RiskTech Forum

Wolters Kluwer: Liquidity Cost Based On HQLA Implied Reserve

Posted: 1 October 2014  |  Source: Wolters Kluwer


Introduction

Responding to the limitations of the Capital Adequacy Ratio in coping with the 2008 global financial crisis, the Basel Committee on Banking Supervision (BCBS) proposed a new liquidity risk management framework with the Liquidity Coverage Ratio(LCR) as the essential component. The bottom line of the Liquidity Coverage Ratio is that for significant financial institutions this will increase by 10% annually from 60% at the end of 2014 to no less than 100% by the end of 2018. Some regulators also encourage banks to calculate Liquidity Cost for risk transfer pricing.

Thus, the decision-making process to raise funds and allocate assets will be a more complicated new issue for banks in selecting sources of funding, setting a balanced structure between HQLA and loans, and calculating Liquidity Risk Cost for proper pricing.

HQLA Implied Reserve is the marginal HQLA requirement of one incremental business unit for deposits and loans. Given the target Liquidity Coverage Ratio and Cash Run-off ratio, the key to meet the requirement in this incremental business unit is to properly allocate deposits absorbed between loans and HQLA, which should equal the target LCR multiplied by the Expected Net Cash Outflow. According to the BCBS guideline, the latter will be the Outflow minus the Inflow or only 25% of Outflow, depending on whether the Inflow is less than 75% of the Outflow. For this fund unit, Outflow is the same as run-off ratio, and Inflow will be the Inflow factor times loans due within 1 month, which is determined by loan tenor.

Following this approach, the loss of interest income as the Liquidity Cost caused by holding HQLA can be kept to a minimum, and Financial institutions can design their own optimal asset - liability structure for both new and existing businesses. Having obtained HQLA Implied Reserve, Liquidity Cost, and interest rate cap of deposits or interest rate floor of term loans, quantitative Liquidity Risk Pricing can be achieved.

With the escalating LCR bottom line, Liquidity Cost is going to be increasingly significant. Operating patterns with lower Liquidity Costs, such as intermediary business and retail or SME deposits, will be favored; while interbank funding will be downscaled due to its high
liquidity cost and HQLA Implied Reserve. Solutions to reduce the Liquidity Cost may be proposed and tried, including Financial innovations, Advanced measurement method, establishment of deposit insurance, and reduction in the statutory deposit reserve in some countries.

However, specific regulatory requirements to calculate the Liquidity Coverage Ratio differ in each country, and the business condition of each bank also varies. Therefore, financial institutions should have a good understanding of the LCR specification and collect substantially effective information after multi-level communication so as to analyze the characteristics of business data, find out major influence factors, and identify exact liquidity requirements. Therefore, banks must design a suitable Liquidity Risk Pricing methodology for their own.

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