WASHINGTON — The U.S. version of an international liquidity rule may include additional factors that make it harder to accurately compare between banks or examine the same institution’s liquidity holdings over time, according to a paper issued Wednesday by the Office of Financial Research.
The paper examines the implementation challenges posed by the liquidity coverage ratio, a post-crisis requirement meant to ensure that all banks have enough high-quality liquid assets to cover their cash outlays for 30 days. The LCR was originally outlined in the Basel III accord and later implemented in a rule finalized by the Fed in September of last year. Both versions require banks to examine their liquidity and maintain adequate reserves.
But certain differences between the U.S. rule and the one proposed by the Basel Committee on Banking Supervision may make it more challenging for regulators to accurately compare banks’ liquidity levels to one another or even to track liquidity within a bank – a stated goal of both versions of the rule.
“Differences in LCR computation among jurisdictions make it difficult to compare liquidity risk across banks,” the OFR paper says. “Although it is tempting to grab a set of banks’ LCR data and draw conclusions about their — and the financial system’s — short-term liquidity risk, the calculation of the ratio is complex and can pose challenges to such analysis.”
The paper says that misinterpretation of a bank’s publicized liquidity ratio – particularly if the ratio is below the required 100% threshold – could shake public confidence in the bank or even cause it to become distressed, even though the data underlying the ratio would show it to be sound. So far, bank regulators have said that ratios would be considered confidential information, but there is a risk that market regulators like the Securities and Exchange Commission, state regulators or exchanges themselves might require such disclosure in the future, the report said.
“It remains to be seen whether disclosure requirements under securities laws or stock exchange listing rules compel banks to publicize LCRs below 100% or the adoption of associated remediation plans,” the report said. “Such public disclosures could make it more costly for a bank to sell liquid assets or take other measures to improve its LCR during times of stress.”
The LCR is calculated as the total value of a bank’s high quality liquid assets (the numerator) divided by the bank’s 30-day cash outflow (the denominator). The resulting value should be equal to or greater than 1, showing that the bank has more HQLA than payment obligations and therefore can sustain itself for at least 30 days.
But there are a variety of inputs that go into both the numerator and denominator of the LCR equation – more than 300 inputs in the Basel standard, according to the report. Those include limits on what kinds of asset can count as HQLA and in what proportion. That standard is meant to ensure that banks hold diversified and highly liquid positions in their HQLA balance sheet, but the paper demonstrates that through the creative use of the repo market, banks adhering to the Basel standard could actually hold lower-quality assets and still meet the LCR.
The U.S. rule attempts to bypass that loophole by calculating the LCR at both the beginning of a month and the end of the month and applying “maturity add-on” consideration for outflows. That difference between the U.S. and Basel rules has the effect of making U.S. LCR calculations more volatile and harder to compare, because it is harder to time inflows and outflows perfectly and in a steady way from month to month, the paper says.
“The maturity mismatch add-on helps address the problem of high liquidity risk during the month even when the bank’s LCR is compliant under the Basel standard, but it also can create time-varying volatility with the potential to increase LCR compliance costs and complicate interpretation of LCR changes,” the paper says. “So shifts in the timing of the same set of cash flows within the 30-day window have significant implications for a bank’s required amount of HQLA.”