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Basel III – Liquidity framework – Introducing the supervisory approach global liquidity ratio standards

According to the reforms to the capital and liquidity framework, Basel III would require the banking sector to maintain and monitor two key minimum funding liquidity standards as part of the supervisory/ regulatory approach to managing liquidity risk. This would be in addition to the supervisory assessments that regulators would be required to undertake to review whether liquidity risk management frameworks set up by the banks are consistent and in line with the seventeen basic principles of liquidity risk management as set out in the Basel Committee’s published document “Principles for Sound Liquidity Risk Management and Supervision”.

The two standards are a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR).

The former is a measure of the strength of the short term liquidity position of the banks. It implies that banks should hold, on a continuous basis, sufficient unencumbered, high quality assets that can easily be converted into cash to meet liquidity needs that could arise during a 30-calendar day period of significantly severe liquidity stress. The stress scenario is specified by the supervising authority and in general incorporates most of the shocks to liquidity that was experienced during the recent financial and liquidity crisis. It is given by the following ratio:

LCR = Value of stock of high-quality liquid assets in stressed conditions / Total net cash outflows

The value of this ratio should be greater than or equal to 100%.  It will come into effect in 2015.

The NSFR is a measure of the banks longer term liquidity risk profile. It covers a horizon of 1 year, under conditions of extended firm-specific stress, and aims to dissuade banks from relying on short term funding of their longer term assets rather that they should rely on more stable sources of funding on an ongoing basis. In essence the ratio hopes to ensure that any short term structural funding liquidity mismatches are effectively captured, which can then ensure that they are addressed and removed and that the bank can then move to more stable longer term funding. The NSFR is given by the following ratio:

NSFR = Available amount of stable funding/ Required Amount of stable funding

The value of this ratio should be greater than or equal to 100%. It will come into effect in 2018.

The calculation relies on parameters applicable to various elements of the detailed formulation of these ratios. Most of these parameters are prescribe by the Committee and are said to be internationally calibrated. However there are some parameters that would be specific to the jurisdictions in which the bank operates in. In these instances, national supervisors would be responsible for determining the parameters. In addition to this national supervisors may also subject individual banks to stricter standards or parameters based on the assessment of how that bank’s liquidity risk management shapes up against the Committee’s published basic liquidity risk management principles.

Both ratios will be subject to an observation period prior to their implementation deadlines during which time their calibration and designs will be monitored and assessed to ensure that there are no unintended consequences to the banking sector and financial system because of their introduction.

In subsequent posts we will cover the definitions of the liquidity funding ratios in more detail.

To learn more about the changes that Basel III will bring to the capital and liquidity requirements scene for the banking industry you may like to view this post:

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