Bank Liquidity Requirements:
Basel Oversight Committee Endorses Revised
Liquidity Standards and Extends Fully Phased-In
Compliance to 2019
January 8, 2013
On January 6, the Group of Central Bank Governors and Heads of Supervision, the oversight
body for the Basel Committee on Bank Supervision (the “Basel Committee”), endorsed a revised
formulation of the new minimum liquidity standard, known as the liquidity coverage ratio(“LCR”), 1 one of two quantitative liquidity measures approved in December 2010 as part ofBasel III. Recognizing the need to continue to support the worldwide economic recovery, whileensuring that global banks maintain liquid assets sufficient to meet their short-term cash needs
during times of stress, members of this Basel oversight group supported a package with three
key modifications and clarifications to the LCR that:• expand certain categories of assets included as high quality liquid assets (“HQLA”),
subject to certain limitations, and adjusted the assumptions regarding “cash outflows” tobetter reflect actual reactions to stress;• extend the timetable for full phase-in of the LCR from 2015 to 2019, to correspond with thephase-in period for the Basel III capital rules; and• clarify that banks may use their stock of HQLA in periods of stress, including during thetransition period – such that banking organizations would not be expected to maintain
100% coverage during such periods – subject to direction by their home country banking
regulators.

BACKGROUND
In the wake of the global financial crisis, the Basel Committee, which consists of senior
representatives of bank supervisory authorities and central banks from 27 countries, including
the United States, observed that many banks, even those with adequate capital levels, lacked
sufficient liquidity to withstand short-term economic and financial stress. In response, the BaselCommittee formulated a requirement that banks have an adequate stock of unencumbered highquality liquid assets that can be converted “easily and immediately in private markets intocash” to survive a significant stress scenario lasting 30 calendar days. This requirement, whichis part of Basel III, is intended to improve the banking sector's ability to absorb shocks,
whatever the source, thereby reducing the risk of spillover from the financial sector to the realeconomy.
1BCBS, Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools (Jan. 2013). Available at:
http://www.bis.org/publ/bcbs238.htm.

Memorandum – January 8, 2013

Introduced in December 2010, the LCR is the quotient of two components: (a) the value of abanking organization’s HQLA in stressed conditions, divided by (b) its total expected net cash
outflows over the next 30 calendar days under stressed scenarios. 2 The minimum LCR is 100%.
Under this standard, HQLA must be unencumbered and should be liquid during a time ofstress. 3 The revised standard describes in detail the characteristics that assets must have to beincluded in HQLA 4 and provides specific examples of the type of assets that have thosecharacteristics. HQLA is composed of two levels of assets: Level 1 assets, which may be held in
unlimited amounts, generally include cash, central bank reserves, and certain marketablesecurities issued or backed by sovereigns and central banks. 5 These assets are typically of thehighest quality and the most liquid. Level 2 assets, generally composed of certain governmentsecurities, 6 covered bonds and corporate debt securities, 7 are subject to a 15% haircut before
2The stress scenario contemplated by the revised standard is a combination of bank-specific andmarket-wide events, similar to the shocks that occurred in 2007, including: (a) some retaildeposits run-off; (b) a partial loss of unsecured wholesale funding capacity; (c) a partial loss ofsecured, short-term financing with certain collateral and counterparties; (d) additional
contractual outflows that would arise from a downgrade in the bank’s public credit rating by up
to and including three notches, including collateral posting requirements; (e) increases in market
volatilities that impact the quality of collateral or potential future exposure of derivative positions
and thus require larger collateral haircuts or additional collateral, or lead to other liquidity needs;(f) unscheduled draws on committed but unused credit and liquidity facilities that the bank has
provided to its clients; and (g) the potential need for the bank to buy back debt or honor noncontractual obligations in the interest of mitigating reputational risk.

3The revised standard also notes that, ideally, HQLA should also be central bank eligible for
intraday liquidity needs and overnight liquidity facilities, although the fact that an asset class iscentral bank eligible does not necessarily make it HQLA-eligible.

4

All HQLA assets must be traded in large, deep and active repo or cash markets that arecharacterized by a low level of concentration; and have a proven record as a reliable source ofliquidity in the markets (repo or sale) even during stressed market conditions. As to the latterrequirement, some asset categories also require that price declines or discounts during historicalperiods of stress should not have exceeded specific percentages, ranging from 10% to 40%.
Banking organizations will need to be prepared to support the historical performance of certain
asset categories under stressed conditions.

5Generally, marketable securities issued or guaranteed by sovereigns, central banks, public sector
entities, multilateral banks and similar organizations specified in the revised standard must carry
a 0% risk-weight under Basel II to be included as Level 1 HQLA, in addition to meeting otherfactors. Banking organizations, however, may hold marketable securities without a 0% riskweight that are issued or guaranteed by sovereigns and central banks of countries in which theliquidity risk is being taken, or in the banks’ home countries.

6Generally, marketable securities issued or guaranteed by sovereigns, central banks, public sector
entities, multilateral banks and similar organizations specified in the revised standard must carry
a 20% risk-weight under Basel II to be included as Level 2 HQLA, in addition to meeting otherfactors.
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Memorandum – January 8, 2013

inclusion in HQLA and may not in the aggregate account for more than 40% of a bank’sHQLA. 8
The denominator of the LCR is the organization’s total net cash outflows, which are defined as
total expected cash outflows, minus total expected cash inflows, under the specified stressscenario for the subsequent 30 calendar days. 9 Total cash inflows are subject to an aggregate
cap of 75% of total expected cash outflows, thereby ensuring a minimum level of HQLA
holdings at all times.
In addition to defining in detail the components of LCR, the revised standard describes
operational requirements designed to ensure HQLA is available when needed. For example,
banking organizations (i) should periodically monetize a representative proportion of theirHQLA, through sales or repurchase transactions, to demonstrate their liquidity; (ii) must
maintain all HQLA stock under the control of the function charged with maintaining the bank’s
liquidity (generally, the treasury function), and (iii) may be prohibited from including in theconsolidated HQLA assets held within operating units (i.e. at the bank level). 10
7Qualifying corporate debt securities (including commercial paper) include only plain-vanilla
assets with readily available valuations based on standard methods that do not depend on
private knowledge. These would not include complex structured products or subordinated debt.
Qualifying corporate debt securities and covered bonds may not be issued by financial
institutions and must either (i) have a long-term credit rating from a recognized external credit
assessment institution of at least AA-, or in the absence of a long term rating, a short-term rating
equivalent in quality to the long-term rating; or (ii) have been internally rated as having aprobability of default corresponding to a credit rating of at least AA-.

8Home country supervisors may also choose to include within Level 2 assets an additional class ofassets (Level 2B), which may not account for more than 15% of a bank’s total stock of HQLA. The
40% cap on all Level 2 assets and the 15% cap on Level 2B assets should be determined after theapplication of required haircuts, and after taking into account the unwind of short-term securities
financing transactions and collateral swap transactions maturing within 30 calendar days thatinvolve the exchange of HQLA.
Under the revised standard, Level 2B assets would include certain corporate debt securities(including commercial paper) with external ratings between A+ to BBB-, or equivalent internalratings (subject to a 50% haircut); RMBS externally rated at least AA (subject to a 25% haircut);and exchange-traded and centrally-cleared common equity shares, provided the issuer is aconstituent of a major stock index in the home jurisdiction where the liquidity risk is taken(subject to a 50% haircut).

9

Total expected cash outflows are calculated by multiplying the outstanding balances of various
categories or types of liabilities and off-balance sheet commitments by the rates at which they areexpected to run off or be drawn down. Total expected cash inflows are calculated by multiplying
the outstanding balances of various categories of contractual receivables by the rates at which
they are expected to flow in.

10The operating units’ net cash outflows must be included in the LCR calculations in order for anyliquid assets they hold to be included in the consolidated HQLA. Importantly, any surplus ofHQLA held at the operating level could only be included in the consolidated HQLA stock if thosePage 3

Memorandum – January 8, 2013

MORE ASSETS ELIGIBLE FOR HQLA
Most notably, the revised LCR standards includes as Level 2B assets the following:• corporate debt securities (including commercial paper) rated A+ to BBB–, subject to a
50% haircut;• certain unencumbered equities, subject to a 50% haircut; and• certain residential mortgage-backed securities (“RMBS”) rated AA or higher, subject toa 25% haircut. 11

NET CASH OUTFLOWS
The revised standard also makes refinements to the assumed cash inflow and outflow rates, tobetter reflect actual experience in times of stress. The Basel Committee reduced the outflow
stress levels on certain fully insured deposits, insured and uninsured “non-operational”
deposits of non-financial companies, and committed liquidity facilities to non-financial
companies, as shown in the Appendix. With regard to derivatives and commitments that arecontractually secured by HQLA, the LCR assumes a net cash outflow of 0%; however,additional derivatives risk (generally related to collateral substitution or excess collateral thatthe bank is contractually obligated to return upon request of the counterparty) is fully includedin the LCR with a 100% outflow assumption. The LCR also introduces a standardized approach
for liquidity risk related to market value changes in derivatives positions. These and otherchanges made by the revised standard are shown in the attached Appendix.

DELAYED IMPLEMENTATIONThe LCR will be subject to phase-in arrangements that align with those that apply to the BaselIII capital adequacy requirements. Specifically, the LCR will be introduced as planned onJanuary 1, 2015, but the minimum requirement will begin at 60%, rising 10 percentage points
each year thereafter to reach 100% on January 1, 2019, as shown in the table below.

Minimum LCR requirement

20152016

2017

2018

2019

60%

70%

80%

90%

100%

assets would also be freely available to the consolidated (parent) entity in times of stress. Undercertain conditions, banking regulations may prevent a bank subsidiary from transferring assets toits parent.
11The underlying mortgages of eligible RMBS must be “full recourse” loans that have a maximum
loan-to-value (“LTV”) ratio of 80% on average at issuance. In addition, the RMBS must be subject
to risk retention rules, and the banking organization holding the RMBS as HQLA may not be theissuer, or originator of the underlying mortgages.
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Memorandum – January 8, 2013

During periods of stress, the revised standard notes, “it would be entirely appropriate for banks
to use their stock of HQLA, thereby falling below the minimum.”

AREAS OF FURTHER STUDYAs deposits with central banks are one form of liquidity, the interaction between the LCR andthe provision of central bank facilities is expected to be studied in the coming year. In addition,
the Basel Committee will continue to develop disclosure requirements for bank liquidity andfunding profiles and will continue to explore the use of market-based indicators of liquidity tosupplement the existing measures based on asset classes and credit ratings.

RESPONSE OF U.S. REGULATORS
Early last year, the Federal Reserve announced that it intends, in conjunction with other federalbanking agencies, to implement the Basel III liquidity standards for LCR in the United States
through one or more separate rulemakings. The Federal Reserve anticipates that the Basel III
liquidity rules will be a central component of the enhanced liquidity requirements required bySections 165 and 166 of Dodd-Frank. One challenge U.S. regulators will face in adopting thisrulemaking will be their inability to use credit ratings as a measure of risk for certain asset
classes, like RMBS. While qualified RMBS is defined under the revised standard by reference tocredit ratings, Dodd-Frank prohibits regulators from using such credit ratings in theirrulemakings.
Under Dodd-Frank, the Federal Reserve issued proposed rules in 2012 that would establish
liquidity risk management standards for certain U.S. bank and thrift holding companies andnon-banking companies designated as systemically important (See Simpson Thacher memofrom January 2012, here), as well as the U.S. operations of certain large foreign bankingorganizations (See Simpson Thacher memo from December 2012, here). These proposed rules
will subject these organizations to a set of enhanced liquidity risk management standards,
including liquidity stress testing, that increase in rigor for larger organizations. The LCR
requirements of Basel III are expected to be adopted under separate rulemakings as“quantitative liquidity requirements” that complement the enhanced liquidity risk measures
proposed last year.

NEXT STEPSHaving completed work on the LCR, the Basel Committee will be reviewing next the second
liquidity metric, the net stable funding ratio (“NSFR”), which supplements the LCR. Designedto promote resilience over a longer time horizon of one year, the NSFR creates incentives forfinancial institutions to fund their activities with more stable sources of funding. The BaselCommittee intends that the NSFR will become the minimum standard by January 2018.

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Memorandum – January 8, 2013

For more information, please contact a member of Simpson Thacher’s Financial Institutions
Group:Lee Meyerson(212) 455-3675
lmeyerson@stblaw.com

Stacie E. McGinn(212) 455-2250
smcginn@stblaw.com

Maripat Alpuche(212) 455-3971
malpuche@stblaw.com

Elizabeth Cooper(212) 455-3407
ecooper@stblaw.com

Mark Chorazak(212) 455-7613
mchorazak@stblaw.com
This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

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Memorandum – January 8, 2013

APPENDIX
Changes to Cash Outflow Calculations

Insured deposits• Reduce outflow on certain types of fully insured retail deposits from 5% to 3%.
• Reduce outflow on fully insured non-operational deposits from non-financial corporates,
sovereigns, central banks and public sector entities (“PSEs”) from 40% to 20%.
Non-financial corporate deposits (not insured)• Reduce the outflow rate for “non-operational” deposits provided by non-financial
corporates, sovereigns, central banks and PSEs from 75% to 40%.
Committed liquidity facilities to non-financial corporates• Clarify the definition of liquidity facilities and reduce the drawdown rate on the unused
portion of committed liquidity facilities to non-financial corporates, sovereigns, central
banks and PSEs from 100% to 30%.
Committed but unfunded inter-financial liquidity and credit facilities• Distinguish between interbank and inter-financial credit and liquidity facilities and reduce
the outflow rate on the former from 100% to 40%.
Derivatives• Additional derivatives risks included in the LCR with a 100% outflow (relates to collateralsubstitution, and excess collateral that the bank is contractually obligated toreturn/provide if required by a counterparty).
• Introduce a standardized approach for liquidity risk related to market value changes inderivatives positions.
• Assume net outflow of 0% for derivative payments that are contractually
secured/collateralized by HQLA, assuming the bank is legally able to re-use the collateralupon payment.
Trade finance• Include guidance to indicate that a low outflow rate (0–5%) is expected to apply.
Equivalence of central bank operations• Reduce the outflow rate on maturing secured funding transactions with central banksfrom 25% to 0%.
Client servicing brokerage• Clarify the treatment of activities related to client servicing brokerage (which generally
lead to an increase in net outflows).

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Memorandum – January 8, 2013

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