Capital and liquidity ratio improvements do not go “hand in hand”

After the Global Financial Crisis consensus was that the quantity and quality of capital must be improved, while banks must increase their liquid assets at the same time.
As as result Basel III introduced more stringent requirements for capital (Common Equity Tier 1 Ratio > 4.5%, Tier 1 Ratio > 6%, Capital Ratio > 8%, Leverage Ratio > 3%), as well as two new ratios for the liquidity risk management, the Liquidity Coverage Ratio and the Net Stable Funding Ratio.

It has often been said that the simultaneous improvement of the capital ratios and the liquidity ratios is logical; they would move “hand in hand”, since an increase in liquid holdings would at the same time reduce the Risk Weighted Assets (cash and EU member state government bonds carry a zero RWA requirement).

 

E.g., the Dutch Central Bank states about the impact of the Basel III liquidity rules: (1)

An increase of the liquid assets can move hand in hand with a decrease of risky assets, such as loans. This improves the capital ratio.

 

The question is if, in practice, it is that simple. With the help of data provided by the Dutch Central Bank, we can track the development of the capital and liquidity ratios from 2004 till 2014. This development is shown in the graph below.

 

time series for capital ratios, ROE and liquidity ratio, Dutch banks (source: DNB)

time series for capital ratios, ROE and liquidity ratio, Dutch banks (source: DNB)

Visual inspection of the graph leads to the following observations:

  • The two RWA-based capital ratios (Tier 1 Ratio and Capital Ratio) move closely together. Both have increased significantly since the GFC.
  • The un-weighted leverage ratio is less volatile and has only slightly increased after the GFC.
  • The Liquidity Ratio (liquid assets / total assets) has decreased since the GFC.

Inspection of the correlation matrix leads to the same conclusions:

 

correlation plot of capital and liquidity ratios Dutch banks, 2004-2014 (source: DNB)

correlation plot of capital and liquidity ratios Dutch banks, 2004-2014 (source: DNB)

 

The correlation matrix shows a negative correlation between the Liquidity Ratio on the one hand and each of the RWA-based capital ratios on the other hand. Interestingly, it shows only a moderate (instead of a strong) correlation between the RWA-based capital ratios on the one hand and the un-weighted leverage ratio on the other hand.

How can we explain the simultaneous decrease of the liquidity ratio and increase of the RWA-based capital ratios, while the leverage ratio remains relatively constant?

 

The negative correlation between capital and liquidity ratios explained

An explanation is that banks have increased their RWA-based capital ratios by reducing RWA instead of raising capital. (This explains the increase of the RWA-based capital ratios while the leverage ratio remains relatively constant.)
The RWA-reduction has taken place through shifts in the credit portfolio (from high risk loans to low risk loans) rather than replacing loans by liquid assets.

The de-risking of the credit portfolio has had a significant impact. If banks have decreased their liquid holdings simultaneously, this did not negatively affect RWA.

 

The liquidity ratio reported here is defined as liquid assets divided by total assets. If banks have built up their LCR ratio, they have done so by reducing the denominator of the LCR: the 1 month net cash outflow during liquidity stress. This can be done on the funding side of the balance by replacing short term volatile funding with long term stable funding. A special instance of this replacement is a reduced reliance on the short-term wholesale funding market.

 

The reduction of the liquid assets while managing the LCR at the funding side of the balance sheet is rational given the extremely low return on government bonds and the ECB’s negative deposit rate.

 

Parting thoughts

In this post we have rejected the notion that the improvement of the capital ratio and the improvement of the liquidity ratio necessarily co-move. The correlation matrix presented above for the Dutch banks during the past 10 years even shows a negative correlation between the capital and liquidity ratios. The explanation is that banks have significantly reduced the risk in their credit portfolio. This enabled them to simultaneously reduce their liquid assets. This behavior is rational given the extremely low returns for risk-free assets.

 

(1) DNB, Occasional studies, 2010, Macro-effecten van hogere kapitaal- en liquiditeitstandaarden voor banken. The original text runs: “Zo kan een toename van liquide activa gepaard gaat met een afname van risicovollere activa, zoals leningen, wat de kapitaalratio verbetert.”

 

 

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

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