign it. Inventiveness in collateral requires back- office support and, perhaps, a corporate change in mindset -- banks might find themselves holding assets, or securities, which will by their nature necessitate valuation and asset management skills. Risk-mitigation techniques for liabilities (such as the issuance of covered bonds for the bank’s mortgage portfolio) also serve to generate capital and protect the bank’s capital position, although such strategies must be employed in a timely manner and without the risk of redemption in the stress period.
Canadian banks are well-positioned, given their emphasis on retail and business banking, to utilize these tools. A switch to an emphasis on liquidity, from the perspective of the ordinary borrower, is unlikely to be noticed. Higher-risk borrowers, or new borrowers in a loan capital-intensive stage of their business, might find revolving credit or facilities less available, and the bank taking a more aggressive posture with respect to security and collateral. Canadians, on an individual level, have been encouraged for the past few years by public-sector actors to reduce their dependence on debt and save more. A contrary trend, however, is the aging population. Retirees tend, for obvious reasons, to convert assets to cash and deplete their reserves. Balancing these competing public interests may lead banks down a more conservative path with respect to retail operations. The cost of increased liquidity security in that regard may be diminished short-term profits for the sector as a whole.
Consequences for ETFs
The LCR proves a particular difficulty for financial institutions with substantial fully-funded OTC derivatives positions. An example of this that might be particularly germane to Canada is the role of swap counterparty to exchange-traded funds and exchange-traded notes (ETFs/ETNs). ETFs are popular investments in Canada - the largest 25 ETFs by assets under management in September 2013 managed, in aggregate, over
$38,000,000,000 in assets2. It has been observed that “Basel III, if fully implemented, will move banking
regulation towards a liquidity-based system. If a bank counterparty writes a swap that promises immediate liquidity, it will be required to hold 100% in liquid assets against the whole of that commitment…This is a big burden on the counterparties that write swaps for funds, including ETFs.”3
The Bank for International Settlements (BIS), which is an international organization serving as a form of central bank and clearing facility for the world’s central banks and the organizing body for the BCBS, suggests that Basel III’s liquidity regulation may create incentives for banks to avoid the liquid assets requirement in such circumstances. In an April 2011 working paper, BIS commented that “under the proposed LCR standard, unsecured wholesale funding provided by many legal entity customers (banks, securities firms, insurance companies, fiduciaries, etc.) as well as secured funding backed by lower credit quality collateral assets or equities maturing within 30 days will receive a 100% run-off rate in determining net cash outflows.” The Bank goes on to state that “by employing equities and lower credit quality assets to collateralise the swap transaction with the ETF sponsor that might typically have a maturity greater than one year, the bank engaging in this swap
transaction will be able to reduce the run-off rate substantially on the collateral posted.”4 The Bank also notes
that the collateral substitution option, a feature of these swap transactions, could allow the Bank to keep the maturity of the collateral short.
The simplicity of the LCR formula belies the inherent complexity of its calculation. Chapter 2 of the November 2013 guideline, while all-encompassing, merely highlights the numerous particular treatments applied to various cash flows and potential HQLA. Banks must position themselves to be assessing, regularly and comprehensively, both the treatment of their asset portfolio in terms of HQLA inclusion and the aggregate net cash outflow. The calculation encompasses treatments of virtually all of the bank’s liquid assets, including fixed- term deposits, its contractual receivables, and short-term payment obligations. Compliance will require data from the bank’s business, retail, commercial, and investment banking operations, married with knowledge of the bank’s cash position and short-term treasury funding plans. Systems for periodic stress testing must be set up, a reporting mechanism must be established to OSFI, and internal corrective measures are needed to ensure, for example, that key HQLA is not liquidated or converted by a trading desk for business reasons if the bank’s overall LCR necessitates its retention.
- Source: TMX Money, September 2013
- P. Amery, The Liquidity Challenge, May 2012, indexuniverse.eu
- S. Ramaswamy, Market structures and systemic risks of exchange-traded funds, Bank of International Settlements working paper No 343,
Unlike credit control, liquidity cannot be supervised as easily by setting lending or trading limits in advance. Indeed, and particularly with respect to derivative transactions, often the very risk-management techniques employed to limit credit exposure have short-term, adverse liquidity consequences. In short, LCR oversight, and liquidity risk management generally, are major challenges for compliance; the cost of which can be significant.
On the other hand, the switch to a leverage ratio, described above, is meant to be a simpler means of calculating a bank’s required capital cushion. Instead of using the assets to capital multiple, in which the bank’s assets are divided by its net adjusted Tier 1 and Tier 2 capital, the consolidated assets are simply divided by the whole, unadjusted, Tier 1 capital holdings. Simply put, the leverage ratio does not weigh assets in accordance with their relative market or credit risk.
As liquidity risk management will be a complex undertaking, banks will be tempted to focus on core areas of business. Predictions of large-scale divestitures of non-core or illiquid assets are likely overblown, at least insofar as Canadian financial institutions are concerned. Canada’s banks, despite tentacles in most aspects of the financial services industry in this country, avoid exotic, “non-core” areas of business which, if capital- intensive, might prove unmanageable (and therefore worth selling) under the Basel III liquidity regime. However, an aversion to capital-intensive business strategies will likely cool, at least in the short-term, any prospects of significant M&A activity with banks as participants. The cash commitment to even a partially-leveraged acquisition of, for example, further US regional banks, may undermine a bank’s liquidity position.
The tight implementation timetable has, thus far, received little push-back from Canadian regulated entities. This is a cause for relaxation; capital adequacy is so central a concern to banks and the regulator alike that an unfeasible implementation process would be the subject of public (and private) discussion. The comments on the November 2013 draft guideline have not been publicized as of yet, but, given that its contents are unsurprising, banks can treat the draft guidelines as being in near-final form, and should devote the balance of 2014 to ensuring their internal management and compliance reporting lines and technology are sufficient to meet the administrative and reporting obligations OSFI has imposed.