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Weigh up the liquidity ratios introduced under Basel III together with the BIS principles that define sound management of liquidity risk.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Liquidity Risk · FRM2.LTR.1.c

The idea

Basel III added two liquidity standards. The Liquidity Coverage Ratio compares the stock of unencumbered high-quality liquid assets (HQLA) with net cash outflows over a 30-day stress period, using the regulatory definitions, eligibility criteria, haircuts and inflow caps. Level 2 assets take haircuts and caps within the stock. Net outflows are outflows less inflows, with inflows capped at 75 percent of outflows. In ratio form, LCR = HQLA ÷ net cash outflows over 30 days. It must be at least 100 percent. The Net Stable Funding Ratio compares available stable funding with required stable funding over one year, also at least 100 percent, and it limits reliance on short-term wholesale funding. The BIS Principles for Sound Liquidity Risk Management place responsibility on the bank. They ask for a set liquidity risk tolerance, pricing of liquidity costs into business decisions, stress testing, a contingency funding plan, a cushion of liquid assets and disclosure. Do not confuse the LCR horizon with the NSFR horizon.

Formulas

Liquidity coverage ratio

LCR = HQLA ÷ NCO

HQLA
the stock of high-quality liquid assets
NCO
net cash outflows over a 30-day stress period

Must be at least 100%. Net outflows are outflows less inflows, with inflows capped at 75% of outflows, and Level 2 assets enter HQLA after haircuts and caps.

Net stable funding ratio

NSFR = ASF ÷ RSF

ASF
available stable funding, each liability and equity item weighted by its ASF factor
RSF
required stable funding, each asset weighted by its RSF factor

Must be at least 100% over a one-year horizon. Inverting it, or applying no factors to the amounts, are the usual errors; do not confuse its horizon with the LCR's 30 days.

Net cash outflows under the LCR inflow cap

NCO = Outflows − min(Inflows, 0.75 × Outflows)

Outflows
stressed cash outflows over 30 days
Inflows
stressed cash inflows over the same 30 days

The cap stops inflows netting away nearly all outflows. Applying 75% to the inflows themselves, rather than capping them at 75% of outflows, is the trap.

A practice question

From the question bank, with the reason each wrong option is wrong.

Under Basel III, the Liquidity Coverage Ratio (LCR) is defined as:

  1. available stable funding divided by required stable funding over a one-year horizon, with a minimum of 100%.Why not: Describes the Net Stable Funding Ratio, which has a one-year horizon.
  2. Tier 1 capital divided by total on- and off-balance-sheet exposure, with a minimum of 3%.Why not: Describes the leverage ratio, a capital measure unrelated to liquidity.
  3. unencumbered high-quality liquid assets divided by net cash outflows over 30 days of stress, minimum 100%. - correct
  4. liquid assets divided by total customer deposits, with a minimum of 30% in all circumstances.Why not: Invents a simple deposit coverage ratio; the LCR uses 30-day stressed net outflows, not total deposits.

LCR = stock of HQLA / total net cash outflows over 30 days under stress >= 100%. The NSFR is the longer-term structural counterpart.

A harder one

A bank has USD 90 billion of Level 1 assets, USD 400 billion of stressed 30-day cash outflows and USD 380 billion of stressed 30-day inflows. Applying the Basel III cap on inflows, its LCR is closest to:

  1. 450%Why not: Does not apply the cap: net outflows = 400 - 380 = 20, giving 90/20.
  2. 22.5%Why not: Ignores inflows entirely and divides HQLA by the gross outflows of 400.
  3. 78%Why not: Applies the 75% to inflows (285) rather than capping inflows at 75% of outflows.
  4. 90% - correct

Inflows are capped at 75% of outflows = 300. Net outflows = 400 - 300 = 100. LCR = 90/100 = 90%, below the 100% minimum.

The hardest tier

A bank has Level 1 assets of USD 60 million, Level 2A assets of USD 30 million (15% haircut) and Level 2B assets of USD 10 million (50% haircut); caps on Level 2 assets are not binding. Stressed 30-day outflows come from stable retail deposits of 300 (5% run-off), less stable retail deposits of 200 (10%), non-operational deposits from non-financial corporates of 250 (40%) and financial institution deposits of 120 (100%), all in USD million. Stressed inflows are USD 220 million. The LCR is closest to:

  1. 142% - correct
  2. 157%Why not: Omits the haircuts on Level 2A and Level 2B assets.
  3. 259%Why not: Ignores the 75% cap on inflows, so net outflows are 255 - 220 = 35.
  4. 35%Why not: Divides by gross outflows and ignores inflows altogether.

HQLA = 60 + 30 x 0.85 + 10 x 0.5 = 90.5. Outflows = 15 + 20 + 100 + 120 = 255. Inflows are capped at 75% x 255 = 191.25, so net outflows = 63.75. LCR = 90.5/63.75 = 142%.

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