Explain and calculate the liquidity-risk ratios of Basel III, namely the required leverage ratio, LCR (liquidity coverage ratio) and NSFR (net stable funding ratio).
The idea
Basel III added three measures that ignore risk weights. The leverage ratio counts on-balance-sheet assets and off-balance-sheet items in total exposure without risk weighting. As a formula, the leverage ratio is Leverage = Tier 1 capital ÷ total exposure. The minimum is 3 percent, limiting leverage hidden by low risk weights. The liquidity coverage ratio (LCR) compares 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. As a formula, the liquidity coverage ratio is LCR = HQLA ÷ net cash outflows over 30 days. It must be at least 100 percent. Inflows count only up to 75 percent of outflows, so net outflows are at least 25 percent of gross outflows. The net stable funding ratio (NSFR) compares available stable funding with required stable funding over one year, with a weight on each liability and asset. As a formula, the net stable funding ratio is NSFR = available stable funding ÷ required stable funding. It must be at least 100 percent. Candidates mix up the horizons, forget the haircuts or inflow cap, or invert the NSFR.
Formulas
Basel III leverage ratio
Leverage = Tier 1 ÷ Exposure
- Tier 1
- Tier 1 capital
- Exposure
- total on- and off-balance-sheet exposure, unweighted
Minimum 3 percent. Using RWA in the denominator is the usual mistake.
Liquidity coverage ratio
LCR = HQLA ÷ (Out − min(In, 0.75 × Out))
- HQLA
- high-quality liquid assets after haircuts
- Out
- stressed cash outflows over 30 days
- In
- cash inflows over 30 days, after inflow rates
Must be at least 100 percent. Inflows are capped at 75 percent of outflows, so ignoring the cap overstates the ratio.
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
A one-year measure that must be at least 100 percent. Inverting the ratio is the usual slip.
A practice question
Which of the following correctly defines the Basel III leverage ratio?
- Total capital divided by risk-weighted assets, with a minimum requirement of 8% of those assetsWhy not: This is the risk-based total capital ratio, not the leverage ratio.
- Tier 1 capital over total exposure, including off-balance-sheet items, unweighted, minimum 3% - correct
- Tier 1 capital divided by risk-weighted assets, with a minimum requirement of 6% of those assetsWhy not: This is the risk-based Tier 1 ratio; the leverage ratio avoids risk weights.
- High-quality liquid assets divided by total assets, with a minimum requirement of 3% for banksWhy not: Mixes in liquid assets; the leverage ratio's numerator is Tier 1 capital.
The leverage ratio is a non-risk-based backstop: Tier 1 capital over total on- and off-balance-sheet exposure, at least 3%.
A harder one
Assume these weights. Available stable funding: capital 100%, retail deposits 90%, wholesale funding maturing within one year 50%. Required stable funding: cash 0%, government bonds 5%, residential mortgages 65%, corporate loans 85%. A bank has capital of USD 80 million, retail deposits of USD 200 million and short-term wholesale funding of USD 300 million; assets are cash USD 100 million, government bonds USD 150 million, residential mortgages USD 300 million and corporate loans USD 250 million. Its NSFR is closest to:
- 98.8%, below the 100% minimum - correct
- 139.8%, above the 100% minimumWhy not: Uses unweighted funding in the numerator instead of applying the available stable funding factors.
- 51.2%, below the 100% minimumWhy not: Divides by unweighted total assets (USD 800 million) rather than weighted required stable funding.
- 101.2%, above the 100% minimumWhy not: Inverts the ratio, dividing required by available stable funding.
ASF = 80 + 0.9 x 200 + 0.5 x 300 = 410. RSF = 0 + 0.05 x 150 + 0.65 x 300 + 0.85 x 250 = 415.0. NSFR = 410/415.0 = 98.8%, short of 100%.
The hardest tier
A bank's high-quality liquid assets, after haircuts and caps, are USD 120 million. Its 30-day stressed cash outflows are USD 200 million and its inflows, after applicable inflow rates, are USD 170 million. Using the Basel III LCR rules, the LCR is closest to:
- 400%Why not: Deducts the full inflows and ignores the cap of 75% of outflows.
- 240% - correct
- 60%Why not: Ignores inflows entirely and divides by gross outflows.
- 80%Why not: Sets net outflows at 75% of gross outflows instead of gross minus capped inflows (which gives 25%).
Inflows count only up to 0.75 x 200 = 150, so they are limited to 150 rather than 170. Net outflows = 200 - 150 = 50. LCR = 120/50 = 240%.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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