The revised Basel lll liquidity reforms – what will Australia do?

Up till now the Australian prudential supervisor APRA has taken a tough stance on the implementation of the Basel III Liquidity Coverage Ratio (LCR). But in January 2013, the Basel Committee has watered down their LCR standard. The committee allows more types of assets to be included in the liquid buffer and it uses a new, slower timetable for implementation. The big question is: how will APRA react? Will it stick to its tough stance and accelerated timetable or will it adopt the Basel Committee approach and promote international convergence? Since the liquidity buffer has an immediate impact on lending activities and their pricing, there’s a lot at stake.

PictureSydney

Basel III liquidity implementation the Aussie way, less eligible liquid assets and less time

The LCR requirement aims to ensure that a bank has sufficient High-Quality Liquid Assets (HQLA) to survive a liquidity stress scenario for a minimum period of 30 calendar days. In the original plans, banks needed an LCR of at least 100% starting in 2015. Banks have to monitor the LCR on a continuous basis. Reporting will be on a monthly basis, while local supervisors can require banks to step up the frequency in times of liquidity stress, which is a massive operational burden for many banks.

The Liquidity Coverage Ratio measures the extent to which a stressed net cash outflow is covered by High Quality Liquid Assets. The stressed net cash outflow equals stressed outflow minus stressed inflow. The cash inflows and outflows are the result of the multiplication of balance sheet items with run off and draw down percentages

The Liquidity Coverage Ratio measures the extent to which a stressed net cash outflow is covered by High Quality Liquid Assets. The stressed net cash outflow equals stressed outflow minus stressed inflow. The cash inflows and outflows are the result of the multiplication of balance sheet items with run off and draw down percentages

“The big question for Australian banks”

In January 2013, the Basel Committee has watered down the original 2011 requirements for the LCR.

At this moment, it is unclear whether APRA will do the same. The Australian Bankers Association said in a reaction to the relaxation from Basel that “the big question for Australia’s banks is whether APRA chooses to incorporate the changes.”

In 2011 APRA announced that it would tailor the LCR for Australian banks. In the Discussion Paper Implementing Basel III Liquidity Reforms in Australia, APRA states that it will put a number of modifications in place, relating to some specific run off factors and Australia-specific self-managed pension plan fund liabilities (the so-called superannuation funds).

More importantly, it will not allow the use of a bit less liquid (so-called level 2) assets to be included in the High Quality Liquid Asset (HQLA) buffer and it will enable the Reserve Bank of Australia (RBA ) to help banks meet their required HQLA buffer.

APRA tailoring of the HQLA buffer

The Basel III standard allows banks to partially meet their HQLA buffer requirement with the help of corporate bonds and covered bonds (not issued by the bank itself) with a credit rating of at least AA. These level 2 liquid assets are restricted to 40% of the total liquid buffer and a 15% haircut needs to be applied.

APRA has made it clear that it won’t allow the use of level 2 assets in the liquid buffer:

Following a review of a range of marketable instruments denominated in Australian dollars (AUD) against the Basel III criteria for HQLA, APRA advised that:

  • the only assets that qualify for HQLA1 are cash, balances held with the RBA, and Commonwealth Government and semi-government securities; and
  • there are no assets that qualify as HQLA2.

The purpose of APRA is to stay on safe grounds since it thinks that the Australian -denominated corporate and covered bonds trade in insufficiently deep markets to justify their inclusion in the liquid asset buffer. In its explanation it also states that it has given particular attention to the liquidity of the level 2 assets in times of market disruption.

APRA tailoring of the RBA facility

Now the RBA facility. Since the amount of Australian federal and state bonds is not sufficient for banks to cover their collective liquidity buffer requirements, Australian banks will be able to set up a Committed Liquidity Facility (CLF) from the Reserve Bank of Australia (RBA). Banks will bring in collateral that is eligible for repo transactions with the RBA and the RBA will charge a market based commitment fee. Of course, this CLF needs to have a maturity that is longer than the 30-day LCR window (see art. 58 of the Basel III LCR revision paper). This is a fairly Australian specific situation, although some Middle Eastern States are also known to have a low level of government debt. The other option would have been to allow foreign government bonds in the liquid buffer and enforce banks to limit the currency risk. The Basel Committee requires that banks pay the fee based on the size of the facility; the fee is not based on the drawn part only.

The January 2013 modification to the LCR by the Basel Committee: more assets and more time are allowed

On January 6, 2013, the situation changed, since the Basel Committee announced significant changes to the LCR definition.

The result is that the requirements have been watered down for two main reasons:

  • The definition of level 2 assets has been broadened so as to include Residential Mortgage Backed Securities (RMBS). The RMBS needs to have a maximum average Loan-to-Value of 80% when the RMBS is issued. Also, the RMBS needs to contain “full recourse” mortgage loans, meaning that in the event of a default, the borrower remains fully liable for any shortfall between the value of the mortgage and the recovery value of the house. This limits the use of RMBS securities as level 2B assets in the US where often mortgage loans are “non recourse”. These so-called level 2B assets may only comprise up to 15% of the liquid buffer and are subject to a haircut equal to 25%. The RMBS needs to have a credit rating of at least AA.
  • The revised timetable allows for an LCR that is phased in from 2015 starting with a value of only 60%; each year 10 percentage points are added until the minimum requirement has reached 100% in 2019.

On top of these changes, some run off percentages have been lowered, especially the run off percentage of non-financial corporate deposits (40% instead of 75%) and the unused portion of committed liquidity facilities provided by banks (30% instead of 100%).

Mervyn King, the governor of the Bank of England and chairman of the group of central bank governors says about the LCR modification (my italics):

The agreement reached today is a very significant achievement. For the first time in regulatory history, we have a truly global minimum standard for bank liquidity.

EU Internal Market Commissioner Michel Barnier is no less complimentary of the LCR relaxation:

I welcome the unanimous agreement reached by the Basel Committee on the revised liquidity coverage ratio and the gradual approach for its phasing-in by clearly defined dates.

In a balanced statement rating agency Standard & Poor’s is also positive about the relaxation:

The decision to relax the original rules came as no surprise because some of the underlying assumptions were relatively conservative, and could have added to pressures on Western banks to reduce debt and leverage, and constrain new lending.

Banks in Europe also welcome the relaxation. They hope that the less ambitious LCR timetable will help them to adjust to a reduction of central bank liquidity that was provided thanks to the expansionary monetary policies of both the European Central Bank and Bank of England. European bank share prices soared after the announcement of the LCR relaxation. An example is Deutsche Bank whose stock price increased by 3% upon the news.

Stock price Deutsche Bank, source Bloomberg (ticker DBK:GR)

Stock price Deutsche Bank, source Bloomberg (ticker DBK:GR)

 

Truly global?

Up till now APRA has not announced whether it will stick to the original timetable or allow Australian banks a number of extra years to build up an LCR equal to 100%.

For the Basel III capital requirements Australian banks are already on an accelerated timetable. APRA says about this accelerated timetable (Implementing Basel III capital reforms in Australia):

Basel III provides generous transitional arrangements for the new Basel III capital requirements, in respect of minimum capital ratios, deductions from regulatory capital and capital instruments. In APRA’s view, ADIs in Australia are well placed to meet the new requirements and APRA therefore proposed to adopt an accelerated timetable for introduction of the Basel III minimum capital ratios and regulatory adjustments, and the capital conservation buffer.

So given its position on the capital rules, why would the APRA relent on the liquidity timetable?

Some analysts have already indicated that it is unlikely that APRA will allow Australian banks to benefit from the watered-down liquidity rules. It may very well stick to its opinion that the inclusion of level 2 corporate and covered bonds in the liquidity buffer of Australian banks will not make these banks safer.

Also, in rejecting the level 2 assets and setting up the RBA Committed Liquidity Facility, APRA uses the latitude that is given to local supervisors with the help of provisions that have been included in the Basel III LCR revision paper.

On the other hand, the more restrictive definition of liquid assets and the faster timetable may be harmful for Australian banks when competing within international financial markets. They will be faced with assets being tied up in a liquid buffer instead of being available for lending. Standard & Poor’s says about this downside of the liquidity buffer:

The LCR recalibration was announced by the Basel Committee on Jan. 6, 2013, with the stated aim of making the framework more realistic. We take this to mean that a broader range of banks could implement the new approach without aggressive deleveraging.

It will also force them to include the additional costs of the liquidity buffer in the interest rates that are charged to their customers.

The Basel rules are meant to be adopted in local legislation in order to create an international harmonisation of capital and liquidity rules. This convergence is seriously hampered if local authorities – for whatever good reasons – deviate in significant ways from the original rules.

So here’s the balancing act: follow the new Basel rules in order to contribute to international convergence and a level-playing-field or focus on local special circumstances and liquidity conditions?

We are eagerly looking forward to APRA’s decisions.

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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