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This economic demonstration has been nourished by the works undertaken by Mr. Alain Tourdjman from BPCE, and benefited from the full support of the ESBG Economic Affairs Committee.


1.1. The Basel III framework:

The Basel III framework was devised to reduce several risks in the banking system (credit risks, market risks,

operational risks). The framework focuses on:

Building a buffer to improve the absorption capacity of external shocks through the management of liquidity and ■ the quality of banks’ own funds.

Reducing the recourse to leverage in the economy.

■ The goal of the framework is to reduce the exposure to excessive risk-taking activities in which financial institutions

engaged during the crisis:

Concerning soundness: Banks engaged in risky activities that rendered in (lending but also off-balance sheet ■ exposures) banks’ own funds becoming insufficient to hedge losses.

Concerning liquidity:

• Excessive dependence on external funding to refinance short term borrowings

• Funding low liquid long term exposures by more volatile short term funding.

Concerning the role in the economy:

• Boosting inappropriate and dangerous indebtedness and the creation of bubbles in the economy by leveraging via derivative markets.

• Endangering the whole financial system by exposing it to the failure of a systemic financial institution.

1.2. Basel III and the liquidity risk:

For a financial institution, liquidity risks exist when an institution is exposed to a credit run due to a great and unexpected loss of confidence of their depositors and borrowers.

The Liquidity Coverage Ratio (LCR) (1 month of maturity) is a short term ratio that sets the stock of free or low ■ risk assets that are liquid or highly liquid: they are easy to sell, even in a crisis scenario, within 30 days. The LCR sets up a ratio of: high liquid assets/less than 1 month maturity liabilities ≥ 100%.

The Net Stable Funding Ratio (NSFR) (long term 1 year) is a long term ratio that aims for banks to change ■ their funding structure in order to achieve a more stable funding of their activity. The NSFR sets up the proportion of: stable funding (long term liabilities) /weighted long term assets 100%.


1.3. The economic context of the implementation: bank constrains

The implementation of the Basel III framework will take place during a difficult period for financial institutions:

Firstly, due to the constraints of solvability, building own fund buffers through the markets is currently much more ■ difficult - in particular for those financial institutions of countries going through crisis.

The disappearance and attrition of certain banking activities limits the internal capital accumulation capacity.

The vicious circle between the sovereign crisis and the banking crisis:

• The depreciation of European sovereigns makes it difficult to set aside provisions for the potential losses and put pressure on the soundness of institutions.

• This leads to uncooperative behavior: individual rationality of agents vs. collective interests.

Figure 1: DJ Euro Stock Index Source: Rexecode

–  –  –

Figure 2: Average ROE of 33 banking goups of the Euro zone Source: Rexecode Banks’ profitability has dramatically dropped in recent years.

1.4. Liquidity funding trends The current economic situation is also a context in which funding has become a nightmare for many financial

institutions which are replacing that by Central Bank funding. A shift in the liquidity paradigm has been observed:

The long term funding through the markets is increasingly more costly and selective; it ceased to be an option ■ for managing the long term liquidity needs.

The access to the liquidity provided by the central bank is used as an instrument to refinance their obligations ■ and not as a permanent substitute for interbank lending.

Trends in interbank lending are a deep slowdown due to the crisis and increasing dependence on central bank ■ funding.

Figure 3: Private and public bonds interest rate Source: ECB


Figure 4: ECB Balance Sheet: Main components

–  –  –

Due to the financial crisis and the sovereign debt crisis, interbank funding in Europe has declined both in size and in percentage over total assets Figure 5: Short term wholesale funding of the Euro Area MFIs, UK, SE and DK

–  –  –

1.5. A risk for growth Any restraint to the access to liquidity or to the contraction of own funds due to the depreciation of sovereign bonds entails a reduction of banks’ balance sheet size. Therefore, the deleveraging process has already occurred and the objective has been quickly reached. In this context, the combined effect of Basel III ratios and the situation of markets makes the implementation in advanced of the rules very harsh for institutions. However this is the case, given that institutions do not want to be seen as the last in implementing the new rules due to fear of the market

reaction. This is combined with the following factors:

crowding out effect; sovereign bonds interest is much higher than most of the assets in the market;

■ banks have to comply with stricter rules when weighting risk - especially for those assets with higher ratios of default.

■ Finally, this results in limiting the credit provision. The worst-case scenario would be the probability of a credit crunch that entails the risk of deflation in the already existing context of recession.

Figure 6: Deleveraging process in European MFIs Source: ECB 2012 Figure 7: Loans awarded to households and non-financial coporations Source: ECB 2012




2.1. The interaction between the LCR and the NSFR The LCR and the NSFR are interconnected: It is estimated that the impact of the implementation of one of them

alone will be thus similar to the effect they will have together. Banks can improve their LCR by holding more highquality liquid assets:1

replacing long-term assets with short-term assets so as to increase cash inflows and hence reduce net cash ■ outflow; and attracting more stable funding, which reduces (net) cash outflow.

■ This is also related to the NSFR, (available stable funding over required stable funding). There are two ways in which

banks can improve their NSFR, namely:

by attracting more stable funding, or ■ by engaging in activities that require less stable funding, which means reducing long-term investments (with ■ maturities above one year) and increasing short-term assets.

In other words, when a bank improves its funding profile by increasing stable funding, both the NSFR and LCR will be improved: the first through an increase in available stable funding, the second through a decrease in cash outflow. Alternatively, when a bank improves its NSFR by reducing its required amount of stable funding – for instance by attracting more high-quality liquid assets such as government bonds – the LCR will improve through an increase in the liquid assets’ stock.

2.2. The consequences of the LCR Considering that institutions have started to purchase high-liquid assets and sovereign bonds, the LCR can have – ceteris paribus – and is already having two consequences:

An increase in the money invested in the central bank deposit facilities and the sovereign debt, which are ■ considered by the regulator as more liquid than the private obligations. All the more when the deposit facilities have a 100% inflow rate for the LCR in the Basel III framework. This will lead to a reduction in the credit provision.

A decrease in assets’ profits due to the interest increase, and the reduction of the quantity of credit.

■ Generally speaking, the extension in the liability maturities and the reduction of asset maturities limits the intermediation role of financial institutions. All in all, the LCR will have a negative effect on lending provision in terms of quantity and change in maturity patterns.

2.3. The LCR The LCR ratio = HQLA/Total Net outflows 100% Total net cash outflows over the next 30 calendar days = Total expected cash outflows – Min {total expected cash inflows; 75% of total expected cash outflows}

–  –  –

These are the main modifications of the LCR adopted in the January 2013 Basel Committee decision which have

considerably softened the LCR:

New layer of Level 2B=15% of HQLA integrated by low rated (AA-) corporate bonds, common equity shares and ■ mortgage backed securities.

Modified definition of outflows and inflows - reduction in the ratio of outflows for deposits:

• insured retail deposits went from 5% to 3%.

• fully insured non-operational deposits from non-financial corporates, sovereigns, central banks and public sector entities (PSEs) went from 40% to 20%.

• “non-operational” deposits provided by non-financial corporates, sovereigns, central banks and PSEs from went from 75% to 40%.

Furthermore, in the European Union the LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, increasing in equal annual steps of 10% until it reaches 100% on 1 January 2019.

Below you can see the detail of the classification of assets and the indicative haircuts set by the Basel Committee.

Concerning the LCR, the liquidity shortage (difference between high-liquid assets and net outflows) was €1170 bn at the end of 2011 for European banks (according to the EBA) and just €225 bn in December 2012 after applying the Basel Committee softening.

Concerning the level of compliance, the average of banks that comply with it after the Basel Committee decision in January 2013 has increased to 125%. 60 banks in Europe do not yet comply with it. Below is the evolution of the

compliance with the LCR in Europe according to the EBA:

Figure 8: Evolution of the compliance with the LCR in Europe Source: EBA 2013


2.4. The NSFR Concerning the NSFR shortfall in Europe, it was €1.390 bn in December 2011 and €959 bn in December 2012.

Therefore, the NSFR will impact European banks in the same way the LCR would have done before January 2013.

The level of average compliance is still under the 100% level which means that many banks will not comply with it.

The NSFR favours a more stable and long term funding that leads to an increase in lending costs

Price effect:

• Increasing the resort to banking resources at the expense of others will increase the borrowing average price.

• Collecting more savings in the long term will trigger an increase in the demand on savings, furthermore the savings costs will also increase due to savers’ aversion to the long term risk.

Volume effect: replacing long term for short term structurally increases the average cost.

■ The revenues – other than those coming from intermediation (fees and security revenues) – will decrease due to the limitation on the balance sheet size, and will increase in other sources of revenues in order to preserve bank profitability, which is essential for ensuring banks access to markets. All in all, this situation will lead to araise in credit cost.

The NSFR could seriously harm a bank’s maturity transformation function and/or incentive arbitrage. For a conservative bank with retail and corporate business mainly funded by customer deposits, the initial ratio is well below 100% (partly due to the required funding factors applied to retail and corporate loans) – according to current Basel draft.

The way to boost the ratio up to 100% would be:

By issuing debt with a maturity over 1 year for an amount of 20 bn.

■ By transforming part of the corporate loans into corporate bonds and replace part of the retail loan portfolio ■ (with maturities up to 1 year) by ABS’s with equivalent maturities.

Banks would be forced to use long term funding to finance short term assets, thus seriously impairing the maturity transformation function of the bank, or transforming its short term loans into short term debt, which would increase the cost of financing without adding any real value.2

2.5. HQLA assets demand and supply The demand for HQLA in Europe is estimated to grow by EUR 2,000 billion in the next two years, whereas supply will grow by EUR 1,500 billion, resulting in a greater scarcity of HQLA. Nonetheless, the total supply of these assets will continue to outsize demand and hence no absolute shortage of collateral assets is expected in the near future.

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