Basel III—Liquidity Standards

IIF Preliminary Analysis

December 2010

CONTENTS Today, the Basel Committee on Banking Supervision

(BCBS) released the final text of the new Basel III
Headlines 2 framework, containing global regulatory standards on
banks capital adequacy and liquidity agreed by the
Liquidity Coverage Ratio 3 Group of Governors and Heads of Supervision. Also
published today were the Results of the
Net Stable Funding Ratio 5 Comprehensive Impact Study and Guidance for
National Authorities Operating the Countercyclical
Buffer. The full text of these documents can be found
Monitoring Tools 6
at http://www.bis.org/press/p101216.htm.
Implementation 6
The BCBS published its original Basel III proposals in
December 2009. Subsequently, the Group of
Annex 1—Liquidity Coverage Ratio 8 Governors and Heads of Supervision published press
Detailed Template releases on July 26 and September 12, 2010, outlining
Annex 2—Net Stable Funding Ratio 12 key decisions and revisions of the original proposals.
The IIF commented extensively on all stages of this
Detailed Template
process

The IIF has undertaken a quick analysis of the final

standards published today. Below we present our
initial assessment of the liquidity standards, focusing
in particular on what we believe are the main issues
and the most salient changes regarding the original
proposals and the July and September 2010
decisions.

The reader should note that these comments reflect a

first reading of the new language, and have not had
the benefit of discussions with members. Comments
are therefore tentative and subject to correction and
amplification as more analysis is done.

We hope this document is useful as you navigate

through the complex new set of regulatory standards.
In the coming days and weeks the IIF will produce
additional analysis of the Basel III framework.

The IIF Regulatory Team

Questions or comments regarding David Schraa Andrés Portilla
this publication may be addressed to: +1.202.857.3312 +1.202.857.3645
dschraa@iif.com aportilla@iif.com

Stefano Mazzocchi Jermy Prenio Dave Sunstrum

+1.202.857.3309 +1.202.682.7455 +1.202.857.3615
smazzocchi@iif.com jprenio@iif.com dsunstrum@iif.com

Global Regulatory Update and other IIF publications are available on the Institute’s website: http://www.iif.com/regulatory/publications

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.

Basel III—Liquidity Standards
Headlines
Ratios: Both the Liquidity Coverage Ratio (LCR) and
the Net Stable Funding Ratio (NSFR) retain their
original design as binding, Pillar 1 ratios that will be
implemented according to the timeline provided
earlier in the year – LCR becoming binding in January
2015, NSFR becoming binding in January 2018.
Firms must begin reporting the ratios, along with the
underlying components, in January 2012 – a slight
delay from the original reporting date for the LCR of
January 2011.
Potential Changes: The BCBS remains open to
changes to the ratios during implementation based on
observation of the performance of the ratios prior to
their becoming binding, and will do a QIS with mid-
year and year-end 2010 data to monitor the effects of
the current format and capture any unintended
consequences. There is no information on what
disclosure policy could be. There is no mention of a
consultative process.
Symmetry: Addressing an issue raised by many
observers, the IIF included, the BCBS took steps to
make the treatment of funding more symmetrical
when comparing outflows and inflows. Reverse
repos, secured funding, and loans from financial
institutions are some of the areas where the BCBS
revised its initial proposals to make the treatment of
flows more balanced, so that related liquidity doesn’t
disappear from the analysis at the systemic level.
Treatment of Financial Institutions: However, the
disfavored treatment of financial institutions has not
changed, as funding from firms classified as such is
still heavily penalized. In this case the BCBS readily
acknowledges that the impetus for such treatment is
to reduce interconnectedness and the likelihood of
contagion during a crisis, instead of basing runoff
factors and haircuts on experience, even in a crisis
scenario.
Liquid Assets and Central Bank Eligibility: The criteria
for inclusion as Level 1 and Level 2 assets in the LCR
have not changed very much from the July 26 press
release. Both Level 1 and Level 2 assets “ideally”
should be central bank eligible, in addition to the
previous requirement that the assets be highly liquid;,
but a footnote makes it appear that the expectation
under most circumstances would be high liquidity and
central-bank eligibility. Exceptions may be made in
jurisdictions where the assets accepted by the central
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page 2
bank are extremely limited.
Insufficient Liquid Assets: The BCBS proposes three
different approaches for jurisdictions that do not have
enough Level 1 or Level 2 liquid assets to meet the
standards. Firms can 1) set up committed liquidity
facility lines with the central bank, with a fee to reflect
a yield comparable to other liquid assets; 2) use liquid
assets denominated in a foreign currency; or 3) allow
Level 2 assets above the current 40% threshold,
subject to additional haircuts.
Operational Requirements: The BCBS has provided a
new definition of “unencumbered”: the asset cannot
be pledged to secure, collateralize, or credit enhance
any transaction, unless part of reverse repo or
securities borrowing transaction (there is also an
exception made for assets pledged to a central bank
or public sector entity (PSE) but not used). The
requirement that assets available for the buffer must
be controlled by treasury (or equivalent) has not been
changed, despite the argument that unencumbered
assets anywhere in the institutions may become
available for liquidity purposes in an emergency.
Credit Ratings: In a move that goes against the
current initiatives to reduce dependence on credit
ratings (e.g., Dodd-Frank, FSB), the definition of Level
2 liquid assets and the required stable funding factor
for corporate bonds still relies on external credit
ratings. However, the document pledges to develop
alternative sources of information on the stability of
these instruments during the implementation process
to reduce the ratios’ credit rating reliance.
Cooperative Banks: Both the NSFR and LCR now
contain specific provisions for cooperative banks that
are required to hold deposits at central institutions,
clarifying how the rules would work for this special
structure.
Capping Cash Inflows: In order to ensure a firm does
not rely solely on cash inflows to fulfill its LCR
requirement, the BCBS has placed a cap that limits
the amount of inflows to 75% of the cash outflows,
guaranteeing that firms must cover 25% of
anticipated outflows with liquid assets.

Basel III—Liquidity Standards
Liquidity Coverage Ratio
The LCR is a ratio meant to ensure that the firm has
enough unencumbered liquid assets to cover a short
term crisis based on a predetermined set of cash
inflows and outflows established by the BCBS. The
specific assets defined as liquid, their respective
haircuts, and the percent of funds flowing in and out
as a result of the crisis are all set in the standards,
and are detailed in Annex 1. The measure has
undergone numerous revisions of detail from its
original conception in December 2009, but is still
fundamentally the same, strict Pillar 1 ratio.
Liquid Assets (paragraphs 21-49)
There are two categories of liquid assets, Level 1 and
Level 2 assets, which qualify for the numerator of the
ratio. Despite concerns that the definition of liquid
assets, even including the new Level 2 category, was
overly restrictive and may create unintended risks as
a result of the market effects of demand for qualifying
assets, and resulting asset concentrations, the BCBS
has not made any changes to the types of assets that
qualify. There is little evidence that the BCBS has
taken either market-focused comments or the current
travail in government bond markets into account.
The BCBS has also addressed the concern that, with
banks holding a heavy concentration of these
narrowly-defined liquid assets, firms could be
vulnerable to cliff effects due to a sudden downgrade
or change in market liquidity: firms are now allowed to
include downgraded assets for 30 days after the
asset no longer qualifies, to give sufficient time to
liquidate holdings.
Moreover, it has stipulated additional criteria that may
narrow applicable assets. Both Level 1 and Level 2
assets should “ideally” also be eligible for intraday or
overnight liquidity facilities at central banks. The
document provides an exception for jurisdictions
where central banks accept a very limited range of
assets – in these places Level 1 and 2 assets can
qualify as long as they fulfill all the other eligibility
criteria. While the language now acknowledges the
importance of central-bank liquidity, cumulative
requirements of high liquidity and central-bank
eligibility will not meet the substance of the industry’s
comments that greater credit should be given for
central-bank eligible assets. In addition to the
liquidity requirement, other restrictions regarding
eligibility are also still in place, so own-issued covered
bonds and self-securitizations, which are central-
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page 3
bank eligible in some jurisdictions, will still not qualify
as Level 2 assets.
The BCBS is also looking for ways to move away
from the current use of external credit ratings as part
of the criteria for liquid assets. During the
observation period numerous measures, such as bid-
ask spread, volume, and turnover, will be tested. As
well, Level 2 assets now have a specific quantitative
benchmark to prove they are reliable during stressed
conditions: a maximum price decline (or increase in
haircut) over a stressed 30 day period not exceeding
10%.
It had been previously established that Level 2 assets
could only make up 40% of the total stock of liquid
assets. The BCBS has now clarified this benchmark –
this 40% total is not calculated on the total amount of
Level 1 assets, but the amount of net Level 1 assets
taking into account the impact of secured funding
transactions unwinding within the 30 day window that
would involve the exchange of a Level 1 asset for a
non-Level 1 asset.
Another open issue the BCBS addresses is
establishing operational requirements for liquid
assets. Previously, the guidance had only stipulated
that the assets be unencumbered and available to the
treasurer. There is now considerable more detail.
Whereas it is now explicitly allowed for firms to hedge
the price risks of liquid assets, there are numerous
restrictions, as follows:
• assets must be managed with the “clear and sole
intent for use as a source of contingent funds”;
• not pledged to secure, collateralize, or credit-
enhance any transaction, or designated for
operational costs;
ο exceptions – assets received by reverse repo
and securities-borrowing transactions, assets
pledged to CBs and PSEs but not used; and
• not co-mingled with or used as hedges on trading
positions, designated as collateral or credit
enhancement.
The operational requirements also maintain an early
provision that the stock be “under control of the…
functions charged with managing the liquidity risk of
the bank.” This is notable, as many market
participants made the case that, in a crisis as severe
as the one prescribed by the BCBS, a firm would
marshal all available liquidity across the firm in order

Basel III—Liquidity Standards
to remain healthy.
The BCBS recognizes that some jurisdictions will not
have enough assets that qualify for Level 1 and Level
2 to make up the buffer AND keep a deep active
market. To determine which jurisdictions fall into this
category, a prescriptive quantitative threshold will be
developed during transition, with possibly qualitative
criteria as well. Once the designation is made, there
are three potential remedies:
Option 1 – contractual committed liquidity facilities
from the CB, for a fee:
• Fee must reflect equivalent yield for level 1 & 2
assets;
• Maturity date outside 30-day window;
• Irrevocable.
Option 2 – use foreign currency liquid assets:
• Regulators would ease currency match
requirement currently in place for the LCR;
• Must be done with freely and reliably convertible
currency;
• Firm must take into account risks in FX market.
Option 3 – use Level 2 assets in place of Level 1
assets, with higher haircut;
Cash Outflows (paragraphs 54-104)
The BCBS has not made serious changes to the
outflow assumptions that were originally proposed in
December 2009 and slightly tweaked earlier this year
– the final numbers can be found in Annex A. There is
still a heavy emphasis on retail and SME deposits,
presumed to be highly stable funding, and punitive
runoff rates for financial-institution funding in order to
reduce interconnectedness and prevent contagion.
The document also goes into detail defining what
constitutes “operational relationships” with other
financial institutions – this was necessary following
the July announcement that deposits from financial
firms for operational reasons would be given a 25%
runoff requirement. Clearing, cash management, and
custody are all given generic, though detailed,
definitions, and it is stipulated that only the funds
which directly meet these operational requirements –
and no excess funds in the same account – will be
eligible. Prime brokerage and correspondent banking
accounts are explicitly disallowed from receiving the
“operational” designation.
The BCBS has also addressed the concerns of
cooperative banks, whose special structures would
IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
page 4
have been heavily penalized by the original proposals.
Deposits in institutional networks of cooperative
banks have been given a 25% runoff factor. This
factor only applies to operational deposits which exist
to maintain minimum requirements and are in place
as pooled task-sharing funds.
The framework for secured funding has also been
revamped. Short-term funding backed by Level 2
assets is able to be rolled over, but with a 15%
haircut. As well, funding from domestic sovereigns,
central banks and PSEs are assumed to maintain
funding during the crisis, so short term funding from
these bodies backed by non-liquid assets is given a
25% runoff, instead of the previous 100%. This
change reflects the reality that such entities are
unlikely to withdraw funding from the market during
the prescribed crisis, and addresses the Institute’s
contention that such facilities would not be
withdrawn. Equities are still not recognized as being
a source of any stable secured funding during a short
term crisis, as the Institute had repeatedly urged the
BCBS to consider.
There have not been significant changes made to the
off-balance sheet assumptions. A 100% runoff is
given to derivative payables. For the draws on credit
and liquidity facilities, the runoff is now net of any
Level 1 or Level 2 assets posted as collateral.
The document also attempts to delineate between
credit and liquidity facilities more clearly, stating that
a liquidity facility is “any committed, undrawn back-
up facility put in place expressly for the purpose of
refinancing the debt of a customer in situations where
such a customer is unable to obtain its ordinary
course of business funding requirements in the
financial markets.” This responds to comments about
the lack of clarity between “credit” and “liquidity”
facilities, which get radically different treatment (10%
and 100% respectively). It is still not entirely clear (a)
whether the definition is workable in practice, and (b)
what products will be caught by the “liquidity”
definition; on a first glance, it appears to catch CP
and municipal backup lines, for example. Working
capital facilities are explicitly excluded, but without a
great deal of definitional detail.
Finally, the BCBS has left in place the allowance for
national discretion on all other contingent funding
liabilities, such as trade finance and letters of credit.
While this may be a fragmentation issue going
forward, the document stresses in paragraph 18 that

Basel III—Liquidity Standards
these parameters “should be transparent and clearly
outlined” by regulators, which should help industry
participants monitor implementation.
Cash Inflows (paragraphs 105-118)
Cash inflows were originally left to national discretion
in the December 2009 proposals, but are now
explicitly defined by the BCBS and will require a more
thorough analysis in the near future – in particular the
assumptions on reverse repos and securities
borrowing. These new details have helped to
increase the symmetry of treatment of many types of
funding in the ratio, and increased the odds of
consistent implementation across jurisdictions. Cash
inflows in excess of 75% of the total cash outflows
calculated by the firm will not count towards the LCR
– a new development in the Basel liquidity regime.
This restriction is to ensure a firm does not depend
solely on inflows in a crisis, and to guarantee a firm
has a minimum amount of liquid assets at its
disposal.
For reverse repos, rollover assumptions are the same
as for the outflows: repos backed by highly liquid
assets, 0% runoff for Level 1 and 15% runoff for level
2; all other repos, the cash is fully expected to flow
back into the firm. There is one exception: if the
collateral is used to cover short positions, then the
inflow is not recognized.
Lines of credit are not recognized as producing cash
flows at all – this is a notable point of asymmetry that
is justified as necessary to reduce contagion. As well,
operational deposits with other financial firms
(including those from cooperative banks to the
centralized institution) are given a 0% inflow rate.
Inflows for all other transactions are determined by
counterparty, as long as they are fully performing.
100% of contractual inflows from financial institutions
are assumed to flow back into the firm as financial
firms withdraw funding from each other. 50% of
contractual flows from all other customers are
counted, as the firm is assumed to continue
extending some of the funding.
IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
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Net Stable Funding Ratio
The NSFR is a long-term ratio that measures how
much stable funding a firm has to endure a year-long
liquidity crisis. Much like the LCR, the NSFR depends
upon a predetermined set of run-off factors for
different categories of funding, and mandates that the
amount of “available stable funding” a firm has must
match the stable funding required for its assets.
Also like the LCR, the NSFR has not been
fundamentally changed, despite the further
deliberations of the BCBS announced over the
summer. The BCBS seems intent on beginning
implementation as is, and fixing any major issues
during the observation period. That being said, there
have been some notable changes to the assumptions
on types of funding. The full structure of the ratio can
be found in Annex 2.
Available Stable Funding (paragraphs 124-128)
The BCBS lays out four buckets of funding types that
have different levels of stability, and gives a haircut
for each accordingly. The only major change here
from previous releases is that the BCBS has clarified
that funding from domestic sovereigns, central banks,
and PSEs can be included in the 50% ASF factor
bucket along with non-financial corporates.
Required Stable Funding (paragraphs 129-136)
The BCBS also delineates different types of assets by
stability, and stipulates how much stable funding is
required for each type. The one general change
noticeable in this section is that all loans and bonds
now must be unencumbered, following the same
definition given for liquid assets in the LCR.
Previously included in the 0% required factor bucket
were secured funding arrangements that are assets of
a bank maturing within one year. The BCBS has now
mandated that firms must look through the secured
funding transaction and apply the required stable
funding factor for the asset used to settle the
transaction at the maturity date. This is a more
conservative approach, as firms will only be able to
maintain the 0% factor if the transaction is settled in
cash.
Sovereign, central bank, and PSE debt with a maturity
of greater than one year is included in the
denominator in the new language. If these securities
are given a risk weight of 20%, they only require 20%
stable funding. As well, the minimum external credit

Basel III—Liquidity Standards
rating for corporate and covered bonds at the 20%
stable funding level has been lowered from AA to AA-,
although this only slightly addresses industry
concerns that the original level was set too high.
However, these securities now carry the same
definition as Level 2 liquid assets – meaning they
should “ideally” central bank eligible. This same
designation applies to the corporate and covered
bonds in the 50% required stable funding category.
Equities and gold were pointed out during the
consultation process as two assets that were given
unduly high required stable funding factors, as neither
was shown to lose 50% of value during a crisis – in
fact, gold tends to increase in value during a crisis.
This concern has not been addressed, as large cap
equities and gold are still given only a 50% stable
funding factor.
The BCBS had announced earlier this year that
residential mortgages that qualify for the 35% or
lower risk weight would only require 65% stable
funding, up from 100%. This category has now been
expanded to include other loans to non-financial firms
with a maturity greater than one year that qualify for
the 35% risk weight.
The treatment of small businesses as analogous to
retail customers has been reinforced in the 85%
bucket, where loans to small businesses with maturity
less than one year now qualify along with loans to
retail customers with the same maturity.
Off-balance sheet designations have not changed
from the July release – undrawn portions of credit and
liquidity facilities require 5% stable funding, and all
other contingent funding obligations – e.g. letters of
credit and other trade finance instruments - are
determined by national supervisors.
The BCBS still plans to evaluate possible interim
buckets for matching assets and liabilities in the
NSFR during the observation period, noting especially
its intention to provide incentives for firms to have
longer-dated funding within the one-year period.
Monitoring Tools (paragraphs 137-183)
The monitoring tools the BCBS proposed last
December received considerable less attention, and
understandably so – the hard, binding ratios are going
to have a much larger impact on financial firms.
However, there are developments here that will
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page 6
definitely create a burden, or at least increased work,
for firms.
The four ratios are:
• Contractual Maturity Mismatch
• Concentration of Funding
• Available Unencumbered Assets
• LCR by Significant Currency
For the Contractual Maturity Mismatch ratio, firms are
going to need to record “all securities flows”, as well
as all customer collateral and whether they are
permitted to rehypothecate it.
The paper also explicitly defines the “Leverage
Coverage Ratio by Currency” ratio, which earlier had
just been part of the LCR implementation. This will
make sure there are no major currency mismatches in
the LCR, except where permitted by the exception
stated above. The ratio will also only apply to
currencies if aggregate liabilities in that currency
make up more than 5% of total liabilities. This ratio
will also be used by host supervisors to monitor
whether cross-border firms have enough liquidity to
handle the liquidity needs of the legal entity.
The “Concentration of Funding” ratio will probably be
used by the BCBS in their work investigating
concentrations and large exposures in the financial
system; this work is due to be finalized by the end of
2011.
Finally, the paper gives a view regarding what the
next project the Basel Liquidity Working Group will
take on: "One area in particular where more work on
monitoring tools will be conducted relates to intraday
liquidity risk."
Implementation (paragraphs 184-197)
Firms are expected to begin reporting the underlying
data for the ratios on January 1, 2012. This
recognizes that the industry would not be ready for
the original observation period start date of January
1, 2011 for the LCR.
The LCR will be calculated and reported at least
monthly, with the operational capacity to increase the
frequency to weekly or even daily in stressed
situations at the discretion of the supervisor. The
NSFR will be calculated and reported at least
quarterly. The BCBS sets a two-week limit for the
 page 7
Basel III—Liquidity Standards

time between the end of the reporting period and
when the data should be available.
There may also be many more demands by
supervisors across jurisdictions to report ratios. The
standards and tools are allowed to be used “on any
subset of entities of internationally active banks”,
which means host supervisors may ask for
calculations of the ratios and monitoring tools, and
demand adherence to the ratios, on a legal entity
basis. In any case, banks “should actively monitor
and control” liquidity exposures and funding needs at
the levels of legal entities and foreign branches and
subsidiaries, as well as at the group level.
decided by the end of 2011.
New QIS. As part of the BCBS’s pledge to monitor
closely the implementation of the ratios and their
wider effects, there will be a QIS using data from
year-end 2010 and mid-year 2011 focusing on the
liquidity aspects of the new Basel regime. This
analysis will focus on the impact of the standards on
financial markets and the broader economy, the
impact on different business types and sizes, as well
as specific issues, such as the treatment of lines to
non-financial corporations. Any revision as a result of
these finding will be made to the LCR by mid-2013
and to the NSFR by mid-2016.

The document expressly permits supervisors to set
minimum monitoring ratios for the LCR by currency in
jurisdictions where the banks’ ability to raise funds in
foreign currency or transfer liquidity from one
currency to another may be limited.
The ratios and underlying components will need to be
reported to supervisors starting January 2012. The
LCR will be introduced as a binding constraint on
January 1, 2015, and the NSFR will become a
minimum standard by January 1, 2018.

The standards also confirm as a general principle the

need for firms to factor in the availability of liquidity
from different jurisdictions in their ratios, taking into
account restrictions that inhibit the transfer of assets
and flows within a cross-border group.

The new language seems to set a high standard in

determining the assets as “freely available”: “no
liquidity should be recognized by a cross-border
group in its consolidated LCR if there is any doubt
about the availability of the liquidity.” Liquid assets
held by a consolidated entity that are used to meet its
local LCR requirements can be included in the
consolidated LCR insofar as used to cover the
outflows of the entity, but any assets in excess of the
stressed not cash outflows must be excluded.

The implementation of the LCR for cross-border

groups will require firms to apply the liquidity
parameters of their home supervisors for all
categories of funding, assets, and flows, except for
retail and SME deposits, which will be given the
factors of the host jurisdiction.

There is no information on disclosure as of now.

Comments by leading regulators indicate divisions of
opinion about disclosures: some clearly prefer not to
require disclosures, whereas others may wish more
disclosure. But despite the lack of clarity right now,
there has been a push since the crisis to increase
transparency of risk, and both the FSB and the BCBS
are considering further risk disclosures, which may be

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
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Basel III—Liquidity Standards

Annex 1—Liquidity Coverage Ratio Detailed Template

Taken from BCBS 188

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 page 9
Basel III—Liquidity Standards

Annex 1—Liquidity Coverage Ratio Detailed Template

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
 page 10
Basel III—Liquidity Standards

Annex 1—Liquidity Coverage Ratio Detailed Template

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
 page 11
Basel III—Liquidity Standards

Annex 1—Liquidity Coverage Ratio Detailed Template

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.
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Basel III—Liquidity Standards

Annex 2—Net Stable Funding Ratio Detailed Template

Taken from BCBS 188

IIF. com © Copyright 2010. The Institute of International Finance, Inc. All rights reserved.