Gaming the LCR

As banks begin to publish their Liquidity Coverage Ratios, there appears to be an opportunity to both game the system and for legitimate figures to be distorted by market analysts, regulators and the press. We have already begun to see some of this gaming albeit not intentionally; firms are merely responding to regulatory pressures by adjusting their funding strategies to meet new Basel III requirements. If the LCR ultimately does get manipulated by any means however, this would meaningfully decrease the value of this statistic.

As pointed out by participants in a Risk Magazine webinar today, the Liquidity Coverage Ratios that have been quietly published so far by banks look strangely dissimilar. There was an expectation that LCRs should fall into a band or range. Instead, it appears that different bank managers are taking different enough approaches to the calculation, and that the final results lose their intended meaning.

Our own research has found practical applications into what we presume to be innocent enough adjustments to funding strategies. For example, evergreen repo contracts that refresh at 31 days help banks avoid poor LCRs. Repo contracts that refresh at 361 days help banks look better on their Net Stable Funding Ratio. Analysts that can take the time to look under the hood will understand what these differences mean on a bank by bank basis.

The trouble really comes when analysts, regulators and the press with not enough time or experience to know what the numbers mean begin to put these figures side by side. We have seen variations of this problem occur summary times it no longer seems even fair to point them all out. New rules are complicated and the Liquidity Coverage Ratio is even more so. To make matters worse, national regulators are already taking slightly different approaches to LCR calculations; this will make international comparisons all but impossible. As just one example of this, see the European Union’s take on Level 2 assets in the LCR (don’t worry, Finadium did the homework in this March 2012 report).

What can be done to solve this problem? One logical approach is the mass-scale education of analysts, regulators at all levels and journalists in the technicalities of financial markets. I agree, that’s not going to happen. The next best thing is to work on creating an apples to apples comparison of the LCR and other new ratios to keep distortions down and let clear information make its way to the market. Without some serious work in this area, the efforts of the Basel Committee in creating new financial ratios for bank risk management may be for naught.

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