Yves Mersch: Basel III and liquidity surveillance in Luxembourg -
building an operational systemic and micro-prudential framework
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the General
Assembly of "The Luxembourg Bankers' Association", Luxembourg, 27 April 2011.
* * *
Ladies and Gentlemen,
I would like to thank the ABBL General Assembly organizers' for inviting me to share with
you some thoughts on the challenging question regarding the recent Basel III liquidity
regulation proposals, their potential impact for the Luxembourg banking system, and how
those changes are integrated by the BCL within its mandate for liquidity surveillance. Let me
say upfront that liquidity surveillance has to be put in the broader perspective of the
increasing key role of central banks in financial stability and macroprudential policymaking.
The recent financial crisis has highlighted the need to go beyond a purely micro approach to
financial regulation and supervision. The policy debate and proposed changes in regulation
and supervision are focusing in particular on developing a macroprudential framework, on
constructing macroprudential tools and on reflecting upon their usage, their relationship with
other policy areas such as monetary policy, microprudential, fiscal to competition, their
implementation and their effectiveness. In Europe, beyond changes in the architecture, there
is a number of major planned reforms in financial regulation; as you can see on the slide in
front of you (taken from the eighth Financial Stability Review of the BCL to be presented
tomorrow) the spectrum of those changes is vast. It covers capital and liquidity regulatory
frameworks, financial institutions, as well as markets and markets infrastructures. Our task
today refers to the important pillar of liquidity surveillance. Note, however, that all these
prospective changes are taking place within the context of evolving national supervisory
frameworks. I am convinced that no matter how those mandates finish being structured
across countries, central banks, by their unique role in monetary policy and settlement and
payment systems oversight, ought to have a clear mandate in financial stability and a key
role in macroprudential policy. One of the alleged strengths of our country has been its
capacity to rapidly adapt, and often even lead, key policy and structural developments
around the world. Given the large proportion of countries that have already given their central
banks a clear mandate in financial stability and in macroprudential policy formulation,
implementation and coordination, our challenge is clear. Already in 2010, the BCL has
provided legislative proposals to the Executive branch in this respect as well as what
concerns a regulative regime.
Current main reforms in financial regulation
Capital and liquidity Individual financial
Markets
institutions
Capital
Central counterparties
- OTC markets
Corporate
governance

Capital ratio

Conservation buffer
Crisis management and
 Countercyclical buffer
resolution

Leverage ratio
Alternative
investment
Rating agencies
funds
Liquidity
Systemically important
 LCR
financial institutions

NSFR
Initiatives from the Basel Committee Initiatives from the European Commission
Given the role of liquidity in the recent crisis, an international consensus on liquidity
regulation is emerging and has been assigned high priority among regulators and
supervisors.
Let me start by making some remarks on the background of ongoing efforts directed towards
forging a consensus view for the future Basel III framework. As you know, Governors of
national central banks (NCBs) along with Heads of Supervision authorities, albeit without
Luxembourg given the country's current institutional framework, have been working in order
to finalize a definition of liquidity that will permit regulators to minimize system-level
distortions through the penalization of those banks holding assets with poorly structured
liquidity profiles. As observed during the crisis, illiquid assets played a central and significant
role in the aggravation of the turmoil. In fact, the "illiquidity" phase of the crisis was
particularly acute as the speed with which assets became illiquid lead to a significant
negative impact on the ability of banks to have access to funding. Now, one naive way of
addressing such systemic liquidity problems would be through the imposition of elevated
liquidity requirements - spread equally - across all institutions with the central bank playing
the essential role of liquidity provider. However, a model such as this one runs the risk that
all institutions may, during a crisis, exhaust their liquidity requirements simultaneously
leading to a systemic crisis. This is not an effective approach to regulation. So what is the
alternative? To date, policy-makers have not yet reached a final consensus on a suitable
macro-prudential framework able to safeguard against systemic liquidity risk. This is why
work on liquidity regulation is viewed by the Basel Committee in Basel (CGFS, FSB) as being
of central importance going forward. So, today I shall discuss the proposed Basel III liquidity
ratios and their impact on our country, while taking advantage of this opportunity to let you
know how we envision liquidity surveillance, what we have done, and what we plan to do in
the near future.
The Basel III regulations will provide regulators with standard empirical measures of
liquidity risk providing them with a toolkit that can help to mitigate funding and market
liquidity risk.
Central banks are deeply involved with liquidity management at the macroeconomic level
and are recognized as the de facto emergency liquidity providers during times of crisis. In its
current form, the Basel III definition of liquidity relies on two particular measures that have
been proposed in the context of adopting a new global liquidity standard. As you surely know
by now, these are the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio
(NSFR). It is broadly recognized that these measures of liquidity should be designed so that,
from a macro-prudential perspective, they can be used as possible tools to help alleviating
and mitigating a rise in systemic liquidity risk. They should help increase the banks' liquidity
buffers and lower maturity risk transformation, which in turn should make them more
resistant against the transmission and amplification of liquidity shocks. In particular, there are
two types of risk that need to be targeted. These are market liquidity risk and funding liquidity
risk.
Market liquidity risk results from firms being unable to engage in quick and efficient sales of
assets, a desirable property of efficiently functioning financial markets. In an illiquid market,
asset sales may be hindered thereby adversely impacting the price of the asset. Funding
liquidity risk, on the other hand, may result in firms being unable to meet their expected cash
flow requirements over the long or short-term. This can adversely impact a firm's ability to
access funding, particularly on short notice. Regulators recognized that both types of risk
lead to market inefficiencies and thus result in undesirable implications for financial firms
and, ultimately, the real economy. You can therefore see that quantitative liquidity measures
such as the LCR and the NSFR, while based on a well established tradition on liquidity risk
management theory, are a welcome innovation from a regulatory perspective given that - for
the first time - they provide regulators with the capacity to introduce and harmonize standard
measures in liquidity risk management practice. Since these empirical measures will be
central to the new Basel liquidity standards, I believe it would be advisable for me to spend
some time discussing each indicator in turn.
The LCR will be used to help mitigating short-term liquidity stress thereby allowing
financial institutions to maintain smooth access to short-term funding requirements.
Let me begin with the LCR. It is the current consensus of the Basel Committee that the LCR
should be introduced after an observation or trial period thereby providing a window of
opportunity during which any refinements to the measure could be introduced. From a
technical perspective, the LCR is a short-term measure of liquidity which is specifically
intended to ensure that financial firms can continue to access near-term liquidity needs in an
efficient manner. In principle, this should make certain that banks have a sufficient quantity of
liquid assets so as to be able to withstand up to a month-long period of sustained and severe
liquidity stress.
For illustrative purposes, let us consider what would have been the evolution of the LCR in
the context of Luxembourg's financial sector. While the Banque centrale du Luxembourg
(BCL) has not yet formally adopted this measure in its role as a liquidity supervisor of the
Luxembourg financial system, it is developing the framework necessary for the
implementation of Basel III. I will describe its main components later.
In an internal study conducted by the BCL, the evolution of the LCR was evaluated based on
a sample of banks that excludes less-relevant branches and covers the period spanning from
2003:Q1 until 2010:Q4.
Figure 1
The evolution of the LCR for
Luxembourg's banks, 2003q1 - 2010q4
Source: BCL calculations.
You can observe the evolution of the LCR for this period in the accompanying figure. It was
found that the median of the LCR decreased from roughly 82% in 2003:Q1 to a minimum of
52% in 2009:Q1. Since then it has been increasing almost consistently until the present time.
One possible interpretation of this behavior for the period until 2009:Q1 is that banks were
reducing their holdings of liquid assets. However, since the end of the crisis, financial
institutions have been holding increasing amounts of liquid assets which represents the
beginning of the re-stabilization of the liquidity conditions in the domestic financial markets.
The NSFR will help to enhance the medium to long-term funding needs of banks
thereby mitigating liquidity runs.
Let me now turn to the second of the two proposed liquidity measures, the NSFR. In contrast
to the LCR, the NSFR is designed as a medium- to long-term measure of liquidity intended to
mitigate any future liquidity runs and, subsequently avoid any possible knock-on effects of a
systemic liquidity crisis; like firms' default, for example. In fact, the NSFR addresses the
issue of maturity mismatch between a bank's assets and liabilities. It is important to make
clear that the NSFR has not been designed to play the role of an early warning indicator
(EWI) of liquidity difficulties. Indeed, if one were to apply the NSFR to the period leading up
to the recent crisis, the NSFR would have revealed to be an inconsistent indicator of future
liquidity stress. This results from the inherent difficulties of attempting to separate liquidity
from solvency.
Figure 2
The evolution of the NSFR for
Luxembourg's banks, 2003q1 - 2010q4
Source: BCL calculations.
As part of the same internal study I alluded to earlier, the NSFR was evaluated over the
period from 2003:Q1 to 2010:Q4 using the same sample of banks as for the LCR. If you look
at the figure displaying the evolution of the NSFR before you, you can see that, on average,
the NSFR declined continuously from a median of 90% in the first quarter of 2003 to a
median of 67% at the end of 2008. Since that time, the NSFR has slowly started to recover.
Its decline until 2008 can be mainly attributed to a faster increase in total assets in
comparison to capital as well as to an increase in wholesale funding from banks and
nonfinancial corporations (NFCs). These results for the NSFR in Luxembourg are broadly similar
to the results calculated by the International Monetary Fund (IMF) for Europe.
For the NSFR, I should also mention that this ratio has been the subject of a study conducted
by the Bank for International Settlements (BIS) and entitled "BASEL III: Long-term impact on
economic performance and fluctuations"1. While a slight negative effect on output is not
disputed, the authors - in fact, Mr. L. Clerc form the Banque de France will actually
participate in our Financial Stability Review presentation tomorrow - conclude that the
adoption of tighter liquidity requirements leads to an approximate reduction in output volatility
by 1 percent. Overall this suggests that prudent liquidity controls would have a beneficial
effect for the real economy.
The calibration of the LCR and the NSFR will be critical to ensuring the liquidity and
funding stability of banks, but further research will be required.
Although the members of the Basel Committee have not yet achieved a final consensus on
the exact structure of an operational liquidity management framework, the proposed new
standards for liquidity risk management are a welcome development. In combination with a
more robust and efficient supervisory landscape, the proposed Basel III recommendations
should help to bolster liquidity risk management practices in the financial sector. This will
have an overall welfare-enhancing effect on the real economy and will help to ensure the
stable provision and access to liquidity and funding between financial institutions. In addition
to reducing the risk of a rapid drying up of liquidity, this will aid considerably in mitigating the
risk of excessive interconnectedness in the financial system by encouraging banks to reduce
their common exposures.
As we have seen, these are important ways in which well-calibrated LCR and NSFR can
serve to enhance liquidity and preserve access to stable sources of funding. However,
despite some initial empirical work and theoretical studies, neither the LCR nor NSFR has
been implemented within the context of an operational supervisory framework yet. This both
highlights and elevates the need for further quantitative impact analyses and related studies
in order to ensure that, from a financial stability perspective, there is a reasonable and
justifiable calibration underlying the LCR and NSFR for supervisory frameworks. In this
context, policy-makers can be confident that any calibration is accurate and will not result in
banks being restricted either in their ability to manage short and long-term liquidity or in their
ability to undertake the maturity transformation activities which are vital to their financial
intermediary's role in the economy. This will also lead to a reduction in the cost of financial
intermediation. It is for these reasons that regulators must strive towards striking a balance
between efficient - but not overly restrictive - regulation and a set of rules that do not result
in negative consequences for financial stability. We intend to maintain our dialogue with
assertiveness in this respect and hope that Luxembourg's representation at international
level can be improved through a clear assignment of representatives.
Part II
How the BCL envisions and implements liquidity surveillance
The 2008 BCL mandate to monitor the liquidity of markets and market operators
recognizes central banks' unique role in the surveillance of systemic liquidity risk. The
crisis demonstrated that liquidity risk can emerge quickly. The manner in which liquidity risk
materializes and is transmitted is determined by the nature of funding instruments and
linkages among financial institutions, the degree of leverage of market operators, as well as
their reactions to emerging stresses. Policy responses to the crisis must, at a minimum,
enhance institutions' liquidity risk management and information available to measure and
track systemic liquidity risk. The task is complicated because the assessment of liquidity risk
at the systemic level is often susceptible of a fallacy of composition given that the viability of
banks' individual approaches to liquidity risk will depend upon the strategies being pursued
by other market operators. For instance, if banks have a great deal of interconnectedness via
the interbank market, a liquidity shock impact will be relatively larger than if their
interconnectedness was lower. In addition, if banks' business models were diverse, the
impact of a liquidity shock would be relatively smaller than if banks' activities were
concentrated on just one business line. The 2008 Law, in giving to the BCL the mandate to
monitor markets and market operators' liquidity, acknowledged the necessity of liquidity
surveillance in Luxembourg. On this capacity, the BCL has issued regulations, such as the
BCL regulation 2009/4 requesting banks to apply the BCBS "Principles for Sound Liquidity
Risk Management and Supervision". The Bank actively participates in the shaping of the
Basel III framework for liquidity risk measurement, standards and monitoring. Taking due
account of current regulatory developments, the BCL intends to publish further instructions to
market participants on liquidity management before the end of this year.
In the same way the BCL changed its architecture to comply with its liquidity
surveillance mandate, it will also adapt to its unavoidable role in macroprudential
policymaking in Luxembourg. Following the 2008 new mandate on liquidity
surveillance, the BCL adapted its internal structure and resources so as to ensure that the
Luxembourg market and its financial actors are constantly subject to analytical and
quantitative scrutiny so as minimize systemic liquidity risk in the Luxembourg financial
industry. The BCL has increased technical cooperation with regulators at the national and
international level and is active in committees and working groups that develop regulations,
practices, standards, as well as measures and monitoring tools to improve the financial
sector's ability to absorb liquidity shocks arising from financial and economic stress of
various sources. This encompasses not only Luxembourg recent participation in its second
IMF FSAP exercise, but also in EBA-led stress tests and BIS study groups. But this is only
one leg, albeit crucial, of the unavoidable role of the BCL in macroprudential policymaking in
Luxembourg. As the contours of a macroprudential policy framework take shape, the BCL
will need a clear mandate on financial stability and a prominent role in macroprudential
policymaking, whatever shape the framework ends up taking. But this is just the beginning of
major changes to come in the near future. Given their role in monetary policy, central banks
monitor markets and economic and financial developments that have a bearing on policies
designed to reduce procyclical risks, a key objective of macroprudential policies. Similarly,
given their role in settlement and payment systems oversight, central banks have developed
a unique expertise in systemic risk analysis, inescapable element of macroprudential
measures to reduce the probability of default of individual financial institutions. From a
governance viewpoint, central banks have the right type of incentives to contribute to the
effectiveness of macroprudential policies because failure in this area is costly for them, and
eventually, for their hard-earned independence.
Liquidity risk surveillance requires monitoring liquidity risk pricing both at the macro-
Observers (e.g., Borio and Drehmann) have shown that financial
and at the micro-level.
markets have a tendency to misprice risk over time. This was certainly the case in the run-up
to the crisis. However, it is less widely recognized that banks also had severe pitfalls in their
models for pricing liquidity internally, which resulted in an under-pricing of liquidity risk and
compounded the gravity of the crisis. There is no single best indicator that captures systemic
liquidity risk. This fact stresses the need to monitor a wide range of indicators and,
unavoidably, to use informed judgment to assess liquidity risk. It is necessary to complement
analysis such as the one described above with information on factors that history tells us that
are, in one way or another, associated with liquidity stress and that inextricably link systemic
with firm-level liquidity risk. I think in particular about high leverage levels and degrees of
maturity transformation that rely heavily on short-term funding. A difficulty is that the crisis
highlighted that some of those standard indicators tend to perform poorly or to suggest a
lower level of vulnerability than it is actually the case. For example, when risk premium is
low, financial institutions are encouraged to increase their leverage as their bets tend to look
relatively less risky. In addition, haircuts on collateral tend to fall consistently with this view.
This way, liquidity risk accumulates, and a change in market sentiment suffices to lead to
forced asset sales on banks' leveraged positions. Also, observing changes in collateralized
lending practices and haircut levels are crucial indicators for assessing liquidity risk pricing,
but this information tends to be viewed as proprietary by major market operators. At the
micro-level, financial institutions are being required to enhance their funds-transfer pricing
processes, which will be part of the liquidity management requirements I alluded earlier and
that the BCL will announce in the coming months.
The BCL is developing an operational framework for systemic and micro-prudential
liquidity surveillance. As I have just illustrated, traditional tools for monitoring liquidity risk,
while necessary, proved to be insufficient in the run-up to the crisis. The task of a liquidity
risk supervisor is therefore not simple. The approach taken at the BCL strives to integrate the
multiple facets of liquidity risk. However, to avoid the temptation to "look at everything", the
BCL approach is risk based. There is already convincing theoretical and empirical evidence
that not only size, but also the degree of interconnectedness of banks via the interbank
market, for example or the evolution of non-core liabilities constitutes good proxies for
institutions' systemic risk. These characteristics, as well as the relevance of a given
institution for the key role of the Central Bank in preserving financial stability, determine the
set of financial institutions that are more often and more intensely monitored - classified in
terms of their degree of systemic importance. A key qualitative component of liquidity
surveillance in the BCL is the assessment of banks' liquidity risk management frameworks.
As painfully learned from the crisis, this should be the first-line bulwark to defend an
institution against liquidity risk. Particular emphasis is being laid on issues such as sound
governance both at the banking group and at the local level; the definition of management
risk tolerance level; the set of monitoring tools institutions use for assessing their liquidity
risk; the robustness of stress tests scenarios and the extent to which they reflect
Luxembourg idiosyncrasies; the size and composition of local liquidity buffers; the internal
consistency of banks' contingency funding plans and where applicable; intra-day liquidity
management. In addition, the BCL also pays attention to the soundness of the business
model and the balance sheet structure of local credit institutions and in particular to possible
liquidity risks that are being transferred from foreign-based banking groups to local
subsidiaries. In this regard, some degree of liquidity management at the local level plays a
significant role in the BCL liquidity risk assessment of banks, and it must be subject to its
approval. Finally, the BCL pays particular importance at assessing whether banks' internal
pricing of liquidity within the institution and among group member duly reflects liquidity risk.
But even these tools and procedures are not enough.
The BCL liquidity surveillance framework includes a combination of qualitative and
quantitative elements. On-site visits are an important component of the BCL monitoring
framework in order to assess business models and the liquidity situation and the risk
management framework of credit institutions. In the absence of a formal MoU, the BCL
surveillance visits are nevertheless coordinated and conducted with the Commission de
surveillance du secteur financier. Since 2009, 14 on-site visits have been performed, and a
similar number is expected to take place over the coming year. Another pillar of the BCL
liquidity framework is off-site surveillance. While structural liquidity risk may be monitored
and analyzed through information provided by financial institutions (prudential and statistical
reporting requirements), by the micro-prudential approach or even by market intelligence, the
BCL endeavors to have timely cash-flow based liquidity projections from market participants
on a short-term basis. At the moment, 45 financial institutions which are important from a
financial stability and a monetary policy perspective, provide a forward-looking daily liquidity
reporting that includes a five-day forecast. The forward-looking nature of indicators is at a
premium given the sudden realization of liquidity risk. This is the reason for the Bank's
analysis and close interaction with the industry in all aspects regarding the two liquidity ratios
of Basel III and the monitoring tools proposed such as maturity ladder reporting, funding
concentration, and the availability of unencumbered assets. Another key in-house liquidity
monitoring tool compares every bank's liquidity position using two different scores: one that
compares a bank's liquidity position across peer banks and another that compares a bank's
liquidity over time based on 21 different risk factors. The tool mainly helps identifying banks
with weaker liquidity positions and streamlining monitoring tasks. The framework is also
useful to draw inferences about the general liquidity trends within the Luxembourg banking
sector for the purpose of ensuring financial stability. The framework integrates on- and
offbalance sheet data and market and macroeconomic information. Finally, the BCL uses other
indicators for analyzing the liquidity situation of banks at a micro-level. They include micro-
and macro-prudential indicators, albeit of a backward- or coincident-nature, such as
loan-todeposit ratios, liquidity ratios, banks' data on funding structure by maturity and geographical
distribution, portfolio analysis, inter-bank and intra-group activity information, and data on
banks' participation in payment systems.
Liquidity surveillance and EU financial stability frameworks are still built on a national
basis, but surveillance frameworks are evolving. Each EU national central bank is the
LLR to financial institutions domiciled in its territory with the obligation of informing the ECB.
This situation implies that host countries are in theory the providers of ELA to subsidiaries
and branches, but do not have access to supervisory information about branches, and thus,
have no way of assessing the risks involved in the ELA operations they undertake. Basel III
still proposes the application of regulations on a consolidated basis. This means that
branches located in Luxembourg should be supervised by the home supervisor. This is
clearly problematic for Luxembourg since some branches are relatively large and
systemically-relevant, and have to be monitored. Also there is a tendency for groups to run
their subsidiaries like branches which inevitably leads to conflicts of jurisdictions. The
challenge for BCL risk-based liquidity surveillance is to take account of the activities and the
liquidity risk profile at the group level. A major consequence of this state of affairs is that the
distinction between liquidity and solvency, and the ensuing impact on the sharing of the costs
of the operation, remain opaque. On the other hand, home-country authorities may delay
providing information or taking crisis-management actions to avoid capital losses,
reputational effects or political backlashes. So the home authority does not always have the
incentive to keep small-country host authorities informed in an acceptable way. In turn, host
country authorities may seek to retain as much intervention authority as possible. The EU
level MoUs signed in 2005 and 2008, being voluntary in nature, did not help much. As a
result, several Colleges of Supervisors and Cross-border Stability Groups are being put in
place to alleviate the remaining tension between home-country lead responsibility for
integrated supervision of LCBGs and the host country responsibility for financial stability. The
BCL currently participates in several Colleges of Supervisors and Cross-border Financial
Stability Groups. Additionally, bilateral arrangements with other home supervisory authorities
and/or regular exchanges of views with representatives from banks' head offices take place
in order to keep abreast of developments at the group level and to raise potential concerns
with regards to the situation at the domestic level.
Basel III is work in progress, and one-size-fits-all is incompatible with the richness of
Luxembourg business models. The final contours of the Basel III framework are still to be
made precise. It is already clear, however, that the framework is not yet well suited to cover
the diversity of banks' business models that characterize the industry in Luxembourg. The
BCL is involved in technical discussions to strike the right balance between efficient liquidity
surveillance and competitive and robust banks. Discussions cover, for example, the
possibility of recognizing some stable funding in the period over the one month to which the
proposed LCR applies and the period over one year to which the proposed NSFR applies.
Investment funds' deposits are so far not considered as a reliable funding source within the
LCR - except those having a proven operational relationship - and are not considered as
available source of funding in the NSFR. Another feature under discussion is the asymmetric
treatment of the loss of funding in covered bonds, and the covered pool inflow which is not
considered as unencumbered, and thus cannot be included within the stock of highly liquid
assets. This situation makes it quite difficult to respect the LCR for certain business models.
These two issues are particularly relevant for custodian banks and banks mostly involved in
covered bonds issuance, respectively, but they are not the only ones under consideration.
The road map is complex, but the way is clear. I have already alluded to the results of the
top-down analysis conducted by the BCL on the new liquidity standards in the first part of my
talk. This analysis is currently being complemented through a bottom-up approach
instrumented by means of a joint survey of the BCL and the CSSF with a representative
sample of domestic credit institutions covering a large share of total assets. Without going
into the details of this survey, the results of which will be presented and discussed at the
occasion of an ABBL conference scheduled to take place on 24th May, it is already clear that
Luxembourg banking sector does on aggregate fall short of the required standards at the
current juncture. I draw five preliminary lessons from these results: first, the BCL working at
home with the industry and abroad with standard-setting entities, needs monitoring the
implementation of the upcoming liquidity standards during the observation period, and
especially the LCR. Second, it seems almost unavoidable that the new standards will induce
certain banks to adjust their business models in order to comply with the new agreed pricing
of liquidity risk components and offer products with more stable or more fee-based income.
Third, as mentioned above, the BCL will use the survey and its internal studies during the
upcoming review and calibration process at the international level in order to flag those
issues that are considered to unduly penalize sound business models. Fourth, contrasting
and comparing the top-down and the bottom-up approach is a rich source of information that
the BCL intends to use for refining national regulation taking into account current and future
qualitative and quantitative liquidity requirements and for designing reporting requirements.
Finally, the BCL foresees a continued and increased focus on on-site visits and
complementing the daily liquidity reporting in the near future by other requirements following
the implementation of Basel III as a clear way of strengthening liquidity surveillance and
boosting the robustness of Luxembourg banks.
Concluding remarks
Let me conclude with a few final remarks. When