1. Regulatory Context

In response to the Basel Committee on Banking Supervision’s (BCBS) “Basel III: International framework for liquidity risk management standards, and monitoring,”1 (first published in December 2010) in October of 2013, the Federal Reserve Board (The Fed) formally proposed rules to adopt standards on minimum liquidity requirements specifically, the Liquidity Coverage Ratio (LCR). The Fed’s proposal is largely consistent with the BCBS’s standards on LCR, however the proposed US LCR is more stringent in certain requirements.2

The Federal Reserve Board’s formal proposal presents a marked shift from other regulatory regimes because the Fed’s proposal:

  • Applies more stringent rules on which assets meet the High Quality Liquid Asset (HQLA) criteria
  • Requires a higher rate of cash outflows for certain funding types
  • Accelerates the transition and implementation timeline

In summary, covered banks will be required to maintain a ratio that measures their ability to withstand a liquidity stress period as measured by:

LCR = High Quality Liquid Assets/Cash Outflows over a Stressed 30-day period

The Fed’s proposal imposes more stringent pressure on both the numerator and denominator elements of the LCR ratio. Coupled with an accelerated transition and implementation timeline, covered banks, especially those challenged with implementation issues probably found themselves struggling to meet the proposed January, 2015 deadline. For details pertaining to the differences between the Fed’s proposal and Basel’s guidelines and possible implications, please refer to the Appendix.

2. Overarching Concerns
Since the publication of its proposal in October 2013, the Fed has worked with financial institutions to address their concerns and finalize the proposal. Some of the overarching concerns and implementation considerations are summarized below:

2.1 More Realistic LCR Stress Test Assumptions

Considerations

Description To calculate LCR, covered banks should stress test their cash outflows to observe the behavior of their liquidity position under stressed conditions over a 30-day period. Covered banks have voiced concerns that some of the tests, such as the net contractual cash outflows test are too linear and do not take into account maturity behaviors and the product idiosyncrasies (especially those with call features) of certain funding types.3
People Minimal
Process Covered banks should carry out their own stress tests using the Fed’s guidelines and their own scenarios and sensitivities taking into account maturity and product specific behaviors of certain funding types. In our view, this could allow the covered banks to substantiate their concerns with empirical evidence as noted in their response to the Fed.
Technology We also believe covered banks should ensure that the integrity of the data inputs for their stress tests, (e.g. accurate maturity bands, product attributes, cash outflow rates, etc.) is of the highest quality and does not jeopardize the affectivity of the test results. Also, they should take steps to ensure their stress testing capabilities can carry out an integrated test taking into account second and third order effects across different lines of business (LOBs) and regions to maintain the consistency of their test’s approach and methodology.

2.2 Daily Calculation of LCR

Considerations

Description The Fed proposed that LCR be calculated daily, however covered banks have indicated that in light of other regulatory demands, the daily calculation of what could be considered an “accurate” LCR places a heavy burden on the overall organization from both a resource and cost perspective. They further state that the ability to calculate a daily LCR by January 2015 is almost impossible and may be in need of a shortcut in approach and methodology yielding that may involve less accurate metrics.3
People It is our view that the impact on a covered bank’s business operations may depend on its manual process to aggregate and calculate LCR. The more manual the process, the more human capital would be required to sustain a process to calculate a daily LCR. International banks subject to different local requirements would require timely coordination across functional areas and lines of businesses to help ensure that the resources with the correct skillset are in place to support the process.
Process Given the high frequency of the requirement, we believe regulators may be satisfied with a “light touch” daily LCR which could possibly influence covered banks to maintain two processes: calculate daily LCR and calculate monthly LCR. We feel that covered banks would need to maintain consistency, where applicable, in both processes. They would also need to substantiate the validity of any operating assumptions used to calculate the daily LCR. In summary, maintaining two separate processes may lead to inconsistent results and a complex operating model for covered banks with a large international/regional footprint. We also consider that it would be best if regulators felt the need to give guidance on whether covered banks should demonstrate the ability to report LCR on a daily basis or submit a daily LCR report to the Fed.
Technology Banks should consider having in place the technology capabilities to aggregate the inputs, stress test the cash flows, and calculate a daily LCR in a system’s environment with minimal manual intervention. Due to other regulatory demands such as Basel III Net Stable Funding Ratio, Intraday Liquidity Monitoring and BCBS’s Risk Data Aggregation among others, covered banks may want to consider a tactical approach to help comply with the daily LCR reporting requirements. But they should also give thought to outlining a strategic roadmap that can help balance regulatory demands and institutional appetite for IT investments.

2.3 Enhanced Definition of HQLA

Considerations

Description Covered banks proposed that the Fed take into consideration the uniqueness of the US markets and further review market liquidity and creditworthiness of assets in defining which assets qualify as HQLAs. They argue that the current definition of HQLA will force covered banks to hold onto low risk assets, stifling innovation and sound risk taking.3 (Please refer to the detailed response paper for specific recommendations on which assets should be included in HQLA. You can access it here.)
People Minimal
Process The definition of HQLA and its sub-levels (level 1, level 1b, etc.) are subjective in some aspects. Establishing a framework to assess and manage product attributes in the context of HQLA eligibility could help enhance covered banks efforts to optimize their HQLA inventory.
Technology In our view, adequate IT infrastructure that helps capture and manage product attributes and collateral management at the most granular level, would help covered banks substantiate HQLA requirements and optimize their HQLA inventory.

2.4 Requirement to separately calculate LCR for subsidiary companies

Considerations

Description Covered banks have highlighted the possibility of “trapped liquidity” resulting from delineating LCR calculations between the parent bank and its subsidiaries and holding companies.3 Imposing this division we feel could lead to a scenario where excess liquidity at a subsidiary or holding company is not accessible to the parent bank, leading to “trapped liquidity” that could not be included in the consolidated LCR calculations. Covered banks who must comply with the Foreign Banking Organization and International Holding Company (FBO/IHC) conversion requirements face an additional burden, since the Fed requires a different approach for the treatment of intra-entity cash flows, assets, and funding sources.
People Coordination across LOBs, regions, and functional areas to help define the bank’s legal and organizational structure and demystify the structural complexities of modern financial institutions should be considered.
Process Financial institutions should consider investigating any mitigating measures where the parent bank can transfer the “trapped liquidity’ under stress scenarios consistent with proposed guidelines. Having a defined framework and process in place could help the covered bank consolidate “trapped liquidity” at the parent bank level, and also draw down any “trapped liquidity” during times of stress.
Technology Capabilities that help define and maintain organizational hierarchies with supporting reference data management should be considered by covered banks to support efforts to facilitate a clearer view of their legal and operating organization structure. A sound foundation to manage entity reference data could help identify and utilize any “trapped liquidity.”

 

The Federal Reserve has taken a leadership position with its recent proposal. It has signaled to the market its regulatory emphasis with the accelerated implementation and transition timeline along with stricter rules on defining HQLAs and run-off rates on certain funding types.

Sources:

  1. Basel III: International framework for liquidity risk measurement, standards and monitoring,” Basel Committee on Banking Supervision, December 2010. Access here.
  2. Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards, and Monitoring,” Department of the Treasury, Office of the Comptroller of the Currency, Federal Register, November 29, 2013. Access here.
  3. Liquidity Coverage Ratio: Liquidity Risk Measurement, Standards, and Monitoring, Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, January 31, 2014. Access here.
Newsletter Contacts:

Samantha Regan
Janki A.Shah

Newsletter Authors:

Taehong Lee

 Appendix

A.1 Comparison of Federal Reserve proposal and BCBS guidelines (see here)

A.1.1 In-Scope Institutions

BCBS Guidelines Fed Proposal
  1. Banks with no specific guidance on level of assets
  2. No guidance on a modified LCR for smaller banks
  1. Banks with assets ≥$250 billion
  2. Banks with assets ≥$50 billion (modified LCR over 21-day stress period)

A.1.2 LCR Timing and Transition

Calendar Year BCBS Guidelines Fed’s Proposal
2015 LCR ratio of 60% LCR ratio of 80%
2016 LCR ratio of 70% LCR ratio of 90%
2017 LCR ratio of 80% LCR ratio of 100%
2018 LCR ratio of 90%
2019 LCR ratio of 100%

Possible Implications

It is our view that the accelerated timeline may impact firms that have in-flight Basel III compliance and/or liquidity risk management projects. The Liquidity Risk function has historically been a siloed function within Finance/Treasury and historically regulators did not require any detailed information specific to liquidity risk. Because of the lack of regulatory scrutiny, much of the information required to calculate the LCR may not be readily available. Identifying these data points, we believe, may require a coordinated effort across the organization to analyze existing data sources that provide the required data to a data mart, underpinning a liquidity risk reporting and analytics function. We have observed that in certain cases this has proven to be highly complex, because many of the data points require calculations and/or derivations, so the accelerated timeline and transition may require clients to reprioritize their book of work in order to achieve compliance by the new requirement dates.

Also the topic of regulatory compliance vs. process improvement becomes a more relevant topic. This is due to the fact that some liquidity risk projects have dual objectives; achieving regulatory compliance and best-in-class reporting and analytics. The accelerated implementation timeline may influence firms to reevaluate the economics of “must have” vs. “nice to have” liquidity risk reporting and analytics capabilities.
A.1.3 Definition of High Quality Liquid Assets

BCBS Guidelines Fed Proposal Differences in HQLA Definition
Level 1 Assets

  1. Central bank reserves (including required reserves)
  2. Marketable securities representing claims on/or guaranteed by sovereigns, central banks, public sector entities (PSEs) with 0% risk weights under standardized approach
  3. Sovereign and central bank debt securities with > 0% risk weight under international Basel II’s standardized approach
Level 1 Assets

  1. Excess Federal Reserve Bank balances (balances above reserve balance requirement)
  2. Foreign withdrawable reserves
  3. Securities issued or unconditionally guaranteed by the US Department of the Treasury
  4. Liquid and readily-marketable securities issued or unconditionally guaranteed by any other US government agency with full faith of the US government
  5. Certain liquid and readily marketable securities that are claims on, or claims guaranteed by, a sovereign entity, a central bank, or other PSEs (0% risk weights under standardized approach)
  6. Certain debt securities issued by sovereign entities. (0% risk weights under standardized approach)
Level 1 Assets

  1. Excludes required central bank reserves
Level 2A Assets

  1. Marketable securities representing claims on or guaranteed by sovereigns, central banks, PSEs or Multilateral Development Banks (MDBs). (20% risk weights)
  2. “Plain-vanilla,” senior corporate debt securities (including commercial paper) and covered bonds with a rating of AA- or higher
Level 2A Assets

  1. Certain claims on, or claims guaranteed by a US government sponsored enterprise (20% risk weights)
  2. Certain claims on, or claims guaranteed by, a sovereign entity or a multilateral development bank (20% risk weights)
Level 2A Assets

  1. Excludes securities issued by public service entities
  2. Excludes high investment grade corporate debt securities (included as level 2B assets instead)
Level 2B Assets

  1. Residential mortgage-backed securities (RMBS)
  2. “Plain-vanilla,” senior corporate debt securities (including commercial paper). A+ and BBB-
  3. Common equity shares
Level 2B Assets

  1. Publicly traded corporate debt securities provided they are investment grade (BBB- or higher)
  2. Publicly traded shares of common stock provided: it is included in the S&P 500 Index, non-domestic shares that are as liquid and readily-marketable as equities traded on the S&P 500
Level 2B Assets

  1. Excludes RMBS

Possible Implications

From a business perspective, we believe the stricter definition of HQLA may influence how clients structure their balance sheets. This could encourage them to hold higher quality assets that generally yield lower returns and impact their overall risk appetite, business strategies, and capital plans. Specifically, investments in any public service entities, financial companies, and structured products may be curbed since they would not be included in the stock of HQLA. We also believe the stricter definition may indirectly encourage clients to hold larger amounts of Federal Reserve notes and other low risk sovereigns. The concentration of investments in sovereigns could present a systematic risk in the event of a sovereign credit crisis such as one recently observed in the Eurozone.

From a technology perspective, optimizing HQLA and LCR may be a topic of consideration for firms. If missing data and/or poor data quality is the root cause for the less than optimal stock of HQLA, an optimization analysis similar to that of risk-weighted assets (RWA) optimization may be of value for some banks.

A.1.4 Peak Net Cash Outflow

BCBS Guidelines Fed Proposal
Net cumulative cash outflow on the 30th day Highest net cumulative cash outflow within the 30-day stress scenario period

A.1.5 Run-off rates on Funding Types

Category BCBS Guidelines Fed Proposal
Unsecured retail funding
Stable retail deposits 3% 3%
Other retail deposits 5% 10%
Other retail funding 100%
Retail-brokered deposits
Brokered deposits that mature 30 calendar days after the calculation date 10%
Reciprocal brokered deposits, entirely covered by deposit insurance 10%
Reciprocal brokered deposits, not entirely covered by deposit insurance 25%
Brokered sweep deposits, issued by a consolidated subsidiary, entirely covered by deposit insurance 10%
Brokered sweep deposits, not issued by a consolidated subsidiary, entirely covered by deposit insurance 25%
Brokered sweep deposits, not entirely covered by deposit insurance 40%
All other retail brokered deposits 100%
Unsecured wholesale funding
Non-operational, entirely covered by deposit insurance 20% 20%
Non-operational, not entirely covered by deposit insurance 40% 40%
Non-operational, from financial entity or consolidated subsidiary 100%
Operational deposit, entirely covered by deposit insurance 5% 5%
Operational deposit, not entirely covered by deposit insurance 10% 25%
All other wholesale funding 100% 100%
Commitments
Undrawn credit and liquidity facilities to retail customers 5% 5%
Undrawn credit facility to wholesale customers 10% 10%
Undrawn liquidity facility to wholesale customers 30% 30%
Undrawn credit and liquidity facilities to certain banking organizations 40% 50%
Undrawn credit facility to financial entities 40% 40%
Undrawn liquidity facility to financial entities 100% 100%
Undrawn liquidity facilities to special purpose entities (SPEs) or any other entity 100% 100%

Note: The proposal is expected to be finalized in the upcoming months. We will update the community once the finalized rule is published.

DISCLAIMER: This blog is intended for general informational purposes only, does not take into account the reader’s specific circumstances, may not reflect the most current developments, and is not intended to provide advice on specific circumstances. Accenture disclaims, to the fullest extent permitted by applicable law, all liability for the accuracy and completeness of the information in this blog and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professional.
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