Grant Spencer: Comments on the Basel liquidity standards and central
bank operations
Remarks by Mr Grant Spencer, Deputy Governor and Head of Financial Stability of the
Reserve Bank of New Zealand, at the tenth Asia-Pacific High-Level Meeting on Banking
Supervision, Auckland, 27 February 2014.
* * *
Introduction
While sourced in sub-prime credit losses, the Global Financial Crisis (GFC) was felt by most
countries, including Asia Pacific countries, as a massive liquidity shock. This was felt in
banking systems as a loss of market liquidity (ability to sell assets) and as a loss of funding
liquidity (ability to issue securities).
The immediate policy response was for central banks to provide large doses of liquidity to the
banks and for governments to provide guarantees on bank debt securities. Most of these
measures were subsequently pulled back as market and funding liquidity was restored in
2009.
The longer term policy response to the unprecedented liquidity shock of the GFC has been
two-fold: central banks have strengthened and broadened their capability as system liquidity
providers, and prudential regulators have begun to strengthen liquidity requirements for
banks. Central banks have become better prepared to respond to systemic liquidity shocks in
their various forms, and at the same time new prudential standards are requiring banks to be
better prepared to withstand liquidity shocks on their own account.
The topic I wish to discuss here is the extent to which the new Basel liquidity requirements
may have implications for central banks' policy operations, and vice versa. I will discuss the
extent of alignment between the two policy arms as well as some potential implications of the
Basel III standards for central banks' policy operations.
Basel III liquidity standards
The maintenance of prudential liquidity standards is fully consistent with the central bank's
public policy function of system liquidity support. Banks left to their own devices may hold
liquidity buffers that are less than socially optimal, due to:
1. banks not allowing for systemic externalities that can result from liquidity shortages;
and
2. banks potentially relying on the central bank to offset systemic liquidity shocks,
thereby creating moral hazard effects.
New Basel III standards will start to be introduced from January 20151 with the Liquidity
Coverage Ratio (LCR), to be followed in January 2018 by the Net Stable Funding Ratio
(NSFR). These standards are intended to strengthen banks' ability to independently
withstand liquidity shocks, by holding sufficient liquid assets to withstand a 30-day name
crisis (the LCR) and to reduce the inherent maturity mismatch in banks' balance sheets
(NSFR)2
In specifying the LCR, the Basel Committee on Banking Supervision (BCBS) has focussed
on the need for banks to hold high quality liquid assets (HQLAs) that will remain liquid in
private markets, even in a crisis situation. This essentially means that the bulk of LCR assets
must be public sector securities that are "traded in large, deep and active repo or cash
markets." The aim clearly is to base the standard on the best available liquid assets and to
achieve cross-border consistency for internationally active banks.
However, for many countries, this model does not fit. In Australia, South Africa and Norway,
for example, government securities are relatively limited in supply, and they are often locked
away in long-term investment portfolios, thus further limiting the liquidity of secondary
markets.
The BCBS has considered situations where the market for HQLA might not be large enough
to support LCR requirements and has developed alternative liquidity arrangements (ALAs).
Permissible ALAs include:
3. the use of a contractual committed liquidity facility (CLF) provided by the relevant
central bank for a fee. So far, Australia and South Africa have adopted this option;
4. the use of foreign currency HQLA to cover domestic liquidity needs, with haircuts to
cater for currency risk. It appears Hong Kong and Singapore may adopt this option.
5. the additional use of Level 2A assets, such as high quality corporate debt and
covered bonds, i.e. going above the 40 percent cap for Level 2 assets, but with
higher haircuts.
The BCBS state that the use of ALAs is only available where a jurisdiction can demonstrate
and justify that an issue of insufficiency in HQLA genuinely exists. Additionally, the
jurisdiction implementing the ALAs faces ongoing obligations relating to supervisory
monitoring and reviews.
New Zealand liquidity standards
The Reserve Bank of New Zealand (RBNZ) introduced very similar, but non-Basel
conforming, liquidity requirements in August 2010. The high dependence of the New Zealand
banks on short term wholesale funding (mostly from offshore) was shown in the GFC to be a
significant vulnerability of the banking system and we were keen to reduce this risk as soon
as possible. Our aim was to be in line with Basel thinking but we wanted to move promptly
and did not wait for final decisions on the Basel standards. It was also evident early on that
the Basel emphasis on HQLAs was going to be an issue in New Zealand where some two
thirds of government securities are held offshore, contributing to a general lack of liquidity in
debt markets.
The RBNZ's Liquidity mismatch ratio3 is very similar in concept to the LCR. We have a
oneweek ratio which requires banks to hold sufficient primary liquid assets4 to meet net outflows
under a one week name crisis. There is also a one month mismatch ratio requirement where
primary and secondary liquid asset holdings must be sufficient to meet potential outflows
under a 30-day crisis. There is a close alignment between the eligibility of assets to meet the
RBNZ liquidity standards and the eligibility of those assets as collateral in RBNZ operations.
This acknowledges the role of central bank eligibility in underpinning private market liquidity
as well as the central bank's ultimate role as lender of last resort to the banking system.
Restrictions are placed on holdings of the lower quality "secondary" liquid assets in order to
ensure that banks hold a majority of primary rather than secondary liquid assets.
More importantly, from an overall funding risk perspective, RBNZ introduced a Core Funding
Ratio4 (CFR) similar to the proposed NSFR. The current minimum requirement of 75 percent
was phased in over a three year period. The CFR requirement has promoted a significant
improvement in the stability of the New Zealand banks' funding base, with short term
wholesale funding falling from 35 percent of total funding in 2008 to 15 percent in 2013.
While the CFR was introduced as a micro-prudential requirement, the RBNZ has more
recently nominated the CFR as a potential macro-prudential instrument. This means that the
CFR could be adjusted through the financial cycle with a view to increasing funding resilience
and average funding costs in the upturn, and taking pressure off funding costs in the
downturn. I will come back to this a bit later in the context of the interaction between liquidity
standards and monetary policy.
Central bank liquidity facilities
Cecchetti and Disyatat (2009)5 differentiate between three kinds of potential liquidity
shortage, relating to central bank cash, the funding of institutions, and the liquidity of key
markets. In normal times, the central bank targets a supply of settlement cash consistent with
maintaining short term market rates in line with the official policy rate. During the crisis, this
approach was insufficient to restore stability. It was also necessary to introduce new funding
facilities, and to broaden existing facilities in terms of the counterparties dealt with and the
range of assets accepted as collateral.
While most of the special funding facilities have been curtailed since the GFC, some
countries have found it necessary to maintain direct funding facilities, for example the BOE's
funding for lending scheme. Further, it is probably fair to say that many of the special
facilities used during the GFC effectively remain on standby, i.e. they could easily be
reactivated in a new crisis situation.
Many central banks have also retained the broader scope of their mainstream liquidity
facilities. Examples here include BOE, BOJ, RBA, and RBNZ. These more permanent
changes reflect lessons learned in the GFC about the different dimensions of financial
system liquidity. Many central banks appear to have broadened their perspective on the
"Lender of Last Resort" function and what this implies for central bank policies in normal
times as well as during a crisis.
One aspect of this broader approach is seen in central banks being more explicit about the
key markets they will support6. This might involve a prior commitment to directly support
particular markets in a crisis, (eg. the FX market, the interbank market, the short term repo
market). It might also involve an ongoing commitment to accept certain securities as eligible
collateral. During the GFC, the market liquidity of debt securities became critically dependent
on their collateral eligibility at the central bank. Central banks adjusted their credit standards
in order to accommodate the broader range of collateral instruments, albeit with larger
haircuts to mitigate the risk. By maintaining broader ranges of eligible collateral, central
banks are effectively continuing to support the liquidity of a range of debt markets.
So in the post-GFC environment, central banks are generally now better prepared and more
willing to support financial system liquidity in its various forms, through existing facilities,
through dormant special funding facilities that can be reactivated as necessary, and through
ongoing commitments to support liquidity in key financial markets, including by accepting a
broader range of collateral instruments.
Alignment of Basel standards and central bank liquidity policies
The first point I would make here is that an increased preparedness by central banks to
support system liquidity is totally consistent with a more rigorous approach to prudential
liquidity standards. Externalities associated with liquidity shocks were clearly evident in the
GFC, highlighting the need for banks to be prepared for both local and systemic liquidity
shocks. Further, more active central bank liquidity support may accentuate the moral hazard
problem by reducing incentives on banks to self-insure against liquidity shocks. There is thus
a clear case for stronger prudential liquidity standards to ensure banks are better able to
withstand liquidity pressures, notwithstanding the role of the central bank as underwriter of
system-wide liquidity.
However, it is difficult to say that the new Basel III liquidity standards have been aligned with
the developments in central bank liquidity policies. First, the Basel III initiative is attempting to
promote a convergence across countries towards a single international liquidity standard,
whereas central bank liquidity policies have if anything become more diverse since the crisis.
Second, the Basel III standards have focussed on safe haven liquid assets that are expected
to retain their value and liquidity in a crisis, irrespective of central bank liquidity policies.
While this approach may work in the major developed economies, it does not recognise the
crucial role that central bank liquidity policies can play in smaller economies, particularly
where there is no deep government security market.
Of course, during the consultation process, the Basel III standards have been modified to
accommodate certain local conditions through the alternative liquidity arrangement (ALA)
provisions. In particular, the Committed Liquidity Facility (CLF) variation has been designed
to accommodate countries where there is a shortage of Government stock (such as Australia
and South Africa). This is a positive move in that it recognises the essential role of the central
bank in liquidity provision during a crisis. However, the other variations under ALA, while
allowing a wider range of LCR-eligible assets, do not link these to local central bank liquidity
policies. For example, while there is an expectation that level 2A assets should be eligible
central bank collateral instruments, there is no such expectation for level 2B assets.
In the broader scheme, this issue comes down to a trade-off between international
crossborder consistency and regulatory efficiency on a country-by-country basis. For the home
countries of internationally active banks, the former is clearly important to avoid regulatory
arbitrage. But for countries hosting predominantly domestic banking businesses, the need for
international consistency is probably less important than the local characteristics of domestic
markets when it comes to designing efficient liquidity standards.
Basel III impact on central bank operations
As I mentioned earlier, minimum prudential liquidity standards, including the Basel III
standards, are essentially complementary to central bank liquidity policies. The more
prepared banks are to meet liquidity shocks, the less work will need to be done by central
banks. However, there may be implications for central bank liquidity operations in two
respects.
First, with banks required to hold their best quality liquid assets to meet the LCR
requirement, they may offer lower quality liquid assets to the central bank in its regular
market operations. This would result in central banks having to manage their credit risk more
carefully, including paying closer attention to haircuts and securities pricing. This effect would
likely persist in a crisis even though supervisors would be able to "release" the LCR
requirement. Banks will tend to hoard high quality assets in a crisis, even though the LCR
requirement may be reduced. A variation of this effect is for central banks, in the face of a
high quality collateral shortage, to move away from sole reliance on reverse repos for
injecting system liquidity. An obvious alternative instrument for this purpose, and one which
we use extensively in New Zealand, is FX swaps.
Second, for countries adopting the CLF as an alternative to HQLA, there is a question about
how this will affect central bank liquidity operations in a stress situation. Typically, under
existing arrangements, the central bank can closely control the quantum of system liquidity
injections, given that standing (on-demand) facilities have a penalty margin attached. In the
case of the CLF however, banks will be free to fully access funds to the extent of the
committed credit lines. This could potentially make it more difficult for the central bank to
manage the quantity and price of short term funds in a crisis situation.
Interaction between prudential liquidity standards and monetary policy
Another area where the Basel liquidity standards might affect central bank policies is the
transmission of monetary policy. This interaction arises in the context of the NSFR or, in New
Zealand, the Core Funding Ratio (CFR). These requirements are being introduced as
microprudential measures, intended to improve banks' resilience to liquidity shocks by reducing
the maturity mismatch between assets and liabilities. The main impact of this policy, as
observed with the CFR in New Zealand, will be for the banks to increase the average term of
their funding, incurring some increase in average funding costs as a result of the term
premium.
My point here is that if the stable funding requirement is treated as a"set and forget"
prudential standard, it could have pro-cyclical characteristics7 that influence the transmission
of monetary policy. The particular situation of concern is in a cyclical downturn when a fixed
NSFR will require banks to continue to roll over term debt at a time when term premiums are
increasing, rather than allowing the banks to moderate the cyclical impact on their funding
costs by shortening the average term of their borrowing. This could cause a weakening of the
monetary policy transmission mechanism in that bank cost of funds might not reduce to the
same extent as usual following a monetary policy easing in a cyclical downturn.
If this pro-cyclical effect is significant then monetary policy adjustments to official interest
rates may need to be more vigorous, potentially in both the upturn and the downturn, to
achieve the same effect on bank cost of funds, and thereby bank lending rates.
An obvious way to avoid this pro-cyclical effect of the NSFR would be to adjust the NSFR
through the cycle, which would effectively make it a macro-prudential tool. This is indeed the
approach that RBNZ is intending to take by including the Core Funding Ratio in its
macroprudential"toolkit"8. However, no countercyclical adjustments have yet been made to the CFR.
Conclusion
The GFC has rightly led to: 1) A new emphasis on liquidity standards for banks; and 2) A
more comprehensive approach to the management of banking system liquidity by central
banks. These two policy arms are complementary.
However, while the Basel III liquidity regime has been created with the aim of achieving
common liquidity standards for internationally active banks, the post-GFC evolution of central
bank liquidity policies has been diverse and very local in character, making it difficult to
achieve alignment between the two policy arms. Alignment has not been assisted in my view
by the approach that has been taken to allowable variations in the Basel III standards. While
the alternative CLF arrangement brings the central bank explicitly into the scope of the LCR
for countries adopting that variant, the important role of central bank policies is not
recognised more broadly.
Regarding the implications of the Basel III liquidity standards for central bank operations, the
main impact is likely to be on the quality of assets that central banks may need to accept in
reverse repo operations. Banks are more likely to hoard their higher quality liquid assets to
meet LCR requirements, including in a crisis situation. This will reinforce the need for central
banks to improve their credit assessment capabilities, including closer attention to pricing
and haircut requirements.
A more substantive implication of the Basel III liquidity standards relates to the potential for
the NSFR to have a pro-cyclical impact on banks' cost of funds. Such effects could arise if
banks are prevented from modifying the term structure of their debt in response to large
changes in the interest rate term premium. In this regard, the prudential and monetary
authorities may find that the NSFR cannot be treated as a "set and forget" policy ratio.
Appendix 1: Alternative liquidity approaches under the LCR
The following describes how some countries are implementing Alternative Liquidity
Approaches under Basel III.
Australia - the RBA and APRA have introduced a "Committed Liquidity Facility" (CLF) that
provides an insurance overlay to otherwise "low quality" liquid assets, at a cost of 15 basis
points per annum. The CLF will be sufficient in size to cover the shortfall between a bank's
holdings of HQLA and its LCR needs. Qualifying collateral for the facility will comprise all
assets eligible for repurchase transactions with the RBA under normal market operations and
other assets the RBA deems appropriate (including self-securitisations). Banks will be
required to demonstrate that they have taken all reasonable steps towards meeting their LCR
requirements through their own balance sheet management, before relying on the CLF.
APRA will be reviewing each ADI's liquidity risk management framework and management
practices as the basis for approving the CLF for LCR purposes.
South Africa - The South African Reserve Bank has approved the provision of a CLF and
the utilisation of statutory cash reserves as part of HQLA for liquidity regulation purposes.
South Africa has a limited availability of Level 1 HQLA and virtually no Level 2 assets that
satisfy the Basel III criteria. The CLF will be provided for an amount up to 40 per cent of any
particular bank's liquidity requirements. The commitment fee is scaled so that the fees
charged increase as the reliance on the CLF increases. There is also a drawdown rate of
100 basis points and drawdowns will be for a period of 30 days.
Norway - Norwegian authorities acknowledge that the LCR requirements will pose a
challenge to Norwegian banks due to lack of Government bonds, but also due to strict
cashflow run-off assumptions imposed by the Basel III requirements. Net cash outflows in a crisis
forms the denominator of the LCR equation. Where the strict rules around the run-off of
cash-flows do not align with the characteristics of the underlying assets and liabilities, the
required net cash outflow assumptions may be overstated and the required HQLA will
consequently be higher. At this point Norwegian authorities have not stated their final policy
position.
Malaysia - also have issues with the Basel III approach to the proposed cash flow
assumptions, particularly as they relate to institutional savings schemes. In Malaysia, these
schemes are dominated by pension funds, which predominantly manage household savings.
However, the LCR cash outflow assumptions for investments from institutional funds are
more severe than for investments for retail funds, even though the underlying savings are
from households in both cases. As a result, HQLA requirements for banks are higher than
might be expected.
Hong Kong SAR - Given the limited supply of HQLA denominated in Hong Kong dollars, the
HKMA expects Hong Kong to be a jurisdiction which needs to adopt alternative
arrangements for LCR purposes. HKMA have stated that they are likely to use option 2 for
alternative arrangements, which allows the use of Level 1 foreign currency HQLA to cover
local currency liquidity needs.
Appendix 2: Basel III Liquidity Coverage Ratio (LCR)
Definition of HQLA
There are two categories of assets that can be included in the stock of High Quality Liquid
Assets. "Level 1" assets can be included without limit, while "Level 2" assets can only
comprise up to 40% of the stock. Supervisors may also choose to include within Level 2 an
additional class of assets (Level 2B assets). If included, they will be within the 40 percent
limit on Level 2 assets and comprise no more than 15 percent of the total stock of HQLA.
Level 1 assets are limited to:
1. coins and banknotes;
2. central bank reserves (including required reserves);
3. marketable securities representing claims on or guaranteed by sovereigns, central
banks, PSEs, the Bank for International Settlements, the International Monetary
Fund, the European Central Bank and European Community, or multilateral
development banks, and satisfying certain conditions such as being assigned a 0
percent risk-weight under the Basel II Standardised Approach and traded in large,
deep and active repo or cash markets characterised by a low level of concentration;
4. where the sovereign has a non-0 percent risk weight, sovereign or central bank debt
securities issued in domestic currencies by the sovereign or central bank in the
country in which the liquidity risk is being taken or in the bank's home country; and
5. where the sovereign has a non-0 percent risk weight, domestic sovereign or central
bank debt securities issued in foreign currencies are eligible up to the amount of the
bank's stressed net cash outflows in that specific foreign currency stemming from
the bank's operations in the jurisdiction where the bank's liquidity risk is being taken.
Level 2A assets are limited to the following:
(a) Marketable securities representing claims on or guaranteed by sovereigns, central
banks, PSEs or multilateral development banks that satisfying certain conditions such as 20
percent risk weight under the Basel II Standardised Approach, traded in large, deep and
active repo or cash markets characterised by a low level of concentration;
(b) Corporate (non-financial) debt securities (including commercial paper) and covered
bonds that satisfy certain conditions around a satisfactory credit rating and traded in large,
deep and active repo or cash markets characterised by a low level of concentration;
Level 2B assets are limited to the following:
1 Residential mortgage backed securities (RMBS) that satisfy certain conditions.
2. Corporate (non-financial) debt securities (including commercial paper) that satisfy
certain conditions including a minimum credit rating
3. Common (non-financial) equity shares that satisfy certain conditions such as being
exchange traded and centrally cleared, denominated in domestic currency and
traded in deep markets.
Reserve Bank of New Zealand mismatch ratio
The Reserve Bank's mismatch ratio is akin to the LCR, although it is not compliant with Basel
III requirements. All New Zealand incorporated registered banks are subject to minimum
oneweek and one-month mismatch ratios. The aim of the mismatch ratios is to reduce the risk
that an individual bank is brought down by a short-term loss of confidence.
One-week mismatch ratio
One-month mismatch ratio
Primary liquid assets contain the following classes of assets:
1. ESAS balances with the RBNZ
2. NZD currency demand balances with other NZ banks
3. Foreign currency notes and coins held by the bank, and foreign currency demand
balances held with overseas banks, subject to a haircut;
4. NZ government securities denominated in NZD
5. Other securities with haircuts:
1. High rated local authority securities
2. High rated State owned Enterprise securities.
3. High rated Kauris,
4. High rated two-name and single-name RMBS
Secondary liquid assets have larger haircuts and contain the following classes of assets:
1. Local and Foreign government guaranteed securities
2. Lower rated local authority securities
3. Lower rated corporate securities
4. Asset back securities
5. Registered bank securities
Reserve Bank of New Zealand core funding ratio
The Reserve Bank's mismatch ratio is akin to the NSFR. The basic notion underlying the
CFR is a comparison between an estimate of the funding of the bank that is stable and can
be assumed to stay in place for at least one year ('core funding'), and the core lending
business of the bank that needs to be funded on a continuing basis. The CFR is currently
applied to locally incorporated banks. A bank must maintain its one-year core funding ratio at
not less than the minimum specified in its conditions of registration, at the end of each
business day. For most banks this is currently set at 75 percent.
One-year core funding ratio =
Where the one year core funding dollar amount =
• all funding with residual maturity longer than one year, including subordinated debt
and related party funding
• plus 50 percent of any tradable debt securities issued by the bank with original
maturity of two years or more and with residual maturity at the reporting date of
more than six months and not more than one year
• plus non-market funding that is withdrawable at sight or with residual maturity less
than or equal to one year
• plus Tier 1 capital