In what looks like a culmination of over a year’s worth of discussion, the Basel Committee on Banking Supervision yesterday released updates to the Liquidity Coverage Ratio that most famously pushed back a full implementation until 2019, although banks will need to hold 60% of the LCR starting in 2015. The less pronounced news is that corporate bonds and equities are now being included as part of the LCR, and that’s important but doesn’t do everything that some banks hoped for. Let’s take a look at what this means.
As we’ve been discussing for some time now, the LCR requires banks to measure its total High Quality Liquid Assets (HQLA) over net cash outflows over the next 30 days. The final ratio needs to be over 100% (more high quality assets than cash outflows). The initial ideas was that HQLA is supposed to be unencumbered pristine assets, made up of 60% cash, government bonds and equivalents (Level 1 asset) and 40% other very high quality assets nonetheless including agencies and the highest rated corporate bonds (Level 2 assets). An almost immediate problem came with Greece’s financial crisis; who was to say at that point that Greek debt was Level 1 HQLA, but that unacceptable assets including BP bonds, currently Level 2, or IBM stock, currently nowhere, were not? We wrote a big research report on this in March 2012 (“Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets“.
Not only the definition of HQLA but also the 60/40 split was under attack. The EU, in one analysis of the Capital Requirements Directive IV, proposed a split of 50/50 to give banks more breathing more. This is a really big deal. The easier time that some banks have to meet their HQLA requirements compared to other banks in other legal jurisdictions, the more competitive they are. This belies the point of Basel III, which is one regulatory system worldwide. The EU approach also (still) leaves room for individual countries to modify the LCR to suit their own regimes. We’d talk about the Balkanization of financial regulations, but that would be unfair to the Balkans. This situation has been a real mess for the last year.
Now, the Basel Committee is attempting a compromise. In yesterday’s Annex 1, the Committee said that lower rated corporate bonds and some equities are now acceptable as part of the LCR:
“HQLA are comprised of Level 1 and Level 2 assets. Level 1 assets generally include cash, central bank reserves, and certain marketable securities backed by sovereigns and central banks, among others. These assets are typically of the highest quality and the most liquid, and there is no limit on the extent to which a bank can hold these assets to meet the LCR. Level 2 assets are comprised of Level 2A and Level 2B assets. Level 2A assets include, for example, certain government securities, covered bonds and corporate debt securities. Level 2B assets include lower rated corporate bonds, residential mortgage backed securities and equities that meet certain conditions. Level 2 assets may not in aggregate account for more than 40% of a bank’s stock of HQLA. Level 2B assets may not account for more than 15% of a bank’s total stock of HQLA.”
Put another way, the 60/40 split stays intact, making banks still obligated to have the same amount of highest quality assets. But in the 40% part there is some leeway. The new rules will not help banks solve the big problem of collateral misallocation or dislocation, by which we mean that enough high quality assets exist worldwide for banks to meet their requirements, and the requirements of their OTC derivative customers, but it may be expensive to access or hold. Rather, there is now leeway on the other side for banks that want to include some additional assets, still better than what some Central Banks have taken over the years as collateral, for the LCR.
We don’t think that the story ends here. We think that individual regulators will continue to press on the 60/40 split. Lowering the amount of cash and government bonds that banks must hold, and increasing the amount of corporate bonds and equities, is the biggest lever that will ease concerns and the economic imbalances that we see occurring today driven by collateral and bank balance sheet demands.
Here are some earlier Securities Finance Monitor articles on this topic: