Making every drop count

Basel III liquidity requirements and implications for US institutions

New regulatory rules have operational and strategic implications

In December 2010, the Basel Committee on Banking Supervision issued Basel III: International framework for liquidity risk measurement, standards and monitoring. This step coincides with its release of enhanced capital standards and completes the reformed framework called for by G20 leaders. Collectively, these new global standards, referred to as Basel III, are intended to strengthen the resilience of global banking institutions. Before the financial crisis, the focus of banking regulators was primarily on capital. One outcome of the crisis, however, has been recognition by regulators and financial institutions alike that liquidity is of equal importance and must be addressed in a comprehensive risk management framework. Consequently, most large financial services firms have made significant investments in their liquidity risk management frameworks. The current focus of leading institutions is to enhance their reporting and stress testing capabilities through investments in data and technology infrastructure, as well as to incorporate liquidity formally within their enterprise risk and funds transfer pricing frameworks. The management of funding and liquidity is increasingly a core part of the strategic planning framework and proactive balance sheet management. The new Basel III liquidity rules mark the first time that specific global quantitative minimum standards for liquidity have been introduced. Monitoring of the new standards commenced as of year-end 2010. Specifically, the new rules call for an additional Quantitative Impact Study (QIS) to be conducted based on year-end 2010 and mid-year 2011 reference data. Banks should anticipate a specific QIS request in the first quarter of 2011. To provide institutions with time to develop their reporting systems, the first observation-period reporting to supervisors is expected by January 2012 for both standards. The liquidity coverage ratio (LCR) will have to be met from January 2015, with any revisions to its calibration to address unintended consequences issued by mid-2013. The net stable funding ratio (NSFR) will undergo a longer observation period and will not

be introduced until January 2018. Revisions will be made to the NSFR no later than mid-2016. Banks will also be required to observe the principles regarding governance and management of liquidity risk set out in the September 2008 Principles for Sound Liquidity Risk Management and Supervision. These principles were also the foundation for the US Interagency Policy Statement on Funding and Liquidity Risk Management, which was introduced in March 2010. The final Basel III liquidity rules, as well as global supervisory efforts such as the December 2010 report by the Senior Supervisors Group (SSG), Observations on Developments in Risk Appetite Frameworks and IT Infrastructure, provide a global foundation that should help to harmonize the regulatory and infrastructure expectations for liquidity being defined by supervisors. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) calls for enhanced prudential requirements for liquidity and capital for financial services institutions. Consequently, US supervisors have been working to define expectations for enhanced capabilities for funding and liquidity, including how these capabilities are incorporated within enterprisewide initiatives such as recovery and resolution planning. The detailed fourth generation (4G) daily liquidity reporting being rolled out by the US Federal Reserve for large financial institutions is an example of the direction of supervisory expectations. While the final Basel III rules for liquidity are consistent with the original proposal and the July 2010 followup press release, there are noteworthy additions and changes to assumptions. National discretion. Since the Basel liquidity rules are minimum standards, national differences will occur, particularly in those items subject to national discretion, such as reporting formats, as well as assumptions for deposit runoff rates, contingent funding obligations and market valuation changes on derivatives. The rules specify that where differences

exist, the home supervisor parameters should apply to all entities being consolidated, except for retail or small business deposits, where local assumptions should be used. This means that global banks will need to monitor parameters set by the local supervisors in the countries where they take deposits and to develop the flexibility to incorporate these differences in their risk analyses. Secured funding. The final rules provide a less binary runoff of secured funding transactions differentiated by counterparty, which is positive for institutions. However, the rules require that institutions have detailed secured funding management information capabilities in order, for example, to identify reverse repurchase agreements (repos) covering short positions. Liquidity coverage ratio by currency. The final rules introduce the LCR by currency as a new monitoring tool. While this is not a standard and no minimum threshold is defined, the requirement to analyze and report the LCR by significant currency will increase the data and reporting challenges faced by banks as they implement the rules. Market valuation changes on derivatives. LCR parameters must incorporate an additional liquidity need associated with collateralization of market value changes in derivatives. While the specific assumptions are left to national discretion, the Basel rules make it clear that the factor cannot be zero. This is likely to result in increased liquidity charges for banks derivatives trading businesses.

Making every drop count Basel III liquidity requirements and implications for US institutions

Summary of key liquidity changes in Basel III

Final rule
LCR stress assumptions Public debt credit downgrade impact scaled up to and including three notches Partial loss of unsecured wholesale funding capacity (a loosening of requirements) Removes explicit need to fund balance sheet growth, although unplanned balance sheet growth due to action to mitigate reputational risk must be considered Funding needed to buy back debt should be considered (a tightening of requirements) No more than 75% of cash outflows can be offset with cash inflows buffer of high-quality liquid assets must be at least 25% of expected outflows (a tightening of requirements) 50% of cash inflows from retail and small business owner transactions must be rolled over (a tightening of requirements) Definition of high-quality liquid assets Amends and clarifies details for two levels of high-quality liquid assets specifically added and defined in detail. Level 1 assets are cash, certain government securities and other 0% risk-weighted assets under Basel II. Level 2 assets are limited to 40% of buffer after adjustments and have a minimum 15% haircut. Level 2 assets have a 20% Basel II risk weight and meet specifically defined criteria Characteristics defining high-quality liquid assets for liquidity buffers are clarified to require historical data analysis to demonstrate breadth and depth of markets Definition of unencumbered liquid assets for liquidity buffer Use of assets needed by entities other than parent to meet legalentity requirements Jurisdiction- and currencyspecific liquid asset requirements Deposit runoff assumptions Clarifies market practice that assets received through reverse repos and securities financing transactions that have not been rehypothecated can be used as buffer assets Final guidance provides detailed clarification for expectations, including assets being freely available to the parent in times of stress (a tightening of requirements) Detailed new guidance for considering and addressing gaps in liquidity at legal-entity level, including currency gaps (major data and operational implications) Runoff of operational deposits (trust, custody and cash management services) covered in detail clarifies that depositing bank cannot assume availability of deposit, prime brokerage deposits require 100% runoff, not operational deposits (a loosening of requirements and major data and operational implications) Minimum runoff for stable retail deposits lowered to 5% and 10% for less stable funding; same runoff assumptions for wholesale unsecured funding from small business customers (a loosening of requirements) Assets obtained through reverse repo and securities financing transactions are not specifically defined as eligible for buffer Lack of detailed guidance on use of liquid assets held by entities

Previously proposed guidance

Public debt credit downgrade of three notches (Complete) loss of unsecured wholesale funding capacity Required funding of balance sheet growth

Funding to support debt buy-back not specifically mentioned No specified cap on offsetting outflows with projected cash inflows No specified rollover for retail and small business lending Annex introduced permissible Level 2 assets, but further clarification was needed

Lack of detailed guidance on legal-entity liquidity expectations

Runoff factor for operational deposits not in original proposal, added in July following QIS and comment letters

Runoff assumptions for stable retail deposits 7.5% and less stable retail deposits 15%; same assumptions for funding from small business customers

Final rule (contd.)

Derivatives 100% outflow from net derivative payables, net of collateral (a loosening or tightening of requirements depending on direction) Increased liquidity needs for collateralization of derivative market value changes; parameter is defined by national discretion, but cannot be zero Frequency of reporting LCR remains a monthly requirement, with an operational capability to move to weekly or daily in a stress environment; NSFR must be prepared at least quarterly no more than two weeks allowed to prepare reporting (major data and operational implications) Reporting LCR analysis by currency is a new requirement to provide insight to currency mismatches not a formal standard, so no specific limits defined (major data and operational implications) Assumes a less binary runoff of secured funding transactions for certain collateral, differentiated by counterparty: 0% runoff backed by Level 1 assets 15% runoff backed by Level 2 assets 25% for domestic sovereign/central bank counterparties for non-eligible assets 100% for other counterparties for non-eligible assets Specific requirements for the treatment of short-term collateral upgrade trades Need to adjust reverse repo for short coverage Removal of specific match book allowances (a loosening of requirements and major data and operational implications) National discretion Formalizes expectation that local market factors will be applied at the consolidated level Leaves a number of areas for national discretion, including deposit runoff, derivatives and non-contractual items Reporting format not formally specified only that LCR categories are a minimum; local regulators may specify different formats Also uncertainty on intra-day requirements (major data and operational implications)

Previously proposed guidance(contd.)

Left to supervisors discretion

Both LCR and NSFR had to be produced at least monthly

Monitoring tools

No specific LCR analysis by currency was required, only assetliability breakdown Assumes 100% runoff for non-government Level 1 debt Exemption for evidence match book repo activities

Secured funding

Making every drop count Basel III liquidity requirements and implications for US institutions

Implementation
The experience of many firms after the introduction of similar monitoring, reporting and stress testing-based buffer requirements in the UK indicates that meeting the stress testing and reporting requirements will pose considerable data and systems challenges. Banks should start now to carry out a gap analysis in order to understand the challenges and initiate projects to deal with them. Enhancing the governance of liquidity risk and embedding the new metrics in the organization will pose challenges as well. The economic cost of meeting the new requirements will need to be attributed to the business functions, which will pose challenges for existing funds transfer pricing frameworks. The new regulatory rules for liquidity will also have important operational and strategic implications for bank management. The Basel Committee impact study showed considerable costs stemming from this aspect of Basel III, with the need for spreads to rise by 25 basis points to cover them. The new Basel III liquidity rules establish two separate minimum standards to be met by internationally active banks: 1. The LCR, which is designed to establish a minimum level of high-quality liquid resources sufficient to meet an acute stress lasting for 30 calendar days 2. The NSFR, which is designed to influence the structure of funding by creating incentives for banks to fund assets that are not readily saleable with stable funding The timeline for introduction of the NSFR standard was extended to 2018 to monitor the effects. And although the standards will be common across jurisdictions, some specifically identified parameters will be set by local supervisors to reflect local conditions. Before we look at the two ratios in detail, it is worth noting that the Committee has also set out a number of additional metrics for all supervisors to collect and monitor. Standard monitoring tools The Committee has significantly increased the amount of information on liquidity that supervisors should collect from banks for example, contractual cash flow mismatches by time bucket, as well as an LCR analysis by currency. Although this reporting will not have minimum thresholds or be reported in the form of a formal ratio or table, it will create systems costs and difficulties and will need to be embedded in the management of the business. In the case of contractual cash flows and the LCR analysis by currency, many banks have systems for calculating maturity mismatches by currency that include behaviorally adjusted maturities rather than including everything according to contractual maturity. Going forward, firms will need both. Also, regulatory reporting requirements for liquidity are not harmonized across different jurisdictions, resulting in major challenges in classification and aggregation of data for global institutions. Additional dimensions, such as legal entities and type of deposit, hitherto not significant, have to be considered. An important lesson learned from global banks that have implemented the UK Financial Services Authoritys (FSA) mismatch reporting is that a single source of underlying data, aligned to books and records and used for both internal risk management and regulatory reporting, is a foundational design principle. Institutions that did not utilize this approach have had numerous problems requiring costly tactical solutions that diverted management attention. Under the Principles of Sound Liquidity Risk Management and Supervision, although contractual data will be supplied to regulators who make their own behavioral adjustments, banks should conduct their analyses of the inflows and outflows using behavioral assumptions. The metrics must also be fully embedded in strategic thinking. 1. Contractual maturity mismatch by time bucket, possibly overnight; 7 days, 14 days; 1, 2, 3 and 6 and 9 months; and 1, 2, 3, 4, 5 and beyond 5 years 2. Concentration of funding covering wholesale funding by specific counterparties, instruments and currencies 3. Available, unencumbered assets could potentially be used as collateral for secured funding in the market or at existing central bank facilities 4. LCR by significant currency (a new provision) so that bank management can capture potential currency

mismatches that can increase liquidity risk. Since the foreign currency LCR is not a standard, there is no minimum threshold defined by supervisors. The rules note that supervisors in specific jurisdictions could define minimum reporting levels 5. Market-related monitoring tools, e.g., bank-specific credit default swap spreads, equity prices and marketwide metrics, such as liquidity of different assets and asset prices Each supervisor will be establishing the templates for reporting the items and this, too, will create complexities for banks operating in different jurisdictions, if, as is likely, host authorities as well as home-state authorities request data. Liquidity coverage ratio The LCR is one of the two new quantitative liquidity requirements. It has been defined as:

2. The second level will be available to cover up to 40% of the required buffer. This level includes a wider range of bonds after application of a minimum 15% haircut. It includes government and public sector entity (PSE) debt with a 20% risk weight and non-financial corporate and covered bonds rated AA- and above. There would be other requirements to ensure eligibility, regarding bid-ask spreads, price volatility and so forth. Not only must these assets be unencumbered, but they must be freely available to meet the liquidity of the group entities covered by the ratio. They also cannot be used as hedges for trading positions and must be under the control of the function or functions charged with managing liquidity risk (typically the treasurer). Periodically, they must be monetized, either through repo transactions or sales, to test the liquidity of the markets. The net cash outflow that must be covered by the highquality liquid assets is the cumulative expected cash outflow minus the cumulative cash inflow over the 30 calendar-day period. Both outflows and inflows must reflect a stress period. A maximum of 75% of cash outflows can be offset by cash inflows. Therefore, the minimum size of the high-quality liquid asset buffer is 25% of stress-cash outflows. To calculate both the stock of unencumbered assets and the net cash outflow, a stress scenario must be applied that will be forward-looking over the next 30 calendar days. The Committee has set out the scenario that should be used: a combined firm-specific shock and a market shock that would result in the components shown in the table on pages 9 and 10. The stress test is designed to pick up a number of different impacts on the liquidity profile of the organization. From the liability side, it will capture the speed with which wholesale markets can react to bad news by withdrawing access to unsecured funding, as well as tightening terms for secured funding. Partial loss of unsecured wholesale funding capacity must be assumed, and shortterm secured funding is assumed to be lost unless it is collateralized with high-quality liquid assets.

Stock of high-quality liquid assets Total net cash outflows over the next 30 calendar days

100%

This ratio will prescribe the quantity of high-quality liquid assets that a bank will have to hold at any point in time: the stock must equal the 30 calendar-day stress-cash outflow. The high-quality assets used to meet the test must be unencumbered, and both the value of the stock of high-quality liquid assets and the net cash outflow must be calculated for the stress period. Since the original proposals were issued, the Basel Committee has liberalized the definition of what counts as a liquid asset. This was an important change for institutions with significant holdings of US agency securities in their liquidity portfolios. Global institutions should also consider the impact of cross-currency risk in assessing the currency profile of their liquidity portfolios. There are two levels of liquid assets: 1. The first level consists of 0% risk-weighted sovereigns and cash, plus some other sovereign exposures.

Making every drop count Basel III liquidity requirements and implications for US institutions

Likewise, the runoff of a proportion of retail deposits is assumed, and by dividing the retail deposits into stable and unstable ones, the Committee is recognizing that depositprotection schemes that are able to pay out quickly could slow the loss of retail deposits, and that customers with a stable relationship with a bank may withdraw deposits more slowly. Term deposits can be treated as locked in until maturity if there is a penalty for early withdrawal that is materially greater than the loss of interest. The runoff factors for deposits denominated in foreign currency will be set by local regulators. The final rules include a 25% runoff factor for deposits and other extensions of funding from wholesale customers associated with operational relationships related to clearing, custody and cash management services. However, the rules provide specific guidance to limit the application of this runoff factor. Specifically, there must be a demonstrated operational relationship with deposit pricing below rates for market funding. Only deposit balances necessary to support the operational activities qualify for the 25% runoff factor. Excess balances do not qualify. There is also detailed definitional guidance for clearing, custody and cash management services. The 25% runoff factor also applies to the central institution or specialized service provider in an institutional network of cooperative banks. Where the 25% runoff factor is applied, the depositing bank must assume it has no access to the funds it has placed on deposit as part of its LCR analysis. The ability to produce segmented reporting for operational balances, including segregating excess amounts, as well as supporting this segmentation, is likely to be challenging for institutions and requires investments in infrastructure and new or improved processes.

Basel III shock scenario components

LCR stress components
Institution-specific downgrade Liquidity needs related to downgrade triggers embedded in short-term financing transactions, derivatives and other contracts Retail and small business deposits Stable deposits covered by deposit protection or with stable relationship or deposits in transactional accounts Unstable deposits

Magnitude
Up to and including three notches 100% of collateral

Domestic currency: runoff assumption (at least 5%)

10% minimum Foreign currency: will be determined by national supervisor

Time deposits with residual maturity greater than 30 days with a significant withdrawal penalty or no legal right to withdraw Unsecured wholesale funding Stable and less stable small business customers Operational balances non-financial corporates, sovereigns, central banks and public sector entities (PSEs) Other balances non-financial corporate, sovereigns, central banks and PSEs Other balances by other legal-entity customers financial institutions, fiduciaries, conduits, etc. Secured funding Loss of short-term secured funding

0% or higher to be determined by jurisdictions

Minimum 5% and 10% Runoff assumption 25% unless fully covered by deposit insurance, in which case it can receive the stable retail deposit runoff rate 75%

100%

0% for secured funding transactions backed by Level 1 assets 15% for secured funding transactions backed by Level 2 assets 25% roll-off from domestic sovereigns, central banks or PSEs that are not backed by Level 1 or Level 2 assets. PSEs that receive this treatment should be limited to those that are 20% or lower risk-weighted 100% for other counterparties except those backed by assets allowable for the liquidity pools

Operational activities with financial institution counterparties

Custody and clearing and settlement plus cash management, as well as central bank/service provider in a network of cooperative banks subject to specific supervisory approval

25%

Making every drop count Basel III liquidity requirements and implications for US institutions

LCR stress components (contd.)

Market volatility Increase in market volatility

Magnitude (contd.)
Minimum of 15% haircut for Level 2 assets Liquidity needs relating to market valuation changes on derivatives should be nationally determined 20% calculated off notional amount after haircuts for market valuation change on non-Level 1 posted collateral securing derivatives transactions

Asset-backed commercial paper, structured investment vehicles, conduits, etc. Term asset-backed securities (including covered bonds and other structured financing instruments) Committed lines Drawdown of committed but unutilized credit and liquidity facilities All outstanding lines to retail clients Committed credit facilities to non-financial corporate, sovereigns, central banks, PSEs and multilateral development banks Outstanding liquidity facilities to non-financial corporate, sovereigns, central banks, PSEs and multilateral development banks All other legal entities, including financial institutions, credit and liquidity facilities Other contingent funding obligations Need to fund non-contractual commitments because of risk of reputational damage, as well as other contingent funding liabilities that are contractual Net derivative (payables) outflows Other contractual outflows Outflows relating to operating costs Cash inflows Contractual inflows on existing fully performing exposures only Retail and small business Wholesale financials and non-financials Operational deposits held at other financial institutions Own lines of credit Receivables from reverse repo transactions and securities lending transactions Other cash inflows net derivative receivables Other contractual cash inflows Non-financial revenues

100% of maturing amounts and 100% of returnable assets

100% of maturing amounts

Percentage counted as drawn down 5% 10%

100%

100% Runoff rates determined by each national supervisor. Banks and supervisors should, at a minimum, use historic behavior in determining appropriate outflows 100% 100% 0% Percentage of cash flows counted 50% 100% and 50% 0% 0% 0% for liquid (Level 1) assets and 15% for Level 2 assets. No rollover assumed for non-Level 1 and 2 assets 100% inflow unless covering short positions 100% Treatment determined by supervisors in each jurisdiction 0%

Other contractual cash outflows

The LCR goes much further than just reflecting the characteristics of funding. In particular, it recognizes the liquidity effects that can stem from trading book and derivative exposures in a stress period. As security prices and interest rates become more volatile, so margin/collateral requirements can drain liquidity or

access to unencumbered high-quality liquid assets. Many contracts have triggers that require more collateral to be posted if the institution is downgraded. This will put downward pressure on the available stock of liquid highquality assets.

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The stress test also captures pressures from balance sheet growth because, in a period of market stress, committed lines are likely to be drawn down. The test does differentiate between different types of commitment. There is a significant difference in drawdown assumptions for credit facilities and liquidity facilities. Liquidity facilities are defined as any committed, undrawn back-up facility put in place expressly to refinance the debt of a customer in situations where the customer is unable to obtain its ordinary course of business funding requirements (e.g., commercial paper program). Working capital facilities are classified as credit facilities, rather than liquidity facilities. With the exception of retail and small business customers, the LCR assumes 100% drawdown of liquidity facilities. Retail and small business committed credit and liquidity lines are thought less likely to be drawn down (e.g., credit card limits) than lines given to other customers and, therefore, a 5% drawdown factor is applied. As discussed, for all other types of customers, committed liquidity lines are assumed to be fully drawn. A drawdown factor of 10% is applied for credit facilities for nonfinancial corporates, sovereigns and central banks, PSEs or multilateral development banks. For financial institutions and other customers, a 100% drawdown factor for committed credit facilities must be used. The stress test also reflects the reality that in the face of potential reputational damage, a bank could not walk away from some types of commitments even though the contract may allow it to. One example is the mortgage pipeline for a mortgage bank. Mortgages will have been approved out over a three-month period. Although in some markets, the contractual terms may allow the bank to walk away from the agreement and not provide the mortgage, the reputational damage sustained could make this option unrealistic. This new liquidity stress testing will pose major data and systems challenges. One difficult area is the tracking of triggers and other aspects of derivatives contracts that could require more collateral to be posted. Another will be aggregating data across international organizations; currently, many banks have established systems for managing liquidity that do not combine all entities and also do not recognize all sources of liquidity pressure. Over and above the regulatory minimum stress test, banks are also required to design and carry out their own stress

tests that should incorporate longer time horizons that are tailored to their own business profiles. Banks are expected to share the results of these additional stress tests with supervisors. This, too, will pose challenges. Clear policies and procedures will need to be developed to conduct the regulatory stress tests, design appropriate internal stress tests and provide the necessary governance and oversight. The output will also have to be embedded in the business. Net stable funding ratio The second of the new quantitative liquidity requirements is the NSFR. It is seen as a complement to the LCR and is designed to provide incentives for banks to seek more stable forms of funding. Initially, it will be a monitoring tool, but it will become an actual requirement from 2018. The effect of the NSFR will be that (with certain exceptions) all illiquid securities and loans longer than one year will have to be backed by stable funding greater than one-year funding or shorter-dated funding from more stable sources, such as retail. For some types of loans, 100% backing will be required. A proportion of all non-money market securities, no matter how liquid and high quality, will also have to be backed by stable funding. This will mean that banks cannot rely on short-dated wholesale funding for the trading book, nor, for example, for funding the warehoused loans waiting to go into securitizations. In the QIS, it was clear that the ratio would have a detrimental effect on mortgage valuation and, in response, the requirements have been eased. This situation is expected to be carefully monitored by supervisors during the observation period. The ratio is defined as:

Amount of stable funding Required amount of stable funding

> 100%

Stable funding is defined as those types and amounts of equity and liability funding expected to be a reliable source over a one-year horizon in a stress environment (i.e., funding likely to remain for a year even in a difficult period for the particular institution.)

Making every drop count Basel III liquidity requirements and implications for US institutions

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NSFR required stable funding (RSF) factor

Type of exposure
Cash, short-term unsecured instruments, securities with less than one-year residual maturity and with no embedded option that would extend maturity to more than one year, securities with exactly offsetting reverse repurchase transactions, less than one-year unencumbered loans to financial entities Unencumbered longer-dated sovereign/public sector securities having 0% risk weight under the Basel II standardized approach and with active repo markets Unencumbered AA-rated or higher longer-dated corporate bonds meet all conditions for Level 2 assets in the LCR Unencumbered longer-dated sovereign/public sector securities with 20% risk weight under the Basel II standardized approach, which meet all the conditions for Level 2 assets in LCR Unencumbered gold, equities on a major exchange not issued by financial institutions, non-financial corporate or covered bonds rated A+ to A-, central bank eligible and traded in deep and active market with low concentration Less than one-year residual maturity unencumbered loans to non-financial corporate clients, sovereigns, central banks and PSEs Unencumbered residential mortgages and other loans qualifying for 35% or lower risk weight under Basel II standardized approach Less than one-year residual maturity unencumbered loans to retail clients and small business customers other than those qualifying for the 65% RSF All other assets 50%

RSF factor
0%

The stress event for the NSFR must also cover the following conditions: 1. A significant decline in profitability or solvency resulting from credit, market or operational risk 2. A potential downgrade in debt, counterparty credit or deposit rating 3. A material event that calls into question the reputation or credit quality of the institution The requirements established what percentage of different types of funding can be relied upon as stable over a oneyear horizon. Tier 1 plus Tier 2 capital instruments and other liabilities with greater than one-year maturities are treated as fully stable. Only a proportion of liabilities shorter than one year can be counted, as shown in the table at the left. The ratio uses the same division of retail and corporate deposits into stable and less stable as the LCR does. All other liabilities with a term of less than one year do not count toward the available stable funding (ASF). This rules out deposits from financial institutions that count toward stable funding, for example. It challenges business models in which illiquid assets/loans are funded through interbank sources. The available stable funding is the sum of the types of liabilities the bank has multiplied by the appropriate ASF factor. The amount of available stable funding required to back a banks assets is set according to the lack of liquidity of the different types of assets and/or off-balance sheet items. Each type of asset has a required stable funding (RSF) factor. Where committed credit and liquidity facilities have been provided to customers, the RSF will be 5% of the undrawn portion. The treatment of all other off-balance sheet commitments will be determined by the local supervisors. Consolidated vs. local requirements Global and local supervisors have made clear their expectation that funding and liquidity requirements be considered at a local, as well as consolidated, level. For example, as part of recovery and resolution planning,

5%

20%

50%

65%

85%

100%

NSF funding liabilities and available stable funding (ASF)

Type of liability
Tier 1 plus Tier 2 capital Preferred stock not included in Tier 2 with effective maturities of one year or greater taking into account any explicit or embedded options that would reduce the expected maturity to less than one year Secured and unsecured funding with effective maturities of one year or greater, excluding any instruments with explicit or embedded options that would reduce the expected maturity to less than one year Stable (as defined in the LCR) retail/small business non-maturity deposits and/or term deposits with residual maturities of less than one year Less stable (as defined in the LCR) retail/small business non-maturity deposits and/or term deposits with less than one-year residual maturity Unsecured wholesale funding, non-maturity deposits and/or term deposits with residual maturity less than one year provided by non-financial customers, sovereigns, central banks, multilateral development banks and PSEs All other liabilities and equity not included above

ASF factor
100% 100%

90%

80%

50%

0%

0%

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supervisors expect detailed entity-level funding and liquidity information to be provided, as well as an assessment of the impact on potential recovery options. The final Basel III liquidity rules provide a fair amount of additional clarification on items left to national discretion, such as retail deposits and other non-contractual items, as well as how consolidated LCR results should incorporate local parameters. The LCR standard is expected to be met and reported in a single common currency. However, the new guidelines make it clear that banks are expected to be able to meet their liquidity needs in each currency and maintain highquality liquid assets consistent with the allocation of their liquidity needs. A specific monitoring capability of the LCR by currency and jurisdiction is required. For purposes of the LCR standard calculation at the consolidated-entity level, banks are allowed to include in their liquid asset stock qualifying liquid assets that are held in certain legal entities to meet legal-entity requirements (i.e., local regulatory requirements), as long as the net cash outflows for the specific legal entity are also reflected in the net cash outflows for the consolidated LCR calculation. The liquid assets held locally must be freely available to the parent in times of stress. This specific language in the final Basel III liquidity rules emphasizes to global supervisors the importance of developing a capability to monitor banks liquidity positions and perform stress tests at a legal-entity, as well as a consolidated level. The rules discuss the need to consider legal, operational and regulatory impediments to liquidity mobility as part of the LCR calculation and a firms liquidity stress tests. For example, tax considerations may constrain the mobility of liquidity across jurisdictions. Unlike previous proposals, there is also a detailed discussion of potential options to address jurisdictions with insufficient liquid assets. During the observation period, the Committee will develop prescriptive quantitative thresholds and guidance for jurisdictional insufficiencies. Liquidity governance The regulators are also tightening oversight and requirements with respect to the governance and control of liquidity. The Basel Principles for Sound Liquidity

Risk Management and Supervision sets out a number of fundamental requirements in the area of governance, starting from the top of the organization, and the guidelines in the US interagency guidance are essentially the same. Specifically, a robust liquidity management framework must be established, and a liquidity risk tolerance, appropriate to the business and the strategy, must be clearly articulated. This means that both the board and senior management need to have a thorough understanding of the risks and strategy, and the board must ensure that senior management translates this into a clear control environment with stress testing playing a key role. The guidelines also focus on management of intra-day liquidity positions and risks, which poses systems challenges in many banks. Contingency planning is another area of regulatory focus. This requires planning in advance for how the bank would respond to a severe stress and the actions that would be taken. The contingency planning has to be activated well in advance of any stress to ensure that the actions are achievable. Better liquidity contingency planning is also a theme in the recovery and resolution plans or living wills currently being developed by banks and other major financial services firms. The thinking behind a living will encompasses actions that banks could take to recover from a severe stress event that goes beyond those considered when establishing liquidity and capital buffers, as well as the final resolution if recovery proves not to be possible. Liquidity contingency planning is a key part of this process. However, there is recognition that it must be done in conjunction with contingency planning for capital. This reduces the risk that, for example, a banks contingency funding plan would call for asset sales that may generate liquidity, but may impair the firms capital. There are also guidelines regarding incentive structures. The costs and risks of liquidity should be incorporated into internal pricing, performance management and new product approval. This raises fundamental concerns with regard to the operation of the business and the allocated liquidity costs that have an impact on its financial performance. While most of the largest and most sophisticated financial institutions are working to

Making every drop count Basel III liquidity requirements and implications for US institutions

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integrate liquidity premiums within their funds transfer pricing frameworks, costs must be allocated at a granular level, considering contingent risk, to the entities that are the source of liquidity risk. Very few firms have internal charging mechanisms for liquidity risk, as defined in the Basel guidance, to the cost of funding. More recently, US regulators have been increasingly focused on pricing for liquidity and linkage with economic capital, as well as the performance management process, metrics and reporting. The industry is clearly taking action to improve liquidity governance, spurred in part by the regulatory changes, but also by the concern in many banks about the damage caused by the liquidity crisis. In 2009, Ernst & Young surveyed 38 of the largest banks across 20 countries regarding the changes banks are making to enhance risk governance and to implement the July 2008 Final Report of the Institute of International Finance Committee on Market Best Practices: Principles of Conduct and Best Practices Recommendations. The findings revealed that 61% of all banks surveyed were changing their approach to liquidity governance and, among the G10 banks surveyed, the figure was 73%. In these early actions, many banks made their liquidity risk tolerance more explicit and began to enhance board reporting. Banks also set more explicit limits regarding liquidity risk to communicate risk tolerance, and in some, the entire governance structure has been changed to move away from a solely asset-liability committee (ALCO) governance line toward greater involvement of the CROs independent risk organization. Today, a growing number of large institutions are establishing a balance sheet management committee, chaired by a senior executive, to consider dynamically the strategic interplay between assets, liabilities, liquidity and capital. Within this structure, the asset-liability and capital committees (to the extent they exist) report to the balance sheet management committee. This helps address the fact that in many institutions, the primary focus of the ALCO has been on funding and liquidity ALCOs typically have taken their lead from the asset side of the business (lending or trading). While this approach may have worked in an environment where there was easy access to inexpensive wholesale funding, that is no longer the case. Financial

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services firms recognize that funding is a binding constraint, and it must be closely aligned with business strategy, capital and financial planning. Modeling and enhanced stress testing have also been key areas of focus. But many banks are finding that systems and data are proving to be impediments. A number have recently expressed the need for better consolidated data and also better information about contingent liabilities. Systems and data are said to be slowing down necessary improvements to internal management information, particularly in the wholesale banks. Data and technology The new liquidity rules will require significant enhancements to the data and technology infrastructure of most institutions. While local supervisors will define specific requirements, such activities as producing detailed contractual cash flows over multiple time dimensions by currency, legal entity and potentially, line of business, as well as aligning contractual and behavioral cash flows to books and records, will require new approaches to data sourcing and management. The SSG report, Observations on Developments in Risk Appetite Frameworks and IT Infrastructure, issued on 23 December 2010, states that to make effective business and risk management decisions, it is critical that they [firms] be able to aggregate timely and accurate reporting on credit, market, liquidity and operational risks. The report emphasizes the importance of implementing a comprehensive risk data infrastructure that includes consolidated platforms and data warehouses that employ common taxonomies. The report notes that data should be aggregated on a legalentity, as well as line-of-business basis. The findings of the SSG report are consistent with experiences observed at global financial services institutions as they have worked to comply with the UK FSA cash flow reporting requirements, as well as with the emerging liquidity reporting requirements of other global supervisors. Specifically, it is critical for there to be a single source of high-quality data to support both regulatory reporting and internal liquidity risk

management. This is a significant departure from the historic approach, in which multiple groups generally sourced their own data, resulting in a complex array of databases holding similar data of inconsistent quality and granularity. Adopting a single data-source strategy requires strong sponsorship from executive management and robust data governance. Another important leading practice is to ensure there is a well-defined treasury data model for liquidity risk management that allows for analysis, and for reporting that includes product, line-ofbusiness and legal-entity dimensions. The SSG report also observes that while many firms have devoted significant resources to infrastructure, very few can quickly aggregate risk data without a substantial amount of manual intervention. Given that supervisors expect liquidity positions to be reported daily, significant continued investment in this area is necessary. Most large financial institutions continue to leverage internally developed liquidity risk engines to perform stress testing and other analyses that support activities such as funds transfer pricing and strategic funding plan development. However, an increasing number of firms are implementing vendor systems that provide a single platform for dynamic balance sheet projections, scenario analysis and stress testing. This approach allows the combined impact on liquidity, capital, earnings and solvency to be assessed within a single analysis based on common assumptions, time horizons and risk factors. This is consistent with the recognition by the Basel Committee that capital and liquidity are equally important, and that both must be addressed to strengthen the resilience of the banking sector. Outputs from the risk engine(s) are captured in datamarts that support specific activities, such as liquidity reporting, capital management and funds transfer pricing.

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Strategic implications of the new liquidity rules 2011 will see rapid change in the regulatory environment as countries move to create the rules to implement the new Basel standards for liquidity ratios and the earlier principles regarding governance, stress testing and liquidity risk management. Some countries will wish to see requirements at a subsidiary level (or even a branch level, as in the UK), while others will be content to rely on group-wide rules. Local reporting will also be developed by the regulatory community. This could lead to a patchwork of liquidity regulation, with varying requirements for liquidity pools in different markets and different styles of regulatory reporting. For individual banks, these developments will have to be managed carefully, and the implications for the costs of different types of activity assessed and tracked. During the first half of 2010, the Basel Committee conducted an impact study of the effect of both the new liquidity requirements and the changes to the Basel II capital rules. Now that the path for global liquidity regulation is clear, the impact of different group structures and business models on liquidity costs will also have to be assessed. Some major strategic decisions may be needed as the costs of some types of product lines change. The liquidity rules, together with capital and living wills, will also affect the economics of different bank structures. Many structures have grown up over time, driven more by tax considerations or historical accident than by actual planning. Going forward, some of these may have to be rethought in the light of the final regulatory landscape.

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Key issues for clients

There are real data and systems challenges for many banks in producing group-wide liquidity stress testing, including the capacity to produce reports on a weekly or daily basis in a stress period. The rules introduce a number of new assumptions for stress testing, as well as an expectation that liquidity costs or benefits be attributed to business lines and incorporated within performance measurement and new-product approval processes. This will require significant enhancements to funds transfer pricing frameworks and associated reporting systems. Most institutions recognize that liquidity risk data and technology requirements cannot and should not be addressed in isolation, particularly with a clear regulatory mandate for large banks to produce regular robust enterprise stress testing that considers funding and liquidity needs along with capital. An example of this integration is the recent request for additional Supervisory Capital Assessment Program stress testing by 19 US banks, where the funding and liquidity implications had to be specifically considered within the analysis. Supervisors expect that institutions will develop enterprise infrastructure that directly supports strategic decision making and risk management, and that this capability will be used to support business as usual and stress environments. Contractual mismatch or 4G reporting, foreign currency LCR analyses and funding concentration, as well as the development of processes to determine and charge liquidity premiums, will also be a challenge. The same types of reporting and stress testing requirements have been introduced in the UK, and the programs to implement them have proved lengthy and complex. The calculation of the new liquidity rules, the leverage requirements and the higher capital requirements will affect some business models. Bank strategies must be considered in light of the range of rules being introduced.

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Ernst & Young can help

Ernst & Youngs financial services advisory team can help institutions address the new Basel III liquidity requirements and the emerging supervisory guidance. Our professionals have assisted many of the worlds leading banks with their enhancement of liquidity risk management frameworks, including help with improving organizations governance, policies, processes and infrastructures. Our teams market knowledge and practical experience are supplemented by tools that will aid you in quickly implementing necessary changes. For example, Ernst & Youngs web-based Liquidity Diagnostic Tool consolidates relevant regulatory guidance and leading practices and supports benchmarking and gap analyses to identify and prioritize areas for improvement. The tool also helps address issues within other treasury areas such as balance sheet management, capital and funding and includes treasury and liquidity target-state data and technology architectures, as well as sample business requirements and functional capabilities. Our tools, data and technology implementation methodologies and knowledgeable advisory team enable us to assist you in delivering on the expectations of your stakeholders. To learn more about our Basel III liquidity risk services and how we can help your organization, please visit www.ey.com/us/financialservices or contact one of our financial services professionals: Peter Marshall Mike Sheptin Roy Choudhury Jim Embersit +1 212 773 1983 +1 212 773 6032 +1 212 773 9299 +1 202 327 6078 peter.marshall04@ey.com michael.sheptin@ey.com roy.choudhury@ey.com jim.embersit@ey.com

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Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit www.ey.com. Ernst & Young is a leader in serving the global financial services marketplace Nearly 35,000 Ernst & Young financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, Ernst & Young is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Office today includes more than 4,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America. Ernst & Young professionals in our financial services practices worldwide align with key global industry groups, including Ernst & Youngs Global Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients. With a global presence and industry-focused advice, Ernst & Youngs financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide. Its how Ernst & Young makes a difference. 2011 Ernst & Young LLP All Rights Reserved. SCORE No. CK0419 1012-1214080 NY
This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.