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How Basel III liquidity rules could impact bank investment portfolios E-mail

Rules are not yet final, but banks should have a game plan for the possible outcomes
May 19, 2011
By Tony Meyer, Chief Investment Officer and Hammad Pirzada, Corporate Treasurer of The PrivateBank and Trust Co. With acknowledgement to Greg Zeikus and Dale Kleinschmidt.
This article reflects the opinions of the authors. It does not necessarily reflect the views of PrivateBancorp, Inc.
The wave of regulatory changes continues to sweep over the banking industry, with numerous additional measures still being considered. One of these is the coming of Basel III which, if enacted in its current form, may present numerous challenges to banks on many fronts. Recognition of the potential implications and preparation for them is crucial.

In its effort to promote a more resilient global banking industry, the Basel Committee has proposed several changes/regulations as part of the Basel III framework. Most banks are aware of the increased capital requirements, but the Basel Committee also focused its attention on measures to strengthen banks’ liquidity positions. The committee has proposed two minimum standards to achieve that goal. The first measure, known as the Liquidity Coverage Ratio (LCR), is designed to enhance the short term liquidity position of banks by ensuring that they carry sufficient high-quality liquid assets to help them withstand a significantly stressed 30 day period. The second measure, the Net Stable Funding Ratio (NSFR), is designed to promote longer term liquidity resilience by encouraging banks to obtain more stable funding on an ongoing basis. Our focus in this article is on the LCR.

The LCR is defined as:
Stock of High Quality Liquid Assets
Total net cash outflows over the next 30 days

High Quality Liquid Assets
To qualify as high quality liquid assets (HQLA), assets need to carry low credit risk, be of low duration, have low volatility and inflation risk, be unencumbered, and have been shown to be a desired asset under “flight to quality” situations.

For the LCR, high quality liquid assets are divided into two categories; Level 1 and Level 2. For U.S. banks, Level 1 assets primarily include cash, and securities issued or explicitly guaranteed by the U.S. government or other highly rated 0% risk-weighted sovereigns.

Level 2 assets, which are limited to 40% of a bank’s stock of liquid assets after haircut, will consist of other securities considered to be high quality liquid securities that carry a 20% risk weighting under the Basel II framework. It is likely that this category will include conventional agency Mortgage Backed Securities (MBS), and covered and non-financial corporate bonds rated AA- or higher.

As it is currently written, Basel III will likely push banks to carry a larger proportion of sovereign debt or debt with explicit sovereign backing (such as Ginnie Mae securities) in their investment portfolios, which tend to be lower yielding assets. Alternatively, banks may choose to term-out their deposits to reduce the potential cash outflows in a 30 day period. The combination of lower yielding assets and longer, higher-cost, liabilities (which may also help satisfy the Net Stable Funding Ratio) that would likely be the consequence of the LCR requirement could significantly impact the earnings capability of a bank’s investment portfolio and net interest margin.

Total Net Cash Outflows
Total net cash outflows over 30 days = Outflows – inflows, up to a maximum of 75% of outflows

Expected outflows are determined by multiplying the balance of various types of non-maturity deposits or time deposits and other liabilities that mature or are callable within 30 days and off-balance sheet commitments by the run-off rates specified for various defined categories of liabilities. Similarly, expected cash inflows are determined by applying a factor to the contractual receivables of the institution—however, they are capped at 75% of expected cash outflows. These estimates will likely need to be calculated under assumed stressed scenarios.

As it is currently written, the guidelines apply relatively heavy run-off rates to commercially oriented deposits. This would create a potentially significant amount of assumed cash outflows in a 30 day period, and possibly drive commercially oriented banks to carry a significant amount of relatively low-yielding “liquid” assets.

Higher capital requirements combined with greater levels of liquid assets being carried does not bode well for the earnings potential of banks in the future.

Timing and impact
Both the LCR and NSFR will go through an observation period starting in 2011. After any adjustments required to address issues noted during this period, the LCR will be introduced on Jan. 1, 2015.

Implementation of the liquidity measures under Basel III is still a long way off. It is anticipated that the Dodd-Frank Act will converge with Basel III. However, until U.S. regulators adopt rules to implement Basel III, there will not be total clarity on what the initial implications will be for the banking industry.

If the implementation of Basel III in the U.S. follows a similar timeline to its predecessor, banking institutions are likely to have ample time to adjust. Additionally, many variables remain unknown, including which, if any, parts of these proposed standards U.S. regulators will choose to impose. And to which institutions they will apply. As written, the standards appear to be directed towards large, internationally active banks. However, it is possible that these standards may still form the basis for future regulation applied to all banking entities, and may have a disproportional effect on smaller banks with limited access to capital markets.

Additionally, if GSE reform results in some form of an explicit guarantee being attached to conventional MBS, these securities could potentially fall into the Level 1 asset category.

As written, the LCR, along with other aspects of Basel III, may have unintended consequences such as an increase in the cost of liquidity that does not bode well for bank earnings or ROE going forward. This additional cost of liquidity may be passed on to bank customers through product pricing, potentially hurting the consumer in the end. Additionally, the LCR potentially pushes bank’s asset concentrations into relatively few asset groups, thus altering the economic appeal of those assets and market dynamics in those asset classes. Implementation of the LCR may have consequences not only for banks but also consumers and the overall economy. With this in mind, thorough analysis should be conducted to quantify any potential implications of implementation of this measure to minimize unintended consequences.

With so much uncertainty still remaining, measures to achieve full compliance with the LCR are currently difficult to justify. It would be prudent, however, for banks to recognize the potential implications and to have a game plan in place for such occurrence.
[This article was posted on May 19, 2011, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2011 by the American Bankers Association.] 
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