The Basel Committee's Revised

Liquidity Ratio: A Necessary

Recalibration--And A Concession To
Banks
Primary Credit Analyst:
Richard Barnes, London (44) 20-7176-7227; richard_barnes@standardandpoors.com
Secondary Contacts:
Stefan Best, Frankfurt (49) 69-33-999-154; stefan_best@standardandpoors.com
Bernard De Longevialle, Paris (33) 1-4420-7334; bernard_delongevialle@standardandpoors.com

Table Of Contents
The First Global Minimum For Bank Liquidity
1) More Relaxed Cash Outflow Assumptions
2) Longer Implementation Timetable
3) Broader Definition Of High-Quality Liquid Assets
Attention Now Turns To The Net Stable Funding Ratio
Related Criteria And Research

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The Basel Committee's Revised Liquidity Ratio: A

Necessary Recalibration--And A Concession To
Banks
Standard & Poor's views the Basel Committee's announced revision of the liquidity coverage ratio (LCR) on Jan. 6,
2013, as a necessary recalibration--but also a concession to the world's banks. While the change has no immediate
impact on our ratings on banks globally, it could have a longer-term influence it if delays the rebalancing of funding
and liquidity away from central banks. The decision to relax the original rules came as no surprise because some of the
underlying assumptions were relatively conservative, and could have added to pressures on Western banks to reduce
debt and leverage, and constrain new lending. Nevertheless, the changes, particularly the extension of the timetable for
implementation, were more extensive than we had expected. In practice, however, market participants may demand
that large banks comply with the new LCR requirements in advance of the formal deadlines, as we have already seen
in the case of the Basel III capital ratios.
In our view, the amendments to the LCR methodology indicate regulators' increased willingness to remove obstacles
to banks' ability to finance the economic recovery. The extended implementation period also allows banks more time
to adjust to the eventual withdrawal of the massive liquidity stimulus provided by the world's central banks. Reports
indicate that the European Central Bank (ECB) and eurozone members were at the forefront of the regulatory lobby for
changes to the LCR, reflecting the economic and banking conditions in the region. The Basel Committee on Banking
Supervision will now turn its attention to a review of the net stable funding ratio (NSFR), and we believe a similar
relaxation of the existing rules and implementation timetable now appears probable.
Overview
We believe that the revisions to the Basel Committee's liquidity coverage ratio--the first-ever global quantitative
regulatory framework for liquidity--were a needed recalibration but also a concession to banks.
There are three key changes from the initially proposed LCR:
More relaxed and in our view more balanced cash outflow assumptions in a stress scenario;
A longer and we believe more lenient implementation timetable; and
A broader definition of high-quality liquid assets that includes residential mortgage-backed securities, which
has drawn considerable attention. However, the rules appear to restrict assets to higher-quality securities
where an active market is more likely to exist in a stress period.
The Basel Committee will now turn its attention to a review of standards for funding mismatches beyond the
30-day horizon: the net stable funding ratio. We believe a similar relaxation of the existing rules and timetable
now appears probable.

When assessing banks' liquidity, we consider the position of each banking system and each institution using our own
rating criteria and metrics, which are not affected by the change in regulatory approach (see "Banking Industry
Country Risk Assessment Methodology And Assumptions" and "Banks: Rating Methodology And Assumptions," both

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks

published Nov. 9, 2011). Our current bank ratings generally incorporate the expectation that institutions with weaker
stand-alone funding and liquidity will steadily strengthen their positions and reduce dependence on central bank
facilities. The changes to the LCR methodology could have negative rating implications if they cause a delay in this
rebalancing. Conversely, there could be positive rating actions on banks that choose to manage their liquidity well
above the minimum requirements. Inadequate public disclosure currently hampers analysis of banks' funding and
liquidity positions. We support greater transparency in this area, alongside the introduction of the new LCR standards
(see "How Enhanced Funding And Liquidity Disclosure Could Improve Confidence In The World's Banks," published
on May 29, 2012).

The First Global Minimum For Bank Liquidity

The LCR was developed in response to the global financial crisis, which exposed deficiencies in liquidity risk
management. As a result, central banks had to provide significant collateralized lending to banks to fill the gap as the
private sector scaled back its exposures to them. The LCR represents the first global quantitative framework and
minimum standard for liquidity, in contrast to those for capital, which have existed since the 1980s. Another difference
with the regulatory capital regime is that regulators will have complete flexibility to lower the minimum LCR
requirement during actual stress periods.
The Revised Rules Aim To Lessen Banks' Inherent Liquidity Risk
Banks are exposed to liquidity risk principally because they often face balance sheet mismatches: the contractual
maturity profile of their deposits and other funding is typically shorter than the profile of their assets. As a result,
cash flow problems can be triggered by high deposit withdrawals ("runs on the bank") or the sudden unavailability
of wholesale market funding. Equally, unexpected demands for cash can arise from collateral requirements or
drawdowns of committed off-balance sheet facilities. These problems typically arise during financial crises, and
they can snowball.
Banks can mitigate this risk by holding high-quality assets to sell or to use in repurchase agreements in case of
need. The intent of the rules about quality is to increase the likelihood that the assets will maintain their value in a
stress situation and that a market for them will remain open. Banks can also manage the scale of potential
short-term cash demands through other measures such as lengthening the maturity profile of their funding and
limiting the volume of committed facilities.
The key feature of the Basel III liquidity rules is the "liquidity coverage ratio," which compares a bank's more
liquid assets to potential cash outflows. Banks must hold sufficient "high-quality liquid assets" (HQLAs; the
numerator of the ratio) to cover potential net cash outflows (the denominator) under a 30-day stress scenario.
These assets must be free and clear of creditor claims, that is, unencumbered. The Basel Committee has specified
eligibility criteria for the HQLAs and assumptions on the outflows.

The LCR and NSFR frameworks have been several years in the making, illustrating the challenge of agreeing a
common global approach that is applicable to the different balance sheet structures of the world's banks. The Basel
Committee published a consultation paper on the LCR and NSFR in December 2009 and finalized the rules a year
later. Our view at that time was that the LCR requirement would improve banks' liquidity profiles, but that strict

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks

calibration would constrain lending activity and also affect funding markets and securities pricing (see "Basel III
Proposals Could Strengthen Banks' Liquidity, But May Have Unintended Consequences," published on April 15, 2010).
The Basel Committee's subsequent impact studies confirmed that banks had a lot of ground to make up to meet the
minimum LCR requirement by the January 2015 implementation date. At year-end 2011, for example, 209 banks
around the world had an aggregate HQLA shortfall of 1.8 trillion, or 3% of their total assets. A similar study by the
European Banking Authority found a 1.17 trillion shortfall across 155 EU banks at the same date. (Not all of the 155
EU banks were included in the 209 institutions covered by the Basel Committee survey.) In both exercises, the results
for the participating banks were very widely dispersed (see chart 1), partly because of significant differences in the
prevailing national minimum liquidity requirements. Still, the size of the global and regional shortfalls highlighted the
significance of the balance sheet changes required if banks comply with the original LCR rules.
Chart 1

The LCR recalibration was announced by the Basel Committee on Jan. 6, 2013, with the stated aim of making the
framework more realistic. We take this to mean that a broader range of banks could implement the new approach
without aggressive deleveraging or significant changes to their business models. The revision also likely factors in
uncertain conditions in securities and funding markets, where banks may have found it difficult to increase holdings of
HQLAs or lengthen the maturity profile of their funding. According to the Basel Committee, the current average LCR

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks

for a sample of banks is about 125% under the new methodology, up from about 105% under the original rules.
The changes to the LCR methodology were widely anticipated but went further than we had expected. The Basel
Committee's announcement mentioned that the outcome "was a compromise between competing views around the
world." Regulators in the eurozone (European and Economic Monetary Union or EMU) are understood to have played
a leading role in calling for a relaxation of the LCR requirement, but lobbying by others also likely played a role,
particularly in the revised definition of HQLAs. Ironically, due to their roles as chairs of the Basel Committee and its
oversight body, the press conference announcing and defending the rule changes was hosted by the central bank
governors of Sweden and the U.K., where current regulatory liquidity requirements are among the most stringent of
the Basel Committee member countries.
In roughly decreasing order of significance, the new LCR methodology features three key changes from the original
framework:

1) More Relaxed Cash Outflow Assumptions

A key factor behind the increase in LCRs under the new methodology is a lowering of the assumed flows of cash out of
banks under the 30-day stress scenario. We consider that the original assumptions for these items were relatively
conservative and that the new levels are more reflective of general experience during the financial crisis. As with any
global "one size fits all" approach, the revised stresses may appear strict in some countries and lenient in others, but
we view them as more balanced than previously.
In our view, the main assumption changes under the new LCR approach relate to the withdrawal of corporate deposits
and the bank's usage of committed, undrawn liquidity facilities provided by banks (see table 1). Although the assumed
run-off of certain insured retail deposits was also reduced, we see this as less material since it applies only if the
relevant insurance scheme operates a prefunding system, which is often not the case at present. The revision also
clarified the outflow assumptions for trade finance contingent liabilities, such as guarantees and letters of credit, at a
relatively low 0%-5%. These various changes reduce net cash outflows under the stress scenario, and therefore reduce
the amount of HQLAs that banks are required to hold. The revised treatment of committed facilities and trade finance
exposures also supports the nonfinancial corporate sector, since the original rules would likely have reduced the
availability and raised the cost of these important financing products.
Table 1

Selected Changes To Cash Outflow Assumptions

New assumption

Previous
assumption

3%

5%

Run-off of nonoperational deposits from nonfinancial corporates, sovereigns, central banks,

multilateral development banks, and public-sector entities

40%

75%

Drawdown of committed, undrawn liquidity facilities to nonfinancial corporates, sovereigns,

central banks, and public-sector entities

30%

100%

Drawdown of committed, unfunded credit and liquidity facilities to regulated banks, and credit
facilities to other financial institutions

40%

100%

Run-off of stable, fully insured retail demand and term deposits (where the insurance scheme
meets certain criteria)

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks

Table 1

Selected Changes To Cash Outflow Assumptions (cont.)

Source: Basel Committee on Banking Supervision.

There had been rumors of changes to other key outflow assumptions--such as potential cash and collateral drains from
derivatives and funding vehicles, which are a material item for wholesale and investment banks. But in the end the new
methodology left them as is.
The 30-day horizon of the LCR stress scenario is unchanged under the new methodology, and we consider that this is
relatively short. Moreover, it is impossible to capture all the important aspects of a bank's liquidity profile in a single
ratio. Standard & Poor's believes that the minimum regulatory requirement should be supplemented with internal risk
management tools such as cashflow mismatch reports, stress tests, and scenario analysis over a range of time horizons
to provide a more comprehensive picture of a bank's liquidity.

2) Longer Implementation Timetable

In addition to revising the scope of the LCR, the Basel Committee relaxed the implementation timetable by introducing
a transition period similar to that already planned for the Basel III capital requirements. We view this as a concession
to the banking sector but also a recognition of current economic realities. We acknowledge that regulators face a
difficult balancing act in pushing for stronger bank balance sheets without excessively constraining the availability of
credit to the real economy. Still, the extended phase-in of the LCR suggests that regulators are giving more weight to
banks' ability to finance the economic recovery, and do not wish to be seen as an obstacle to growth. Now it is the
market's turn: It remains to be seen whether market participants will urge major banks to comply with the minimum
LCR requirement more quickly, as we have seen in the case of Basel III capital ratios.
Under the original rules, the 100% minimum LCR requirement was due to be introduced in January 2015. Now, the
minimum will be set at 60% from January 2015 and raised by 10 percentage points each year until it reaches 100% in
January 2019. In normal market circumstances, banks will likely operate with an LCR comfortably above the minimum
requirement to avoid the risk of inadvertent breaches and meet market expectations. The size of the cushion that
banks choose to maintain will depend on the extent to which the LCR varies day to day. And only time will tell what
investors believe are the appropriate ratios that banks should maintain. By emphasizing that HQLAs should be used in
an actual stress situation, the Basel Committee sought to ensure that banks will not be expected to hold "buffers on
buffers."
At first glance, it may seem odd that the LCR implementation timetable has been lengthened when the current 125%
average ratio already exceeds the 100% ultimate minimum requirement. We see two main explanations for this:
The banking sector is currently awash with liquidity but mainly because of increased central bank reserves
(expanded during the financial crisis through quantitative easing and funding programs), which are the most liquid
asset that banks can hold. The extended LCR implementation timetable anticipates a reduction in these reserves
before 2019 as economies recover and the central bank stimulus is managed down. The new methodology's
transition period should help banks to adjust to this liquidity withdrawal without having to make significant balance
sheet or business model changes.

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks
The current average LCR is for a sample of larger banks and may not be representative of the wider banking sector.
Moreover, like the impact study results as at year-end 2011, there is likely to be a wide distribution around the
average, with a number of banks falling below the 100% mark.
Although these are valid points, we still see the longer implementation timetable as relatively lenient considering that
the original LCR proposal was published in December 2009.

3) Broader Definition Of High-Quality Liquid Assets

The Basel Committee also diversified the definition of HQLAs, introducing a new "level 2B" category that gives limited
credit to certain residential mortgage-backed securities (RMBS) and equities, as well as corporate bonds rated between
'A+' and 'BBB-' (see table 2). In practice, we do not expect this to have a transformational effect on the composition of
banks' liquidity portfolios because the level 2B assets will be subject to qualification criteria (constraints on the issuer,
the liquidity track record, and other features), haircuts (allowable quantities of certain assets), and an overall limit
(maximum 15% of total HQLAs) that appear broadly appropriate to us (see table 2). The level 2B assets also attract
higher risk weights (which determine how much capital banks must hold against them) than the best-quality liquid
resources. The application of the HQLA definition may encounter problems in the U.S., where the Dodd-Frank Act of
2010 prohibits the use of ratings in the implementation of regulatory rules. We anticipate that the U.S. Federal Reserve
will need to formulate an alternative approach, further complicating international comparisons.
Table 2

Eligible High-Quality Liquid Assets (HQLAs)

Level 1 assets (minimum 60% of HQLAs)
Haircut (%)
Coins and bank notes

Qualifying marketable securities from sovereigns, central banks, public sector entities, and multilateral
development banks

Qualifying central bank reserves

Domestic sovereign or central bank debt for non-0% risk weighted sovereigns

Level 2A assets
Sovereign, central bank, multilateral development bank, and public sector entity assets qualifying for 20% risk
weighting

15

Qualifying corporate debt securities rated AA- or higher

15

Qualifying covered bonds rated AA- or higher

15

Level 2B assets (maximum 15% of HQLAs)

Qualifying residential mortgage-backed securities

25

Qualifying corporate debt securities rated between A+ and BBB-

50

Qualifying common equity shares

50

Source: Basel Committee on Banking Supervision.

There has been considerable attention about the addition of RMBS to the HQLA definition because a large proportion
of this market was largely illiquid during the height of the financial crisis. However, the Basel Committee's qualification
criteria appear to restrict eligibility to high-quality securities where an active market is more likely to exist in a stress

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks

period. Among other items, the criteria include requirements that the bank holding the RMBS cannot be the issuer, and
that the bank or its affiliates cannot be the originators of the underlying loans. In addition, the underlying loans must
be full-recourse residential mortgages, which would exclude the nonrecourse loans common in several U.S. states,
including California. This may lead U.S. regulators to consider adapting the HQLA definition to reflect local market
features. A requirement for a maximum average loan-to-value (LTV) of 80% at issuance could also restrict the
eligibility of RMBS from countries such as The Netherlands, where the tax deductibility of mortgage interest
encourages higher LTV loans.
The Basel Committee's press release on the recalibration stated that it will continue to work on the interaction
between the LCR and the provision of central bank facilities. The aim of the HQLA definition (and the broader LCR
methodology) is to ensure that banks hold sufficient marketable assets to cope with moderate liquidity pressure
independently, without recourse to central banks. However, in a systemic liquidity crisis, central banks' "lender of last
resort" role remains fundamental to the creditworthiness of the banking sector, in our view. Banks' ability to generate
eligible collateral such as self-securitized RMBS and self-issued covered bonds in such cases is vital, such as for
eurozone banks that borrowed from the ECB's long-term refinancing operations. The Basel Committee's statement
suggests that it may give credit in future to self-generated central bank collateral in addition to the HQLAs. However,
the press release emphasized that the committee would ensure that banks hold sufficient marketable assets to prevent
central banks from becoming the "lender of first resort."
An unavoidable consequence of the common regulatory definition of HQLAs is that banks will load up on these assets
and will therefore be exposed if valuations are ever called into question. This risk has been illustrated recently by the
elevated and volatile yields on government debt of the so-called peripheral eurozone countries. Such bonds are
typically carried as available-for-sale assets, and price changes can cause material fluctuations in reported equity and
Basel III capital measures. In contrast, record-low yields on other countries' government bonds have been a drag on
the net interest margins and overall profitability of banks holding them. We note that the definition of level 1 HQLAs is
essentially unaffected by the LCR recalibration, and therefore still includes government bonds that are either rated
'AAA' to 'AA-' or issued by the bank's home sovereign (with additional criteria on currency risk). A tighter definition
would likely be unworkable in practice given that the LCR is intended to be a global standard. The tendency for banks
to hold material portfolios of home government debt is one of the reasons why we rarely rate banks higher than the
foreign currency rating on the sovereign where they are domiciled (see paragraphs 206-212 of "Banks: Rating
Methodology And Assumptions," published on Nov. 9, 2011).
The HQLA definition includes a range of national discretions for jurisdictions with insufficient liquid assets to meet
banks' aggregate demand. For example, countries with low levels of government debt, such as Australia and Middle
Eastern states, are able to establish committed central bank liquidity facilities to provide their banking systems with
level 1 assets. Although this will create some global inconsistencies, we view it as a necessary and practical solution to
address local market features.

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The Basel Committee's Revised Liquidity Ratio: A Necessary Recalibration--And A Concession To Banks

Attention Now Turns To The Net Stable Funding Ratio

The Basel Committee's press release on the LCR recalibration states that it will now move to a review of the NSFR,
which measures funding mismatches beyond the 30-day time horizon. Like the original LCR rules, the NSFR has been
criticized for being too restrictive, constraining banks' ability to undertake their main social function of transforming
short-term deposits into long-term loans. In light of the changes to the LCR, we expect a relaxation of the NSFR
methodology. In addition, the implementation date may be pushed a year later to January 2019, to coincide with the
LCR and the Basel III capital requirements. But a decision is unlikely to come anytime soon. The complexity of the
NSFR and the challenge of reaching agreement among the Basel Committee members mean that the review will
probably take a couple of years.

Related Criteria And Research

Special Report: Global Banks Still Have Years Of Regulatory Uncertainty Ahead, Feb. 12, 2013
How Enhanced Funding And Liquidity Disclosure Could Improve Confidence In The World's Banks, May 29, 2012
Basel III Proposals Could Strengthen Banks' Liquidity, But May Have Unintended Consequences, April 15, 2010
Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011
Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Additional Contact:
Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com

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