Basel III is forcing banks to innovate

New liquidity requirements demand both stable financing and attractive products

Basel III is forcing banks to innovate

The financial crisis emphasizes the capital and liquidity risks in the financial world. The new Basel III framework was published in December 2010 in order to control these risks better. While Basel II is focused chiefly on counterbalancing losses by capital buffers, Basel III goes a step further. In addition to stricter capital requirements, the new directives of Basel III impose more explicit requirements on the liquidity position of banks. The combination of these requirements in particular makes it more difficult for banks to find the optimum balance sheet ratios.

Although the international directives for controlling liquidity risk are new, minimum quantitative requirements for Dutch banks have already been in effect since 2003. As part of pillar 2 of Basel II, De Nederlandsche Bank (DNB) periodically assesses the liquidity position of banks going out one week and one month

Current Dutch supervision

The Dutch banking supervision authorities have extensive experience in the area of liquidity supervision. Minimum quantitative requirements, based on a standard reporting framework, were introduced in their original form in 2003. The standard reporting framework is a component of Basel II’s pillar 2 and is tested by DNB. These requirements demand in particular that the available liquidity in the following week and following month must be greater than the required liquidity for those periods.

The available and required liquidity are calculated on the basis of weighting factors prescribed by DNB. For all balance sheet entries, as well as for off-balance-sheet entries, the contribution to the available or required liquidity is calculated as a percentage of the market value or the expected cash flows.

In May 2011 the rules for liquidity supervision were refined in new regulations. The main changes concern the level of the weighting factors and the scope to impose additional liquidity requirements. Both lead to higher liquidity requirements in most cases. With these changes DNB has anticipated the introduction of the new international directives, and they can be regarded as a step towards the Basel III requirements.

Basel III directives for liquidity

Basel III imposes both quantitative and qualitative measures in the area of liquidity. Strict requirements are imposed on two new liquidity ratios, as follows:

  • The Liquidity Coverage Ratio (LCR) represents the ratio between the existing and required liquidity within a 30-day horizon.
  • The Net Stable Funding Ratio (NSFR) shows the ratio between the existing and required stable financing, whereby a distinction is made between products with a short and long duration and off-balance sheet entries.

The LCR and the NSFR must be 100% at minimum.

The report to the supervisor contains five quantitative monitoring tools, pertaining to the mismatch between the incoming and outgoing flow of money, the concentration risk, the non-pledged assets, the LCR per currency and several market indicators.

  • Basel III seeks to match the financing with the investments, which means that the durations of financial instruments are more in keeping with each other. To that end all incoming and outgoing cash flows must be allocated to different time intervals.
  • The concentration of financing should remain limited. The focus is on concentration in counterparties, products and/or instrument and currencies.
  • Basel III also looks at the volume of non-pledged assets. These assets could be used as security when raising finance in the future, and therefore provide an indication of the scope for financing in the future.
  • The LCR per significant currency gives an indication of the available and required liquidity per currency. This could reveal a potential currency mismatch.
  • The LCR per significant currency gives an indication of the available and required liquidity per currency. This could reveal a potential currency mismatch.

The qualitative measures are an expansion of the evaluation by the supervisor (Supervisory Review and Evaluation Process, SREP) of the strategies and procedures for risk management. By means of the so-called ‘Internal Liquidity Adequacy Assessment Process’ (ILAAP), supervisors can assess the management of liquidity risk and impose additional liquidity requirements if necessary. The monitoring tools are an important component of the ILAAP.

Although the first Basel III liquidity requirements will not be officially introduced until 2015, DNB is already retrieving the new requirements for the LCR and NSFR now. This information is used to carry out an impact study and to follow banks’ migration towards the new requirements. In order to set the migration of banks towards Basel III in motion, the banks will moreover have to submit an extensive migration plan to DNB.

Comparison between the current and the new rules

The current one-month DNB liquidity test shows similarities with the LCR proposed in Basel III. The NSFR has a one-year time horizon, which is longer than the current requirements imposed by DNB, and is thus an expansion of the framework for liquidity supervision.

Liquidity Coverage Ratio

The most important similarities and differences between the LCR and the one-month DNB liquidity test are explained below.

  • The LCR per significant currency gives an indication of the available and required liquidity per currency. This could reveal a potential currency mismatch.
  • However, the calculation of both standards is different:
    • The LCR distinguishes between the presence of liquid resources and cash flows. The numerator of this ratio indicates that there are liquid assets of ‘high quality’, such as bank balances and cash reserves. The denominator presents the net cash flow within 30 days (the difference between incoming and outgoing cash flows).
    • In the DNB liquidity test, the current liquidity comprises both the liquid assets and the incoming cash flows. The required liquidity is the product of the outgoing cash flows. The difference between the two results in the liquidity position.

The LCR is set up in such a way that sufficient liquid resources must be present for the expected net outgoing flow, the so-called LCR buffer. The DNB liquidity test simply compares all positive and negative contributions to the liquidity. A simplified balance sheet illustrates this difference:

  • Calculation of the current liquidity in the LCR is tied to stricter conditions. For example, the net liquidity outflow must be at least a quarter of the outgoing cash flow. Thus the inflow must not exceed 75% of the outflow; any extra inflow is not included in the calculation of the LCR.

Net Stable Funding Ratio

The NSFR compares the available liquidity with the required liquidity. The design of the NSFR thereby corresponds with the existing DNB liquidity test. However, the NSFR does have a longer time horizon than the LCR and thus assesses a different aspect of the liquidity position, which is not included in the current DNB liquidity framework. Just as in the case of the LCR, the current and required financing is equal to the sum of the weighted liquidity values. Products with a duration of one year and longer are given a higher weighting factor for both the current and the required stable financing. The NSFR stimulates the use of long-term financing for credit put out for long periods, or matched financing.

The consequences for Dutch banks

Basel III leads to stricter requirements imposed on the liquidity position of banks. While the capital requirements used to prevail, banks must also maintain ample adequate liquid resources (of high quality) under Basel III. Despite the fact that the Netherlands was already a front runner internationally in this area, the Dutch banks will also have to evaluate and (re-) optimize their liquidity management and balance sheet ratios. The example below shows how banks will have to reconsider their strategy.

Example 1

The table below shows the balance sheet of a fictitious Dutch bank, which consists of a combination of retail and corporate loans and savings/deposits. Inter-bank relations are also shown.

The balance sheet distinguishes between ìshort term’ and ‘long term’, in accordance with Basel III. ‘Short term’ indicates less than 30 days, and ‘long term’ more than one year. For the sake of simplicity, durations between these two are not considered in this example.

In addition to the total per balance sheet entry, the Basel III weighting factors are included. The Basel III liquidity ratios NSFR and LCR are calculated on the basis of these weighting factors, as shown at the bottom of the table. Both ratios, NSFR and LCR, are higher than 100%, namely 120% and 110% respectively. Thus in terms of these two ratios, the bank meets the Basel III requirements.

Even so, there are considerable mismatches between short-term lent funds (1,580) versus short-term borrowed funds (3,200), and between long-term lent funds (8,570) versus long-term borrowed funds (6,950). Under a normal yield curve, such a mismatch will yield a profit margin.

Calculation of the liquidity ratios:

NSFR = available stable financing / required stable financing = (800+0.8*(2,500)+2,000+2,950+1,200)/(0.85*150+0.65*4,300+0.5*130+2,300+2,200) = 120%

LCR = liquid assets / net cash outflow = 4*(70+70*2/3)/(0.1*2,500+0.25*700) = 110%

Let us assume that market conditions deteriorate, for instance because customers are withdrawing more savings than usual. For now we will assume that funds in term deposits are not withdrawn (given the usual penalty for early withdrawals). In this example customers withdraw 2,200 of short-term retail savings. This will create a financing problem for the bank. The bank could deal with this by raising short-term loans from other financial institutions.

During financially uncertain times this will prove difficult. Let us assume that the bank cannot secure all the required funding by borrowing from other financial institutions. For instance, only 1,660 of the withdrawn savings can be covered by short-term inter-bank borrowing. The liabilities side of the balance sheet now has a shortfall of 540.

To get its balance sheet back in order, the bank can make changes to the assets side. For instance, it could raise charges and/or call in loans, although that would be commercially unattractive. But if such measures were to reduce short-term loans by 540, the balance would be restored.

Example 2

Calculation of the liquidity risks:

NSFR = available stable financing / required stable financiering = (800+0.8*(300)+2,000+2,950+1,200)/(0.85*75+0.65*4,150+0.5*65+2,300+2,200) = 99%

LCR = liquid assets / net cash outflow = (70+70*2/3)/((0.1*300+0.25*2,360)-250-0.5*65-150*0.5-0.5*75) = 52%

In the table above, both liquidity ratios have now dropped below 100%. At this point the bank would not meet the Basel III requirements, and it will have to take action to raise the liquidity ratios back above 100%.

If the turmoil in the financial markets were to continue, then the short-term inter-bank funding might not be available in the future. In that case the bank faces a serious risk in the form of a potential liquidity squeeze. Let us assume that 1,000 of the funding from financial institutions cannot be renewed. The bank’s problems will then be exacerbated, and it will have to do something to retain its retail customers.

Because of the favourable weighting of retail deposits, Basel III offers the bank a clear incentive to focus on this. Regaining customers is not easy and will require product innovation. For instance, the bank could decide to launch a new kind of account. Its terms and conditions should lead to a stable financing situation. Thus the bank could opt for a combination of accounts in which the customer is required to deposit his or her salary into the account and to save a set amount.

Additionally, commercially attractive incentives for customers could also be considered. In that case the account would fall under a different category of the Basel II conditions. Thus for amounts on these accounts, the NSFR factor for available stable financing might be 90% rather than 80%. The LCR factor would also change from 10% to 5%. In this example we assume an inflow of retail savings of 1,000.

In addition to this shift in financing to retail, this example also assumes that the bank is able to convert part of its retail loans into residential mortgages. This change would only have an effect over time, because these loans are new ones. To see the long-term impact of the new strategy, we will shift 1,000 retail loans to mortgages. As a result of these changes the liquidity ratios rise to 117% (NSFR) and 115% (LCR). So the bank meets the Basel III requirements again.

Calculation of liquidity ratios:

NSFR = available stable financing / required stable financing = (800+0.9*(1,300)+2,000+2,950+1,200)/(0.85*75+0.65*5,150+0.5*65+1,300+2,200) = 117%

LCR = liquid assets / net cash outflow = 4*(70+70*2/3)/(0.05*1,300+0.25*1,360) = 115%

The above examples illustrate that the bank has to be innovative with regards to its products. The Basel III requirements make it more difficult for banks to turn a profit in the usual way. In terms of balance sheet management, the stability of commercial products and financing becomes very important.

The ability to attract new customers will depend in part on marketing. Competition on price will have its limitations, given that the aspect of “matched financing” will be in the background. Product innovation coupled with balance sheet management will play a pivotal role.

Conclusion

The duration of investments and their financing must be more in keeping with each other due to the new requirements. However, banks make a (substantial) part of their profit by entering into a deliberate mismatch. Therefore, Basel III forces banks to make a choice between a lower yield, higher product prices and/or the introduction of new products.

In the period prior to Basel III, this was the reason behind an increase in the profit surcharge of various products (e.g. credits). This development is expected to continue in the near future. The new regulations challenge banks to develop products that are regarded as stable financing and remain attractive to their customers. The current challenge to banks is to find a new balance between profitability, customer orientation and product innovation.