Liquidity Risk

The Basel Committee introduced in December 2010 two quantitative metrics for the supervision of the banks’ liquidity risk: the Liquidity Coverage Ratio (the LCR) and the Net Stable Funding Ratio (the NSFR).

The Liquidity Coverage Ratio

The LCR aims at strengthening banks’ short-term liquidity profile. It defines the level of liquidity buffer to be held to cover short-term funding gaps under severe liquidity stress, under a time horizon of 30 days. The first step consists in calculating the difference between the cumulated outflows on liabilities and the cumulated inflows on the assets. For example, deposits received from banks are considered as fully unstable in times of stress, i.e. they are not rolled over: therefore their outflow rate is 100%. This is mirrored on the asset side by a 100% inflow rate on loans to banks maturing within 30 days. If cumulated outflows are bigger than cumulated inflows, then the difference is a net cash outflow, to be counterbalanced by a liquidity buffer, i.e. a portfolio of High Quality and Liquid Assets. These assets must be selected in a narrow list prescribed by the regulation (sovereign debt, corporate debt), excluding any financial asset like banks’ bonds or banks’ certificates of deposits.

In January 2013, the Basel Committee disclosed the final standard for the LCR, the first release of which was issued in December 2010. This new standard entails significant positive changes for the banking industry, whose major concerns have been taken into consideration.

Nearly eighteen months after the endorsement of the CRR/CRD IV package, the final rules on the Liquidity Coverage Ratio (the LCR) are now specified since the publication of the Delegated Act in the official Journal of the EU on 17 January 2015. One will remind that the EU co-legislators (the EU Council and the EU Parliament) had delegated to the EU Commission via article 460 of the CRR, the power to elaborate the detailed LCR. The publication of the Delegated Act concludes an intensive sequence of several months, where the EU Commission has consulted in a very open and transparent manner all the stakeholders involved, e.g. the experts of the EU Member States, the European Banking industry, the European Banking Authority, the EU Parliament, etc.

In elaborating the Delegated Act, the EU Commission has retained the requirements of the Basel Committee’s standard released in January 2013, all but preserving some EU specificities like the classification of liquid assets, the scope of application and the treatment of intra-group flows.

The LCR is a small part of the new fully-fledged prudential framework for liquidity risk set out by the CRR / CRD IV. This framework is indeed composed of a Pillar 1 block (i.e. the LCR, the monitoring tools, the Net Stable Funding Ratio) and of a complete Pillar 2 framework, entailing strengthened obligations for banks (i.e. the so-called ILAAP, the Internal Liquidity Adequacy Process) and for supervisors (i.e. the SREP).

The Net Stable Funding Ratio

The NSFR’s objective is to strengthen banks’ medium- to long-term liquidity profile. It defines the minimum acceptable amount of stable funding in an extended firm-specific stress scenario over a time horizon of 1 year. The NSFR is problematic because it disregards the primary function of banks, which is to collect liquidity and to transform it.

However, taking into account the flows of justified criticisms addressed by the stakeholders, the Basel Committee agreed to review the basics and the calibration of the NSFR as proposed in December 2010. The final standard was released in October 2014, taking on board some comments of the banking industry. The implementation date for the NSFR as a minimum standard remains 1 January 2018. Before that date the EBA will evaluate how a stable funding requirement should be designed. Based on this evaluation, the EU Commission should report to the EU Parliament and to the EU Council together with a legislative proposal in order to introduce the NSFR in EU legislation by 2018.