The Basel Committee endorsed a revised iteration of the Liquidity Coverage Ratio (LCR), a key part of the Basel III capital adequacy and liquidity framework for banks, in January 2013, and released its final set of Liquidity Coverage Ratio Disclosure Standards in January 2014. The LCR is required to be applied by banks on a phased-in basis starting from 1 January 2015. It requires banks to ensure that they hold a stock of unencumbered, High Quality Liquid Assets (HQLAs) equal to their potential losses during a 30-day market crisis, by providing that the stock of HQLAs divided by the bank's "net liquidity outflows" over the next 30 calendar days is equal to or greater than 100% (based on market value of the liquid assets). For this purpose, the precise definition of what comprises HQLAs (and net liquidity outflows) is crucial to the operation of this framework, and the inclusion of certain types of securitisation is important to ensure: (i) there are incentives for issuers to issue new deals and for other banks to buy them to help build up their HQLAs; and (ii) general regulatory support for asset-backed securities as "high quality" and "liquid" in the wake of the global financial crisis (note that the European Banking Authority (EBA) (and other regulatory bodies) are separately considering the concept of "High Quality Securitisation" (HQS) and may develop a more favourable regulatory treatment of HQS going forward). You may also be aware that the securitisation industry has been lobbying for the inclusion of a wider range of ABS beyond RMBS in HQLAs, and the Commission has now taken this on board. The European Commission's LCR framework has now been finalised, in the form of a Delegated Regulation supplementing the Capital Requirements Regulation (CRR), as follows:

To qualify as a HQLA, an asset should meet the strict requirements set out in Articles 7 and 8, and Chapter 2, which set out general requirements for liquid assets, which include that they must be a property, right, entitlement or interest held by a credit institution and free from any encumbrance, they must not have been issued by the institution itself (or its parent, or another bank, investment firm, insurance/reinsurance undertaking, financial holding company or mixed holding company, but note that SPEs are not included in this list), their value must be capable of being determined on the basis of widely disseminated market prices, they must be listed on a recognised exchange (or tradable via active outright sale or repo), and they must meet certain operational requirements (which require holdings of HQLAs to be appropriately diversified at all times, allow competent authorities to impose restrictions or requirements on the holdings of certain HQLAs to ensure compliance with the Delegated Regulation, require banks to have ready access to, and be able to monetise, their HQLAs (which they should do regularly with a representative sample of the assets), ensure banks place their HQLAs under the control of a specific liquidity management function, and require banks to ensure that the currency of denomination of their HQLAs is consistent with the distribution by currency of their net liquidity outflows). Banks are not prevented from hedging the market risk associated with their HQLAs, but they must meet certain conditions in order to do so.

  • As was the case with the original LCR proposals, HQLAs are split into a hierarchy depending on their (perceived) quality. Chapter 2 of the Delegated Regulation sets out this hierarchy, which comprises Level 1 Assets (the highest quality of assets and considered the most liquid) and Level 2 Assets, as follows and in the following proportions:

    • Level 1 assets - includes coins and banknotes, certain exposures to central banks, assets representing claims on or guaranteed by certain central or regional governments, local authorities or public sector entities, assets issued by state or government banks or promotional lenders and assets representing claims on or guaranteed by multilateral development banks. Exposures in the form of "extremely high quality covered bonds" are also Level 1 assets, where the covered bonds meet the requirements of the CRR, are issued in a minimum size of €500 million, receive the highest credit rating available (Credit Quality Step 1, i.e. a rating of 'AAA' to 'AA-') under the CRR, and meet other operational requirements. Level 1 covered bonds are subject to a haircut of at least 7%. There is no limit on a bank's holdings of Level 1 assets, but they must comprise a minimum of 60% of a bank's full LCR holding. A minimum of 30% of the overall LCR requirement must be composed of Level 1A assets, excluding covered bonds.

    • Level 2 assets - generally include sovereign and corporate debt. Level 2 assets must not in aggregate account for more than 40% of a bank's stock of HQLAs. Level 2 assets comprise Level 2A assets and Level 2B assets:

      • Level 2A assets - certain government securities that are assigned a 20% (i.e. Credit Quality Step 1) risk weight under CRR, "high quality covered bonds" where they meet the requirements of the CRR, are issued in a minimum size of €250 million and are rated Credit Quality Step 2 ('A+' to 'A-') under the CRR, third country covered bonds that comply with national law, and meet strict requirements (including Credit Quality Step 1 ratings), and corporate debt securities. Level 2A assets are subject to a haircut of at least 15% and they may not account for more than 15% of a bank's HQLAs.

      • Level 2B assets - lower rated (Credit Quality Step 3, i.e. 'BBB+' to 'BBB-') corporate bonds that meet certain requirements as to maturity, rating and size (with 50% haircuts), asset-backed securities (ABS) meeting the requirements of Article 13 (with applicable haircuts - see below), equities that meet certain conditions (with 50% haircuts) and restricted-use committed liquidity facilities (that must meet the criteria of Article 14). Level 2B assets may not account for more than 15% of a bank's HQLAs.

The inclusion of ABS comes with some restrictions. They must meet all of the following, detailed requirements set out in Article 13:

  • The position must be rated at least Credit Quality Step 1 (i.e. 'AAA' to 'AA-');

  • The position is the most senior tranche or possesses the highest level of seniority at all times;

  • The underlying exposures have been acquired by the SPV in accordance with the CRR in a manner enforceable against a third party, and are beyond the reach of creditors;

  • The transfer of the assets to the SPV must not be subject to clawback;

  • The underlying exposures must have their administration governed by a servicing agreement;

  • The securitisation documentation must include servicing continuity provisions that ensure default or insolvency of the servicer does not result in termination of servicing;

  • The documentation must include continuity provisions that ensure the replacement of derivative counterparties and liquidity providers, where applicable;

  • the securitisation is backed by a homogenous pool of underlying exposures which all belong to one of the following (or a combination of (i) and (ii)):

(i)    residential loans secured with a first-ranking mortgage, provided the loans: (i) meet the LTV requirement in the CRR (80% maximum); and (ii) meet a national Loan-to-Income (LTI) limit of less than 45%;

(ii)    fully guaranteed residential loans provided they meet the LTV and LTI limits in the CRR;

(iii)    commercial loans, leases and credit facilities to undertakings established in an EU Member State to finance capital expenditures or business operations (other than the acquisition or development of commercial real estate);

(iv)    auto loans and leases to borrowers or lessors established or resident in an EU Member State (including the residual value of leased vehicles). All loans and leases must be secured by a first-ranking charge or security over the vehicle or appropriate guarantee in favour of the SPV; or

(v)    loans and credit facilities to individuals resident in an EU Member State for personal, family or household consumption purposes (i.e. personal loans). The position must not be in a "resecuritisation" or a synthetic securitisation;
  • The underlying exposures must not include transferable financial instruments or derivatives, except financial instruments issued by the SPV itself or other parties within the securitisation structure and derivatives used to hedge currency and interest rate risk;

  • At the time of issuance (or when incorporated in the pool of exposures at any time after issuance), the underlying exposures must not include exposures to credit-impaired obligors (as defined);

  • At the time of issuance (or when incorporated in the pool of underlying exposures at any time after issuance), the exposures must not include any exposures that are "in default" within the meaning of the CRR;

  • The repayment of the securitisation positions shall not have been structured to depend, predominantly, on the sale of assets securing the underlying exposures (however, this does not prevent them being rolled-over or refinanced);

  • The structure of the securitisation must comply with all of the following requirements:

  • where there is no revolving period (or the revolving period has terminated and an enforcement or acceleration notice has been delivered), principal receipts from the underlying exposures are passed to the holders of the securitisation positions and no substantial amount of cash is trapped in the SPV on the payment date;

  • where there is a revolving period, the transaction documentation must provide for early amortisation events which must include as a minimum: (i) a deterioration in the credit quality of the underlying exposures; (ii) a failure to generate sufficient new underlying exposures of at least similar credit quality; (iii) the occurrence of an insolvency-related event with regard to the originator or servicer;

  • At the time of issuance, the borrowers (or guarantors, where applicable) shall have made at least one payment (except where the underlying assets are consumer loans);

  • Where the underlying exposures are residential loans, the pool must not include any loan that was marketed and underwritten on the premise that the applicant was made aware that the information provided might not be verified by the lender;

  • Where the underlying exposures are residential loans, the borrower's creditworthiness must be assessed in accordance with the provisions of the new EU Directive on Mortgage Credit;

  • Where the underlying loans are auto loans and leases and consumer loans and credit facilities, the borrower's creditworthiness must be assessed in accordance with the provisions of the EU Consumer Credit Directive;

  • The 5% risk-retention provisions of the Capital Requirements Directive IV (CRD IV) must be compiled with where the originator, sponsor or original lender is established in the EU;

  • The underlying exposures must not have been originated by the bank holding the securitisation position in its liquidity buffer, or its parent, subsidiary or any other closely-linked entity (i.e. "own name" deals are not allowed, for obvious reasons);

  • The issue size of the tranche must be at least €100 million (or the equivalent in domestic currency);

  • The remaining weighted average life of any tranche must be five years or less;

  • The originator must be a credit institution as defined in CRD IV or an undertaking whose principal activity is governed by CRD IV;

  • RMBS and auto loan and lease ABS will be subject to a valuation haircut of 25%; and

  • All other eligible ABS (consumer ABS, and ABS backed by commercial loans, leases and credit facilities) will be subject to a valuation haircut of 35%.

A derogation is provided from Article 13 for RMBS issued before 1 October 2015 (see Article 37) which meet all the Article 13 requirements other than the LTV or LTI requirements. They will still be eligible as Level 2B assets. RMBS issuedafter 1 October 2015 that do not meet the average LTV or LTI requirements set out above shall still qualify as Level 2B assets until 1 October 2025, provided the mortgages were not subject to a national law regulating LTI limits at the time they were granted, and that such loans were granted prior to 1 October 2015.

Restricted-used committed liquidity facilities that may be provided to a central bank must fulfil the following criteria (in order to qualify as Level 2B assets):

  • during a non-stress period, the facility is subject to a commitment fee on the total committed amount which is at least the greater of the following: (i) 75 basis points per annum; or (ii) at least 25 basis points per annum above the difference in yield on the assets used to back the facility and the yield on a representative portfolio of liquid assets, after adjusting for credit risk;

  • The facility is backed by unencumbered assets of a type specified by the central bank. The assets must meet all the following criteria:

  • they are held in a form which facilitates their prompt transfer to the central bank in the event of the facility being called;

  • their value post-haircut as applied by the central bank is sufficient to cover the total amount of the facility;

  • they are not to be counted as liquid assets for the purposes of the bank's liquidity buffer.

  • The facility is compatible with the counterparty policy framework of the central bank;

  • The commitment term of the facility exceeds the 30-day stress period;

  • The facility is not revoked by the central bank prior to its contractual maturity and no further credit decision is taken for as long as the bank concerned continues to be assessed as solvent; and

  • There is a formal policy published by the central bank stating its decision to grant restricted-use committed liquidity facilities, the conditions governing the facility and the types of institution eligible to apply for those facilities.

  • The composition of "net liquidity outflows" also remains largely as set out in the drafts, although the (original) concept of "net cash outflows" has been replaced by "net liquidity outflows". These are defined as the sum of liquidity outflows, minus total liquidity inflows, during the specified stress scenario for the next 30 calendar days. Such outflows include retail deposit amounts, other liabilities, off-balance sheet and contingent liabilities, undrawn loans, mortgages agreed but not drawn down, credit cards, overdrafts, planned derivatives payables, and other additional outflows. The composition of "additional outflows" as set out in the Delegated Regulation results in the unused portion of committed liquidity facilities provided to non-financial corporates being included up to 30% of their value. To calculate the outflow, institutions should multiply the maximum amount that can be drawn down by a corresponding outflow rate (set at between 10-100%, depending on the outflow type). However, the full 100% of outflow for loss of funding on maturing asset-backed commercial paper (ABCP), conduits, SIVs, SPVs and other ABS, covered bonds and other structured financing instruments, will be counted towards outflow, which is less positive for the securitisation industry. Inflows (defined as including various monies due, securities maturing within 30 days, certain trade finance transactions and collateral swaps that mature within 30 days) are subject to an aggregate cap of 75% of total expected cash outflows, ensuring a minimum level of holdings of HQLA at all times, meaning banks cannot rely solely on anticipated inflows to offset outflows. However, institutions specialising in auto finance or consumer credit loans are allowed to apply a higher cap of 90%, subject to their meeting certain criteria. An Annex to the Delegated Regulation sets out the formula by which the actual calculation should be performed.

Allowing for a 6-month period in which to "make allowance for industry preparations", it is proposed that the Delegated Regulation takes effect from 1 October 2015. It will not be in "final" form until it is published in the Official Journal of the EU. In terms of overall timing, a revised timetable for the phasing-in of the LCR standard was agreed in January 2013. While the LCR will be introduced as planned on 1 January 2015, the minimum requirement will be for banks to hold 60% of the full LCR requirement from 1 October 2015 (hence the proposed application date of the Delegated Regulation), rising by 10% for each of the next four years, so that the full 100% requirement is reached by January 2018 (although this plan would suggest that the full 100% requirement would not be reached until 2019).

Useful links:

Basel Committee Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (January 2013)

Basel Committee Liquidity Coverage Ratio Disclosure Standards (January 2014, revised March 2014)

European Commission Delegated Regulation to supplement Regulation 575/2013 with regard to liquidity coverage requirement for credit institutions