Basel III Liquidity Framework: Basel Committee Announces Summary of Changes to the Basel III Liquidity Coverage Ratio

Sullivan & Cromwell LLP - January 7, 2013
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Yesterday afternoon, the Group of Governors and Heads of Supervision (the “GHOS”), the oversight body of the Basel Committee on Banking Supervision (the “Basel Committee”), announced a summary of long-anticipated amendments to the Liquidity Coverage Ratio (the “LCR”) included in the Basel IIII liquidity framework published in December 2010. Although the amendments have been described as a “weakening” of liquidity requirements, in many respects the revisions appear to track more closely empirical data. The announcement indicates that the full text of the LCR amendments will be forthcoming later today.

Basel III defines the LCR as the ratio of the “stock of high-quality liquid assets” to “total net cash outflows over the next 30 calendar days.” Noteworthy changes to the LCR described in the GHOS’s summary announcement include:

  • Phase-In: The LCR will be introduced as planned on January 1, 2015. However, the minimum LCR requirement will begin at 60% (rather than 100% as initially contemplated) and be phased-in over the next four years in 10% increments, reaching 100% on January 1, 2019.
  • Amendments to the Definition of High Quality Liquid Assets:
    • The definition of high quality liquid assets will be expanded to include corporate debt securities rated A+ to BBB- (subject to a 50% haircut), certain unencumbered equities (subject to a 50% haircut) and certain residential mortgage-backed securities rated AA or higher (subject to a 25% haircut). These additional assets, after applicable haircuts, will be limited to 15% of the total stock of high quality liquid assets in the aggregate. Because, however, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) prohibits the use of credit ratings, it remains to be seen how these particular provisions will be modified for purposes of the eventual U.S. implementation of the LCR.
    • The LCR framework will be clarified to allow for the use by banks of their pool of high quality liquid assets during periods of stress, subject to supervisory guidance.
    • The operational requirements for high quality liquid assets will be “refine[d] and clarif[ied]”, and the operation of the cap on Level 2 assets will be “revise[d] and improve[d]”.
    • Changes to the rating requirement on qualifying Level 2 assets will include the “use of local rating scales”. In addition, the LCR amendments will provide for the “inclusion of qualifying commercial paper”.
  • Amendments to Assumed Inflow and Outflow Rates:
    • The outflow assumption on (i) “certain” fully insured retail deposits will be reduced from 5% to 3%, (ii) fully insured non-operational deposits provided by non-financial corporates, sovereigns, central banks and public sector entities will be reduced from 40% to 20% and (iii) non-operational deposits provided by non-financial corporates, sovereigns, central banks and PSEs will be reduced from 75% to 40%.
    • The outflow assumption on committed but unfunded liquidity facilities to non-financial corporates, sovereigns, central banks and public sector entities will be reduced from 100% to 30%.
    • With respect to committed but unfunded inter-financial liquidity and credit facilities, the LCR now will distinguish between “interbank” and “inter-financial” credit and liquidity facilities, reducing the outflow assumption on the former from 100% to 40%.
    • Additional derivatives risks (related to collateral substitution and excess collateral that a bank is contractually obligated to return or provide if required by a counterparty) will be included in the LCR with a 100% outflow assumption. The LCR will also introduce a standardized approach for liquidity risk related to market value changes in derivatives positions and assume a net outflow of 0% for derivatives and commitments that are contractually secured or collateralized by high quality liquid assets.
    • The Basel Committee will provide guidance indicating that a low outflow rate (0% to 5%) is expected to apply to trade finance.

The GHOS press release summarizing the LCR amendments also noted that the Basel Committee will:

    • continue to develop disclosure requirements for bank liquidity and funding profiles;
    • continue to analyze the interaction between the LCR and the provision of central bank facilities;
    • “press ahead” with the review of the Net Stable Funding Ratio. This work was described as a “priority” for the Basel Committee over the next two years; and
    • continue to examine the comparability of model-based internal risk weightings and consider the appropriate balance among “the simplicity, comparability and risk sensitivity” of the regulatory framework “as a matter of priority”. It is unclear whether this is meant to signal a re-examination by the Basel Committee of the advanced internal ratings based approach to risk-weighted assets, which forms the core of the Basel II framework originally adopted in 2006, and/or whether the Committee is also considering the imposition of a standardized-approach backstop to the use of internal models, as was introduced in the U.S. by Dodd-Frank Section 171, the so-called “Collins Amendment”.