The Liquidity Coverage Ratio

Sanjay Basu, NIBM,

October 2019
 Outline
• Stress Scenarios in Basel III.
• Liquidity Coverage Ratio and Net Stable Funding
Ratio – Features and Implications.
 Stress Scenarios
• Downgrade (3-notch) in firm’s public credit rating.
• Run-off on a fraction of retail deposits.
• Loss of unsecured wholesale funding and partial
erosion in the ability to source secured funds.
• Secure short-term funding only for very liquid assets.
• Sharp rise in market volatility that erodes collateral
values.
• Unexpected drawdown on committed lines of credit.
• Non-contractual obligation to fund B/S growth and
mitigate reputational risk.
 Liquidity Coverage Ratio
• A stock of very liquid assets to manage net cash
outflows, under acute stress, for at least 30 days.
• Asset Features
1. Low credit & market risk: High credit quality, low duration,
low volatility, low inflation risk, issued in hard currency.
2. Easy to value: Widely accepted valuation models and inputs;
no exotic products.
3. Low correlation with risk: Remains liquid under severe
stress.
4. Listed in developed exchanges: Transparent and popular.
 Level 1 Assets
• These assets can be included in the stock of liquid
assets without any limit and haircut:
 Cash including cash reserves in excess of required CRR.
 Government securities in excess of the SLR requirement.
 SLR securities within the mandatory requirement to the extent
allowed by RBI (2% of NDTL at present).
 Special/Committed Liquidity Facility (13% of NDTL at
present).
 Marketable securities issued or guaranteed by foreign
sovereigns satisfying all the following conditions:
 Level 1 Assets
1. Assigned a 0% risk weight under the Basel II standardized
approach;
2. Traded in large, deep and active repo or cash markets
characterized by a low level of concentration;
3. Proven record as a reliable source of liquidity in the markets
(repo or sale) even during stressed market conditions; and
4. Not issued by a bank/financial institution/NBFC or any of its
affiliated entities.
5. Adjusted Level 1 assets are arrived at by adding back the
amount of cash lent (reverse repo) and by subtracting the
amount borrowed (repo) upto 30 days against corporate
bonds.
 Level 2 Assets
• Level 2 assets can be included in the stock of HQLA,
subject to the requirement that they comprise no more
than 40% of the overall stock after haircuts.
 The portfolio of Level 2 assets held by the bank should be well
diversified in terms of type of assets, type of issuer and
specific counterparty or issuer.
 All L2 assets must also be traded in large and deep cash or
repo markets.
 A minimum 15% haircut should be applied to current market
value of each L2 asset held in the stock.
• January 2013 – Level 2B assets, consisting of less
liquid securities, with higher haircuts, up to 15% of
HQLA (within the 40% L2 cap).
 Level 2 Assets
1. L2A: Marketable securities that are claims on or claims
guaranteed by sovereigns, PSEs or MDBs with a 20% risk
weight under the Basel II Standardised Approach for credit
risk and not issued by a bank/FI /NBFC or affiliated entities.
2. L2A: Corporate bonds and CP (not issued by bank/FI/NBFC
or affiliated entities), rated AA- or above .
3. Level 2B Assets: RMBS with rating ≥ AA (haircut 25%)
Corporate bonds and CP with rating ≥ BBB- (haircut 50%)
and common shares (haircut 50%)
4. Adjusted Level 2 assets are arrived at by adding the amount
of Level 2 securities placed as collateral (after applying the
haircut) and by subtracting the amount of Level 2 securities
acquired (after applying the haircut).
 High Quality Liquid Assets - Formula
• The maximum amount of adjusted Level 2 assets is
equal to two-thirds of the adjusted amount of Level 1
assets after haircuts have been applied. Any excess of
adjusted Level 2 assets over 2/3rd of the adjusted
Level 1 assets needs to be deducted from the stock of
liquid assets.
 Level 1 assets must be at least 60%. Level 2 assets can at most
be 40%. So, Adjusted L2≤(2/3)×Adjusted L1
• HQLA= L1 + L2A + L2B – Max ((Adjusted
L2A+Adjusted L2B) – 2/3 ×Adjusted L1, Adjusted
L2B – (15/85)×(Adjusted L1 + Adjusted L2A), 0)-
Adjusted L2B – (15/60)×(Adjusted L1), 0)
 Cash Inflows and Outflows
• The total net cash outflows is defined as the total
expected cash outflows minus total expected cash
inflows for the subsequent 30 calendar days.
 Total expected cash outflows are calculated by multiplying the
outstanding balances of various categories or types of
liabilities and off-balance sheet commitments by the rates at
which they are expected to run off.
 Total expected cash inflows are calculated by multiplying the
outstanding balances of various categories of contractual
receivables by the rates at which they are expected to flow in
up to an aggregate cap of 75% of total expected cash outflows
 Cash Inflows and Outflows
• Total net cash outflows over the next 30 days =
Outflows – Min (inflows; 75% of outflows).
• This comprises the denominator of the LCR.
 Compliance with LCR ensures that HQLA is at least 25% of
net cash outflows.
 HQLA should not be for trading purposes or hedging or credit
guarantees/enhancements.
 HQLA exclusively as contingent source of funds.
 Need for CFPs to identify the triggers and the sources of
funds.
 Implications
• Make banks hold more liquid assets, to prepare for
short-term liquidity stress. Accumulation of short-
term debt was the trigger for the global crisis.
 Make them rank traded assets in descending order of liquidity.
 Discourage investments in bonds issued by FIs.
 Spur growth of non-financial corporate bonds.
• Demand for liquid bonds will go up further, while
demand for illiquid bonds may fall more.
 Aggregate market liquidity may worsen.
 Demand for CDs may decline since they are non-HQLA.
 Demand for CPs may improve since they are under HQLA.
 Implications
• The run-off factors and horizons are standardized.
 Some banks could have more unstable liabilities than others.
 Banks borrowing in the repo and call markets can collapse
well before 30 days, while banks reliant on retail deposits
might not face any run-off within a month.
• Make banks aware of the differences in stability
among various sources of funds.
 Push them towards branch-based, retail, insured deposits.
 The run-off factors (extent of premature withdrawal) for
wholesale deposits are assumed to be much higher.
 Interbank lending may decline, since run-off factors for
interbank deposits are the highest.
 Implications
• Banks with higher (lower) HQLA are also likely to
have lower (higher) cost of funds.
 Banks with lower HQLA can impose much higher withdrawal
penalties to reduce the outflow of TDs, within next 30 days.
May encourage 31-day noncallable term deposits.
 Negative carry on callable deposits to be compared with
premium on noncallable deposits.
 Large clients may borrow against such deposits as well.
• Demand for short-term liabilities just beyond the 30-
day window, like 3-month deposits, may increase.
 LCR for NBFCs
• Run-off factors on all outflows fixed at 15%
 NBFCs cannot alter their liability composition to meet LCR
requirements.
 NBFCs must focus only on more HQLA, which hurts yields.
• Discounts on all inflows (up to 30 days) fixed at 75%.
• No restriction on exposure to illiquid assets.
 No cap on investments in HQLA with 15% and 50% haircuts.
 NBFCs may choose illiquid assets to meet their LCR targets.
 The investment portfolio may not be liquid enough.
 Margin Comparison

LCR India

L1 assets 0% 10%

L2A assets 15% 22%

L2B assets 50% 59%

 Volumes (Rs. Bn) & Growth Rates

Dec-12 Nov-17 Growth (%)

CP 1,817.7 4,736.8 95.78%

CD 3,327.7 1,218.9 -100.43%

 Recent Developments
• LCR standards made less stringent in January 2013
1. Pool of HQLA allowed to be drawn down below 100% of
NCO (i.e. LCR allowed to fall below 100%), both under
specific and systemic stress, with the knowledge and consent
of the national supervisors.
2. More securities added under HQLA.
3. Outflow rates on some items (e.g. stable deposits) reduced.
4. Phase-in period from 1.1.2015, when minimum LCR is
expected to be 60%.
5. The possibility of using central bank funds, to supplement
LCR, has been recognized.
 FALLCR
• RBI has allowed banks to include G-secs up to 9% of
NDTL, as L1 HQLA, for meeting LCR requirements.
• This is known as Facility to Avail Liquidity for
Liquidity Coverage Ratio (FALLCR).
 Can be used to obtain liquidity from RBI only under stress, at
2% above LAF rate for at most 90 days, after exhausting all
other sources.
 BIS assessment team feels that this facility makes RBI the
lender of first resort.
 Since this is a CLF and can be used after tapping all other
options, it should be treated as an L2B asset.
 RBI Revisions - March 2016
• Corporate Bonds and CP, rated between BBB- and
A+, allowed as L2B assets.
• Run-off factor on guarantees, LCs and Trade Finance
reduced to 3%.
• HUFs, partnerships and trusts with balances up to Rs.
5 Cr. treated as retail deposits with relevant run-off
factors, while other legal entities attract 100%.
• Deposits against loans excluded from outflows, iff: (i)
loans do not mature within 30 days (ii) deposits
cannot be withdrawn before loan repayment and (iii)
amount of deposits < value of outstanding loans.