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FIG

Striking the balance between safety and profits

Banks have managed their liquidity positions for centuries without the assistance of global standards. The financial crisis changed all that, demonstrating the need for a global regulatory approach to liquidity. Few question this logic, but growth has been an unintended casualty. Solomon Teague reports.

One of the fundamental roles of a bank is to bridge the liquidity mismatch that exists between the savers and borrowers. Typically there are many people looking for a place to store their savings with minimal risk, while borrowers often require longer term funding, for example to finance mortgages or long term projects. 

Banks have long stood between the two sides and helped funnel capital between them, but Basel III’s provisions governing required liquidity levels are changing that dynamic. The further regulation goes in strengthening banks’ liquidity positions, the harder for them to fulfil this function, a change with considerable potentially detrimental implications for society. 

“Today liquidity is as important as solvency, and perhaps more important,” says Elie Darwish, senior fixed income analyst for banks at Natixis. “Basel III has already made significant progress in solvency. But liquidity is more complex and it can lead to banks making changes in their business mix, structural adjustments that can take time to implement.” One example is the growing shift towards increasing depositor bases. 

“There is reduced liquidity in the market, dealers are not willing to put their precious and expensive capital at risk in the same way,” says David Soanes, global head of FIG at UBS. “You increase liquid assets but the consequence is that markets for those assets are less liquid. That has led to wider bid offer spreads, which means the quality of the liquidity has actually gone down.”

This means that while liquidity appears to have been increased throughout the market, the change is potentially illusory, warns Soanes. “Liquidity will evaporate at the first sign of trouble,” he says.

In fact, such is the volatility of the market, arguably the only true forms of liquidity in the market are Treasuries and Bunds, along with cash on deposit at the central bank. But there is a feeling among bankers that the central bank deposit route is too expensive. 

Stress VAR calculations mean once an asset class experiences one outbreak of volatility, it is permanently tainted, says Soanes. Gold, for example, declined 17% in two days, meaning now banks must henceforth hold more capital against their gold trading book, further undermining bank appetite for the yellow metal. That leaves a considerable weight of responsibility on the two remaining debt markets (Treasuries and Bunds) that still command almost unequivocal confidence. 

Basel III’s regulation of liquidity starts by distinguishing between long and short term liquidity: the ability to be flexible to meet short term liabilities, while remaining stable in the longer term. It does this by regulating liquidity via two distinct measures: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

The LCR quantifies liquid assets divided by net cash over a 30 day period, as a measure of a bank’s ability to meet its obligations for a month in the event of liquidity shocks. Banks are expected to have an LCR of more than 100%. 

While it is seen as reckless to allow the LCR to fall below 100% — a level that will be a regulatory requirement from 2015 — many investors believe the sweet spot is between 100% and 120%, says Darwish, as maintaining a liquidity position above that level is deemed excessively costly. 

At one end of the spectrum, investors may be concerned that an institution with such a high LCR is not focusing enough on profitability. At the other, it may encourage risk-taking in other areas to generate some return on equity, says Darwish.  

Although the LCR is not yet enforced by regulators, investors have ensured many financial institutions are already using it. Most are very transparent with their ratios, publishing them once or twice a year, while others use a similar ratio of liquid assets divided by the 12 month wholesale funding cost. This alternative encapsulates an institution’s ability to continue its business for a year in the absence of the wholesale funding markets. 

You say liquid, I say risky

The biggest controversy with the LCR is what does and does not count as “highly liquid assets” for the purposes of regulatory capital. Such criteria are always open for debate and convincing cases can be made for or against various asset classes that may be judged to be on the wrong side of the divide. 

The most obvious example of this is government bonds, which are considered highly liquid despite not always demonstrating this characteristic in recent years. This classification looks perverse in the context of a European sovereign debt crisis and has clearly contributed to market distortion. Some question whether regulators should be pushing banks to hold large quantities of sovereign bonds when the outlook for many sovereigns is so uncertain. 

Conversely, there are undeniably highly liquid assets that are not classified as such by the regulations. The equity market has been among the more reliable markets since the onset of the financial crisis, remaining open throughout as an option to issuers looking to raise capital, notwithstanding some measure of price volatility. 

The NSFR looks at the longer term liquidity and funding position of an institution, calculating the mismatch between the assets and liabilities. A SIV, for example, will score badly on the NSFR because the asset is likely to be long term, for example 10 years, while the funding is short term, with many requiring daily refinancing. Again, the aim with this ratio is to have as close to 100% as possible. 

The NSFR is less established as a measure than the LCR and its formula will be subject to review, meaning it is likely to change in coming months. The regulator will receive feedback from the markets and will look to optimise the ratio, a process it has already been through with the LCR. 

One concern that has already been raised is that the NSFR is pushing many institutions to try to increase their depositor bases, as deposits are seen as among the stickiest and highest quality forms of funding available. 

Pushing banks towards taking on more retail deposits makes sense on one level: deposits have traditionally proved highly stable. But the drive towards increasing retail deposits is already reducing that stability, undermining the original intended aim. (See article on retail deposits on p55).

In the world of regulatory box ticking there are numbers that can be cited as perfect levels of liquidity but in the more nuanced realm of reality there is no such simple answer. It is advantageous for a bank to have greater liquidity, but liquidity comes at a cost. There comes a point when declining profits become counterproductive. 

“If the regulator’s approach is too standardised, it will push the market towards homogeneous behaviour which is likely to create new problems,” says Adrian Docherty, head of FIG advisory at BNP Paribas in London. “We need different institutions to have different approaches and strategies.”

There is no obvious societal benefit to institutions fanning out across the liquidity spectrum, with some institutions setting themselves up as highly liquid institutions and others not. What could be helpful, however, is clarification on how liquidity is defined, to prevent a concentration of investments in certain favoured assets such as government bonds. 

There is some concern that the growing demand for sovereign bonds and other selected investments has come at the expense of other businesses, skewing banks away from socially desirable long term businesses, like writing mortgages. Such activities are costly from a liquidity perspective because they involve taking on long term assets, especially for institutions that rely on the wholesale markets for funding. The crisis has already swept away some of the biggest mortgage banks that had an unhealthy reliance on wholesale funding markets, such as Northern Rock.

Stable but expensive

Taken together the LCR and NSFR will force banks to lengthen the maturity profile of their wholesale funding and increase the proportion that is beyond one year, says Darwish. “While that is good for stability it is also very expensive,” he says.

Yet overall regulators are moving in the right direction, says Docherty. Before the crisis liquidity was a regulatory blind spot and many banks were weak in this area. But there is much further to go before the regulation of liquidity can be considered fit for purpose.

“Regulators could be more intelligent in their approach,” says Docherty. “Banks have a lot of insight, a lot of information they have built up about liquidity, which is being disregarded.”

The will is there to fix the liquidity problem but at the moment the regulator is in no mood to trust banks’ proprietary models. Many feel these models contributed to the crisis itself and are more part of the problem than part of the solution. 

“I think we need to allow internal models to show liquidity scenarios that can then be signed off by the regulator,” says Docherty. “At the moment they are using a basic, standardised formula — though to be fair their formula isn’t terribly bad.”

“The ratios are generally helpful and are not bad policies, but they are driving banks into cul-de-sacs that are constraining their liquidity and their ability to lend into the real economy,” says Soanes. “Regulators have to recognise that they are putting a handbrake on the growth of bank balance sheets.”

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