Putting their money on the new capital rules

Liquidity regulation has not received adequate attention until recently. Regulation of the banking sector over the past two decades largely revolved around Basel-capital requirements. There were no international standards to limit excessive maturity mismatch, so short-term borrowings were increasingly used to finance long-dated assets.

Simply put, ‘liquidity’ is a bank’s capacity to fund asset growth and meet expected and unexpected liabilities at reasonable cost. Liquidity risk arises when a bank cannot meet such obligations.

During the recent global economic crisis, even banks with sufficient capital base experienced difficulties due to imprudent liquidity management through excessive dependence on short-term funding. Also, banks that rely on borrowing from each other no longer trusted their creditworthiness. Credit dried up, and consumers opened multiple accounts to protect their deposits. The crisis demonstrated that illiquid banks can become insolvent in no time, and vice versa.

In general, the Basel II capital rules favoured lower capital for the trading book and higher capital for the banking book, with the assumption that trading book instruments can be disposed of quickly. However, this was proved otherwise during the crisis. Banks used the loophole to park banking book assets in the trading book, indulging in capital arbitrage.

As a result, the new Basel III norms focus not only on improved capital structuring, but also internationally agreed and harmonised liquidity standards. Basel III proposes two key liquidity-related ratios:

Liquidity Coverage Ratio (LCR) is designed to enable banks withstand adverse shocks. It requires banks to hold sufficient high-quality liquid assets (including cash, Government bonds and other securities) to meet severe cash outflow for at least 30 days.

Net Stable Funding Ratio (NSFR) is intended to ensure banks hold sufficient stable funding (capital and long-term debt instruments, retail deposits and wholesale funding with maturity exceeding one year) to match medium- and long-term lending needs.

Given the scale of the liquidity challenge, conventional means of rebalancing banks’ assets and liabilities may not be sufficient to meet the shortfall and build a strong market position. Conventional measures include extending the maturity of liabilities, sale of assets and raising capital. However, they may not be enough to plug gaps in liquidity and stable-funding. In addition, banks will try to attract more retail deposits, but the sum of available deposits tends to grow slowly. Furthermore, other banks will be chasing the same depositors, thereby pushing up interest rates. In short, funding costs are likely to go up, and the yield on high-quality liquid assets may drop.

In India, we have additional challenges, as the local market has regulations in terms of Statutory Liquidity Ratio (23 per cent of Net Demand and Time Liabilities) and Cash Reserve Ratio (4.25 per cent of NDTL), which act as a liquidity buffer. As more than 27 per cent money is already blocked in statutory requirements, and given the Government’s high deficit financing through market borrowings, it would be interesting to see how RBI will allow these liquid assets to be a part of Basel III liquidity estimations.

Banks face a multi-dimensional problem, and liquidity is but one aspect. In today’s complex and dynamic environment, banks should focus on developing a fully-integrated, enterprise-wide risk management framework, consisting of strategies, methodologies, organisational structures, processes and IT. Only then can they perceive, evaluate, and respond to risks at all levels.

(Kuntal Sur is Partner-Financial Risk Management, KPMG in India)

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