Are we there yet ? Part I of a Series on Liquidity Risk

liquidity risk Basel IIIWe’re fast approaching the fifth year, post the global financial meltdown and the banking industry is still grappling with all the regulations that emerged, some, which are still in transition. On top of that, the global economic recovery is by no means rosy. Despite all of this, many banks are making immense efforts and allocating significant resources to meet the new uncertain regulatory future.

As we all know, the regulations whether local, regional or global are tougher, more prescriptive and are intended to have real bite. Problem is that regulations which have the right intentions, may well eventually lead to unintended consequences. If this is true, then should we not make revisions now rather than later; well that argument is raging on in the land of liquidity risk.

Ever since the Basel Committee released BCBS 188 “Basel III: International framework for liquidity risk measurement, standards and monitoring” back in Dec 2010, concern has been expressed on a variety of fronts on how these new standards would impact a bank’s business model. Let’s look at some of the arguments out there doing the rounds, from broadening the definition of a “high quality asset”, localisation, and derivatives margin implications to mention a few.

Does liquidity flow freely across borders during a stress? One would hope so. Basel III proposals require local LCRs (Liquidity Coverage Ratio) to be managed and maintained as per the agreed levels, and group entities need to provide hard evidence of intra-group movement of liquidity. Ironically during a protracted market stress, national interests, will seek to do just the opposite, rendering this exercise somewhat challenging.

Some of the big players out there might assign a higher degree of probability to the breakup of the Eurozone instead of considering it as just an outlier event. . Those who are pragmatic, with operations in troubled Eurozone countries are safeguarding their liquidity by constructing country specific balance sheets, contracting balance sheets wherever possible and ensuring any remaining funding gap is met locally and not from the group’s home territory. A wise move indeed, but not one that would go down well in those troubled local markets Spain, Portugal etc, where funding conditions are tense enough to begin with.

With the new tougher global margin requirements for derivatives coupled with demands of continuously complying with the LCR, it should not be surprising that the supply of eligible high quality collateral will not be able to keep up with demand. There’s a range of estimates being bandied about out there, but suffice to say the shortfall will run in the USD trillions. Taking this into account plus the fact that emerging markets for local government securities does not offer the same depth as US Treasuries or UK Gilt market, it is difficult to see how the Basel III liquidity requirements can remain intact in their current guise.

Banks in full realisation of this have demanded that the strait jacket definition of what can be included as part of the SHQLA (Stock High Quality Liquid Assets) needs to loosened and a more flexible approach, that doesn’t create a concentration of risk in any particular asset class or currency and or lead to greater pro-cyclicality should be adopted. With this in mind banks would like SHQLAs, to include equities, gold, and high quality ABS. Will the Basel Committee yield to these requests? Unlikely in my opinion, as it could be argued banks used a similar approach prior to the global financial crisis, with their local regulators to demonstrate that their hard to value assets were reliable sources of liquidity and could be converted at short notice. However during the crisis the reality was totally different. Unreliable valuations driven by internal pricing models, no transparent observable market pricing, limited number of market makers, lack of appreciation of the divergence of supposedly MTM (Mark to Market ) values and actual liquidation values caused fire sales and finally resulted in a flight to safety.

I hope you will join me next time as I continue to discuss this topic.

Ziauddin Ishaq is the Global Solutions Lead for Liquidity Risk at Oracle.

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