The Treasury of High Quality Liquid Assets – Seen from Above

Robust liquidity risk management means that a bank is able to estimate its future operational cash flows and that it can withstand stressed operational cash outflows with the help of a liquidity buffer.

This philosophy has been implemented in a straightforward way with the help of the liquidity coverage ratio (LCR), but this ratio is in fact only one point on a continuous scale, namely the 30 day maturity.

But let’s focus on this LCR for the 30 day maturity. The bank has to calculate the stressed cash outflow during a month and it needs to have a liquidity buffer that covers this stressed cash outflow. According to the Basel Committee, coverage needs to be initially for 60%, but this will increase towards a minimum LCR requirement of 100% in 2019. The EU will propose a more ambitious deadline of 2018.

‘Easy to sell’ assets

Although a liquidity buffer is needed, it is bad for P&L. Cash does not generate any return, but the liquidity buffer does cause funding costs.

Luckily, it is allowed to use a broader definition for the liquidity buffer in the numerator of the LCR (the High Quality Liquid Assets). The HQLA may be comprised of the following, easy to sell, assets:

  • Level 1 assets: coins, banknotes, central bank reserves and EU government bonds carrying an RWA requirement of 0%;
  • Level 2A assets: corporate debt and covered bonds (not issued by the bank itself) that have a long-term credit rating of at least AA-. A 15% haircut is applicable;
  • Level 2B assets:
    • Residential mortgage backed securities (RMBS); not issued by the bank itself; carrying a credit rating of at least AA. The underlying mortgages are full recourse (in case of foreclosure the mortgage owner is liable for any shortfall in sales proceeds from the house) and have a maximum loan-to-value (LTV) of 80% on average. A 25% haircut is applicable;
    • Corporate debt securities, subject to certain conditions, a 50% haircut is applicable;
    • Common equity shares, subject to certain conditions, a 50% haircut is applicable.

The HQLA buffer needs to be comprised of at least 60% of Level 1 assets. Level 2B assets are capped at 15% of the HQLA buffer.

If the bank maximizes its Level 2B assets and minimizes its Level 1 assets, the treasury that holds the HQLA looks as depicted below (seen from above):

The HQLA Treasury Seen from Above

The HQLA Treasury Seen from Above

The turnaround of the EU: extension to Asset Backed Securities

This month (May 2014), there was an important development related to the Level 2B assets and the EU implementation of the LCR rule.

First the EU seemed to be skeptical about including a broader range of asset backed securities in the Level 2B assets as reported by Bloomberg on March 10, 2014:

The commission’s analysis of ABS markets at this stage is that they don’t seem to meet the criteria for ABS to count as highly liquid, Bohan [the commision’s head of unit of banks, MF] said at the televised hearing. Officials are open to keeping the matter under review and monitoring future market developments, he said.

However, on May 12, 2014, it perspires that the EU is considering to allow banks to deploy a wider range of asset backed debt than residential mortgages only, also reported by Bloomberg (on May 12, 2014).

Of course, only the most senior bond tranche is eligible for inclusion in the Level 2B assets.

The inclusion of a wider range of asset backed securities in the HQLA is not only beneficial for banks (so that at least a modest return can be generated from this part of the HQLA), it is also good news for car manufacturers and buyers if their car loans are included in the Level 2B assets. The inclusion will make banks’ portfolios of car loans much more attractive and easier to securitize.

There is also a risk. If the securitizations will become illiquid as we witnessed during the Global Financial Crisis, the asset backed securities will not comply with the most basic requirement of the HQLA: the assets in the liquidity buffer should be ‘easy to sell’. It is too early to tell whether the requirement to include only the most senior tranche and the 25% haircut will prove to be sufficient mitigants of this risk.

 

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

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