Regulators must review the liquidity coverage ratio

It is 10 years since the Basel Committee on Banking Supervision (BCBS) published its rules on the liquidity coverage ratio (LCR) designed to ensure that banks hold sufficient reserves of cash or cash-like instruments to survive the first 30 days of a systemic or bank-specific stress.

It needs to revisit them urgently.

There are two components to the rules: first, defining what banks should count as high-quality liquidity assets (HQLA) that they can quickly turn into cash in the private markets; second, modelling the likely outflows they will face in a panic.

The collapse of a handful of regional banks in the US in March and the last days of Credit Suisse raise new questions about the core assumptions that the Bank for International Settlements (BIS) made in the years after the financial crisis and are now embedded in Basel III.

By its own definitions, US Treasury bonds no longer meet the standard for high-quality liquid assets.

The BIS outlined certain fundamental characteristics of HQLA, including that they be low-risk, easy to value, show low volatility and be traded in a large and active market for outright sale or repo.

US Treasuries have been extraordinarily volatile and highly risky. Indeed, it was the realization of mark-to-market losses on its portfolio of US Treasury and mortgage bonds that Silicon Valley Bank (SVB) had to sell to raise cash to meet depositor withdrawals that doomed the bank.

In the days following, yields moved at times almost 100 basis points in an afternoon, as investors veered between risk-on and risk-off.

This is extraordinary volatility for the world’s benchmark government bond, reminiscent of what befell the UK gilts market last September. It reveals another ugly truth: liquidity is thin across the curve in US government bonds, except for certain on-the-runs.

The sharp losses in face value since the US Federal Reserve started hiking rates one year ago and difficulties in valuation make it now impossible to raise $99.9 against every $100 of US Treasury collateral.

Look no further for proof than the Fed’s own extraordinary step of launching a new emergency Bank Term Funding Programme (BTFP) in March to extend loans against US Treasuries at face value.

It had to do this because the private markets won’t. And the Basel rules on the LCR dictate that banks must be able to raise cash in the private markets.

The LCR rules on modelling likely cash outflows net of inflows in the first 30 days of a stress are dense and establish minimum floors for outflow assumptions for different types of liabilities, while allowing national regulators to require buffers above these depending on their own analysis of depositor behaviour.

The floor assumption set by the BIS in 2013 for retail deposit outflows ranges from just 3% for stable, insured deposits, up to 10% for less stable, uninsured deposits – while allowing banks to exclude from modelled outflows any term deposits of above 30 days’ notice period. Banks can give these a 0% run-off rate unless they choose to waive penalties.

Deposits from small businesses of under €1 million, while characterized as callable unsecured wholesale funding, have the same run-off rates as retail deposits.

Operational deposits generated by clearing, custody and cash management activities with corporate clients, and which presumably include many of those from the tech companies SVB served, have a floor run-off rate of 25% where the customer has a substantive dependency on the bank and the deposits are required for the activity.

Excess non-operational deposits not bound in as part of the provision of a core cash management or other service attract a 40% run-off rate.

Those are the assumptions of run-off over 30 days. The recent runs are seeing this kind of flight in an afternoon for a few names facing bank-specific stress.

Let’s hope this doesn’t spread system-wide.

Policymakers have a lot on their plate. But revising their own LCR assumptions must be high on the list of priorities.