From 2015 banks will have to satisfy new liquidity standards. Of particular importance is the liquidity coverage ratio, which requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress. This will complicate the conduct of monetary policy and affect short-term yield curves, which will probably price some regulatory term premium.


Liquidity regulation and the implementation of monetary policy
Morten L. Bech and Todd Keister, BIS Working Papers No 432, October 2013

 http://www.bis.org/publ/work432.pdf

The below are excerpts from the paper. Cursive lines and emphasis has been added

Understanding Basel III liquidity regulations

“Basel III introduces — for the first time — a global framework for liquidity regulation. The new regulation prescribes two separate, but complementary, minimum standards for managing liquidity risk: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). These standards aim to ensure that banks hold a more liquid portfolio of assets and better manage the maturity mismatch between their assets and liabilities.”

“Specifically, the LCR requires each bank to hold a sufficient quantity of highly-liquid assets to survive a 30-day period of market stress… The liquidity coverage ratio is calculated by dividing a bank’s stock of unencumbered high-quality liquid assets [HQLA] by its projected net cash outflows over a 30-day horizon under a stress scenario specified by supervisors. The new regulation requires this ratio to be at least one.”

“Two types (or “levels”) of assets can be applied toward the HQLA pool. Level 1 assets include cash, central bank reserves and certain marketable securities backed by sovereigns and central banks. Level 2 assets are divided into two subgroups: Level 2A assets include certain government securities, corporate debt securities and covered bonds, while Level 2B assets include lower-rated corporate bonds, residential mortgage backed securities and equities that meet certain conditions. Level 2A assets can account for a maximum of 40% of a bank’s total stock of HQLA, whereas Level 2B assets can account for a maximum of 15% of the total.”

“The denominator of the LCR, projected net cash outflows, is calculated by multiplying the size of various types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down in the stress scenario. This scenario includes a partial loss of retail deposits, significant loss of unsecured and secured wholesale funding, contractual outflows from derivative positions associated with a three-notch ratings downgrade, and substantial calls on off-balance sheet exposures.”

“The net stable funding ratio (NSFR) focuses on a one-year time horizon and establishes a minimum amount of stable funding each bank must obtain based on the liquidity characteristics of its assets and activities. Implementation of the LCR and the NSFR is scheduled to begin in January 2015 and January 2018, respectively.”

How the liquidity coverage ratio would affect monetary policy

“[Monetary policy implementation] involves setting a target for the interest rate at which banks lend central bank reserves to one another, typically overnight and on an unsecured basis. Because these reserves [held at the central bank] are part of banks’ portfolio of highly-liquid assets, the regulations will potentially alter behavior in the interbank market, changing the relationship between market conditions and the resulting interest rate… Our focus in this paper is on the process of implementing monetary policy in normal times, when banks are expected to fully meet the requirement…We extend a standard model of banks’ reserve management and interbank lending to study how the introduction of an LCR requirement affects the process of implementing monetary policy in a corridor system.”

“When banks face the possibility of an LCR shortfall, the relationship between the quantity of central bank reserves and market interest rates changes. A bank that is concerned about possibly violating the LCR has a stronger incentive to seek term funding in the market and is more likely to borrow from the central bank’s standing facility. Both of these actions add to the bank’s reserve holdings and thus lower the need to seek funds in the overnight market to ensure the bank’s reserve requirement is met. This lower demand for overnight funds tends to drive down the overnight rate, whereas the increased demand for term funding tends to make the short end of the yield curve steeper.”

“In the standard model with no LCR requirement, the overnight interest rate is determined by the total quantity of reserves supplied by the central bank; the type of operation used to create these reserves is irrelevant. We show that once an LCR requirement is introduced, this result no longer holds… the structure of an open market operation determines its effects on bank balance sheets and, hence, the likelihood that individual banks may face an LCR deficiency. This likelihood, in turn, affects banks’ incentives to trade in interbank markets.”

“Once the LCR is in place, the effect of an open market operation depends on how it is structured as well as its size. For example, outright purchases of high-quality liquid assets (HQLA) tend to affect the overnight interest rate and steepen the short end of the yield curve, while purchases of non-HQLA may bring little-to-no change in the overnight rate and a flattening of the yield curve. In our model, the central bank would need to consider how an operation affects all of the components of bank balance sheets that enter into the LCR calculation.”

“The LCR will likely introduce a regulatory-driven term premium, making the short end of the yield curve steeper.”