Redefining Global Liquidity: The Corporate Implications of Basel III
An Executive Interview with Andrew Linton, Head of Product Development and Jason Straker, Head of Client Portfolio Management, EMEA, J.P. Morgan Global Liquidity Group
Why do corporate treasurers need to know about Basel III, given that it is a banking regulation?
Basel III redefines global standards for bank capital, liquidity and leverage, and will profoundly impact how banks manage their balance sheets. Given that a bank’s balance sheet is made up of loans to customers (its assets) and deposits (its liabilities), changes to a bank’s balance sheet have an impact on its customers, particularly in this case on institutional customers.
What are the key elements of Basel III that corporate treasurers need to be aware?
A key element of Basel III is the liquidity coverage ratio (LCR). This has been designed to ensure that a bank can meet its liquidity needs in a severe stress scenario. Specifically, banks need to hold a sufficient stock of unencumbered assets that can be converted into cash within a day, without a decrease in value to meet all of the bank’s liquidity needs over a 30-day stress scenario.
To achieve this objective, banks must hold more high quality liquid assets (HQLA) than the difference between their calculated net cash outflows and inflows under 30-day stress period. HQLA are categorised in different ways: for example, cash, central bank reserves, central bank assets and sovereign debt are ‘level one’ and must comprise at least 60% of total HQLA.
The net cash outflow figure, which is key to the LCR calculation, reflects assumptions about the proportion of deposits (liabilities) that would leave the bank at a time of systemic stress. This is referred to as the run-off factor. The more stable the source of funding is perceived to be, the lower the run-off factor applied to it. Operating cash is considered the most secure, and therefore has the lowest run-off rate. For example, FDIC-insured retail deposits (and deposits guaranteed under similar schemes in other jurisdictions) are considered to be the most stable. Therefore, the run-off factor is only 3%. Non-operating cash, however, is subject to higher run-off rates. At the furthest extreme, uninsured, wholesale funding from financial institutions is considered the least stable, and is subject to a run-off rate of 100% i.e., the assumption is that 100% of this cash would leave the bank in 30 days.
From a corporate treasurer’s standpoint, a 25% run-off factor is applied to operating accounts not fully guaranteed by the FDIC or similar scheme, and 40% to unsecured wholesale funding from non-financial services corporations that ae similarly not fully covered.
While the LCR addresses short-term liquidity issues, another element of Basel III, the Net Stable Funding Ratio (NSFR), targets longer-term liquidity issues, focusing on reducing banks’ funding risk over a one-year horizon. Specifically, the ratio of stable funding (customer deposits, long-term wholesale funding and equity) to weighted long-term assets must be greater than 100%. Weighted long- term assets include 100% of loans that extend beyond one year, 85% of retail loans of less than one year, 50% of corporate loans within one year to maturity and 20% of government and corporate bonds. The aim is to reduce banks’ dependency on short-term wholesale funding, encourage better assessment of funding risk, promote funding stability and address mismatches between the liquidity profile of a bank’s assets and liabilities.
Basel III also increases the quantity and quality of the regulatory capital that banks need to hold from Basel II, in order to help banks withstand unexpected losses. It also identifies 29 globally systemically important financial institutions that are required to set aside higher levels of capital, from 1% to 3.5%.