Basel III – Liquidity Framework – Liquidity Coverage Ratio (LCR) – The Numerator: Value of Stock of High Quality Liquid Assets
In our previous post on the reforms being brought to the liquidity framework by Basel III we had discussed on a broad level the new minimum funding liquidity standards that would be applicable for the banking sector. In this post and the one to follow we discuss in more detail the first standard, i.e. the Liquidity Coverage Ratio. In particular in this post we will be considering the elements of the numerator of this ratio, i.e. the value of the stock of high quality liquid assets in the given stress scenario.
In general the Basel Committee’s document defines high quality assets as assets which remain liquid during times of extreme stress and which ideally are central bank eligible for intraday and overnight liquidity needs.
It also states that liquidity of an asset is impacted by three primary factors:
- The stress scenario that is assumed
- The amount or volume of the asset that is monetized
- The time frame for which liquidity needs are being assessed
In addition to this the reforms document also presents some fundamental and market-related characteristics that liquid assets tend to possess. These include:
- a low level of riskiness,
- the ability to be priced easily and with a degree of certainty,
- low correlation with risky assets,
- listed on a recognized exchange
- the size and activity of their markets
- the diversity of buyers and sellers in the market
- the number of market makers present
- whether the market chooses to remain/ enter in them during a liquidity crisis
Liquid assets also tend to satisfy certain operational requirements
- they are unencumbered, e.g. not pledged as collateral
- they remain separate from assets used as hedges for trading positions, are not used as collateral or credit enhancements or to cover operational costs
- they are managed and controlled by a separate function in the bank
- a proportion of them are periodically sold on the repo market or outright so as to assess their market value, their access to the market, their usability as liquid assets, as well as a preventive measure so that their sale is not considered by the market as a sign that the bank is in stress.
- High-quality assets must be maintained in each currency that the bank operates in.
- If any of the liquid assets become ineligible as liquid asset the bank can continue to hold the asset for an additional 30-calendar day period so as to allow for an orderly adjustment of the liquid asset portfolio as well as sale of the previously eligible liquid asset.
Liquid assets generally fall into two categories:
Level 1 assets are assets such as cash; qualifying central bank reserves; qualifying marketable securities from sovereigns, central banks, PSEs and multilateral development banks; domestic sovereign or central bank debt in domestic currency; domestic sovereign debt in foreign currency.
Level 1 assets have the following characteristics:
- There is no limitation as to how much of these assets can be held within the stock of liquid assets
- They are held at market value
- They are not subject to any haircut, i.e. 100% of their value may be considered in the calculation of LCR. However, national supervisors have the discretion to require their banks to assess a haircut for these assets based on the duration, credit or liquidity risk, etc.
Level 2 assets are assets such as sovereign, central bank, and PSE assets that would qualify for a 20% risk weight under the Basel II Standardized Approach; qualifying corporate and covered bonds rated AA- or higher.
Level 2 assets have the following characteristics:
- There is a 40% cap (after haircuts) on the amount of Level 2 assets that can be held with the stock of liquid assets
- The assets must be well diversified
- There is a minimum haircut of 15% applicable on the market value of the assets.
There is an additional condition that Level 2 assets must satisfy, i.e.
Maximum value of Adjusted Level 2 assets (after haircuts) = 2/3 * Adjusted Level 1 assets (after haircuts)
Where Level 1 and 2 assets are adjusted for the unwinding of those assets that can be exchanged for non-Level 1 and 2 assets in the course of carrying out transactions for short term (<=30 days) secured funding, secured lending and collateral swaps.
In our next post we will consider the elements of the denominator of the LCR ratio, i.e. the total net cash outflows.