In the aftermath of the 2008 crisis, regulators recognized that banks were not resilient enough to sustain periods of liquidity and funding stress, and imposed new rules. Under the new Basel regulations, new ratios constrain the balance sheet structure. Conventional ALM techniques apply once the bank complies with the rules. Many current issues relate to the implications of the new Basel 3 on the structure of the balance sheet and on profitability.
This chapter introduces the new regulatory ratios. It shows how compliance with the set of the new regulatory ratios has a direct effect on how banks manage their balance sheet. These impacts are detailed using an example of a typical banking book.
3.1 The New Regulatory Ratios
The 2011 document “A global regulatory framework for more resilient banks and banking systems”, dated December 2010, revised June 2011 [24], requires that the capital adequacy ratio be enhanced and introduced two new ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The reform is gradual, with full changes being enforced by 2018. A new leverage ratio is also introduced, aimed at preventing an excess buildup of credit in expansion phases.
Regulatory capital is divided into Tier 1 and Tier 2. Tier 1 capital includes equity and retained earnings. Tier 2 capital is made of subordinated debts. Tier 1 capital is available when the bank is solvent and operates as a going concern. If a bank's losses exceed its equity base, it should pay back all creditors. Tier 2 capital is relevant when the bank is no longer a going concern, under the “gone-concern” view.
Under the new regulation mentioned above, Common Equity Tier 1 must be at least 4.5 % of risk-weighted assets at all times. Tier 1 capital must be at least 6.0 % of risk-weighted assets. Total capital (Tier 1 plus Tier 2) must be at least 8.0 % of risk-weighted assets at all times. An additional equity capital conservation buffer is required to ensure that banks build up capital buffers outside periods of stress, which can be drawn down when losses are incurred. A countercyclical buffer can be required for protecting the banking sector from excess aggregate credit growth by raising the cost of credit.
The cumulative effect of these requirements is that the ratio of core capital to risk-weighted assets would reach 10 %, or more, by the time the new regulations would be fully enforced.
The Basel 3 document also addresses the systemic risk implications of large banks, with additional capital buffers, and a greater supervisory discipline over banks designated as “systemic” because of their interconnectedness with the rest of the financial system.9
The goal of the LCR is to improve the short-term resilience of a bank's liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive an acute stress scenario lasting for one month.
The LCR imposes that the liquidation value of eligible short-term assets be higher or equal to the “net stressed outflows” measured over a period of 30 days. The stress scenario might include: a significant downgrade of the institution's public credit rating; a partial loss of deposits; a loss of unsecured wholesale funding; a significant increase in secured funding haircuts; and increases in collateral calls on contractual and non-contractual off-balance sheet exposures, including committed credit and liquidity facilities.
The net cash flows result from the runoffs of assets and liabilities under adverse conditions. They are measured from factors, or percentage runoffs, applied to assets and liabilities. On the asset side, the factors are fractions of assets expected as cash inflows. Term loans have low factors, while traded assets of good quality, which can be sold easily, have higher factors. The stressed outflows are calculated from runoff factors applied to liabilities, which measure the expected outlays of cash for various resources. Short-term wholesale debt has a runoff rate of 100 %. Other resources, such as deposits, are more stable but they are nevertheless expected to face withdrawals under stressed conditions. Long-term resources, such as capital and issued bonds, have no runoff over the short term.
The objective of the NSFR is to promote the resilience over a longer time horizon than the LCR by creating additional incentives for a bank to fund its activities with stable sources of financing. The NSFR aims to limit overreliance on short-term wholesale funding during times of buoyant market liquidity and encourages better assessment of liquidity risk across all on- and off-balance sheet items. The NSFR has a time horizon of one year and imposes that the resources that regulators see as non-volatile over one year be at least equal to the amount of assets that are seen to stay in place under the same horizon.
The ratio is implemented by comparing the available stable funds (ASF) to the required stable funds (RSF). The stable funds are the financing that is expected to stay in place for an extended period of at least one year, excluding any volatile debt. The required stable funds represent the amount of assets that supervisors believe should be supported with stable funding.
According to the NSFR, the ratio of ASF to RSF should be above one. For measuring required and available stable funds, percentages called factors, are used for weighting assets and liabilities. The RSF are derived from assets, by applying RSF factors to existing assets.
The RSF factors measure how easy it is to turn assets into cash. They range from 0 %, for those assets that do not require stable funding, to 100 % for those assets that should be supported entirely by long-term funds. Good quality market instruments, such as investment grade bonds, do not require 100 % of stable funds because they can be sold or financed by pledging them for borrowing. On the other hand, some loans with maturity longer than one year would require close to 100 % stable funding.
The ASF factors measure how stable the resources are and are in the range of 0 to 100 %. Factors in the upper range are applied to stable resources, such as equity and bonds issued by the bank. Factors in the lower range are used for resources that are considered as less stable, or volatile, such as the fluctuating fraction of deposits and short-term interbank debt.
The leverage ratio is intended to prevent the excessive buildup of exposures during expansion period. Banks can build up leverage in expansion, even when they maintain a strong capital base. The purpose of the ratio is to limit the expansion of the balance sheet in growth periods, and, consequently, limit the deleveraging of the balance sheet under recession periods.10
The leverage ratio imposes that core capital be at least 3 % of the balance sheet size, plus some off-balance sheet commitments such as uncancellable banking commitments. The ratio is implemented over a test period extending until 2017.
3.2 Compliance of a Commercial Balance Sheet: Example
The combination of the capital adequacy ratio, the LCR, the NSFR and the leverage ratio results in four constraints on the balance sheet of a bank. An example of a typical balance sheet is used below to show how compliance can potentially reshape a typical balance sheet and impact the profitability of a bank.
The combination of four ratios makes the management of the balance sheet a constrained exercise. The mix of assets and liabilities of the banking book is business driven. In a typical commercial bank, the bank holds corporate loans and loans to individuals arising from consumer lending and mortgage loans, plus an investment portfolio made of financial assets managed under a buy and hold policy. On the liabilities side, commercial resources are the deposits.
Assuming that the mix of commercial loans and deposits is given, the bank should manage its portfolio of liquid assets and its financing in order to comply with regulatory constraints.
The following example relies on a simplified balance sheet of a hypothetical commercial bank (
See “Addressing systemic risk and interconnectedness”, paragraph 32 of the 2010 Basel 3 document [24]. Systemic risk is addressed in the literature: see Arnold, B., Borio, C., Ellis, L., Moshirian, F. (2012), Systemic risk, macroprudential policy frameworks, monitoring financial systems and the evolution of capital adequacy [14]; or Nijskens, R., Wagner, W. (2011), Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risks to the financial system at the same time [111].
Sources on leverage and liquidity include Acharya, V. V., Viswanathan, S. (2011), Leverage, moral hazard, and liquidity, [2], and Adrian, T., Shin, H-S. (2010), Liquidity and leverage, [4].
