Bank liquidity risks

A whole new regulatory environment is taking shape for banks and near-bank financial institutions. The new liquidity and risk management rules, which came into force January 2013 under Basel III, will have a collateral effect on clients and their counterparties.

Pension fund managers are among those who are attempting to identify both the consequences and business opportunities that the rule changes may offer. At first analysis, it is already clear that enhanced requirements for regulatory capital and increased demand for higher-quality and more liquid assets are the main parameters to watch, not to mention new constraints around transactions that involve derivatives.

The 2008 financial crisis shone a spotlight on the liquidity risk inherent in the financial system and triggered enormous regulatory changes. The Bank for International Settlements (BIS) issued a series of initiatives, proposals and recommendations aimed at strengthening the capacity of banks to withstand shocks, increase the quality of their assets and add greater depth to risk management with a view to achieving greater transparency. This new environment
is expected to take shape gradually, with a target of full implementation by 2018.

The BIS exercise consists of inviting banking institutions to align themselves with Basel III. Adjustments are expected to be made during the process. In Canada, the banking system has proven its robustness, but there is still a fear that the Office of the Superintendent of Financial Institutions, known for its conservatism, will instead tend toward a “Basel III+.” One can assume that the banking industry is currently undertaking some serious lobbying in Ottawa in order to avoid what it would call “over-regulation.” While this new regulatory environment has not yet been fully determined, that does not, in any way, diminish the importance of carefully considering its potential collateral effects. From an investor’s perspective, the new requirements—regardless of the form that they ultimately assume—will undoubtedly influence the stock and bond markets, the over-the-counter derivatives markets and financial transactions in general.

Regulatory capital and financial instruments*

Several measures were introduced in a gradual manner beginning on Jan. 1, 2013, in order to increase the required capital levels:

  • increase of several capital ratios (Tier 1 Common, Tier 1 Capital and Total Capital);
  • addition of a contra-cyclical capital cushion: 0% to 2.5%;
  • addition of a capital preservation cushion: 2.5%
  • addition of a cushion for banking institutions that present a significant rise to the financial system: 1% to 2.5%; and
  • new restrictions pertaining to dividends, bonuses and share buybacks if the capital ratio is not higher than the required minimum.

Tier 1 Common consists primarily of common shares and retained earnings:

  • Tier 3 instruments (short-term subordinated debt) are no longer accepted;
  • Tier 1 instruments other than common shares; and
  • Tier 2 instruments issued by an international bank must contain a clause that requires them to be cancelled or converted into common shares when a triggering event occurs, at the discretion of the competent authority.

The liquidity coverage ratio, which defines the level of liquidity required to withstand a 30-day stressed funding scenario, covers two asset levels:

  • Level 1, which includes cash and certain sovereign issuer bonds, is given a factor of 100%; and
  • Level 2, which extends to blue-chip corporate bonds, covered bonds and sovereign issuer bonds, receives a factor of 85%.

The net stable funding ratio, which defines the liquidity level required to face an extended shortfall based on a horizon of one year, is calculated by dividing the assets that must remain on the balance sheet even during a crisis period by the assets that cannot be monetized during an extended crisis.

* From a presentation made by the Caisse de dépôt et placement du Québec.

Three major themes
Patrick De Roy, partner and national practice leader, risk management, with Morneau Shepell, has taken on this task and identified three major themes. The first involves in-house pension plans (primarily DB) for employees of banking institutions. He expects that the transformation of these plans into hybrid or mixed plans, which has only just begun, may accelerate under Basel III, since such moves provide for asymmetrical treatment of actuarial surpluses and deficits. “Even if institutions could be persuaded to turn to other types of plans, they cannot avoid the weight of the past,” explains de Roy.

Under the current rules, pension fund deficits must be deducted from available capital. On the other hand, if there is a surplus, it remains a cushion that cannot be included in the calculation and added to capital. According to De Roy, there is no question that this asymmetry will influence pension fund investment policy and penalize risk taking. “The investment policy for such plans already tends to avoid the risks of the public market. Basel III is likely to accelerate this process.”

The strategies applied to less-liquid assets and the use of derivatives will also be affected. Transparency dictates different treatment, depending on whether transactions occur over the counter (OTC) or are compensated.

“With banks often serving as counterparties, greater capital requirements will generate additional costs that will be passed on to the pension funds involved in transactions of this type,” says De Roy, referring to direct and indirect cost increases, by way of hedge funds, for the largest pension funds.

Finally, Basel III adds two liquidity ratios to the principle of liquidity risk management. One is used to define the short-term flexibility level that is required in order to deal with a liquidity shortfall, based on a pessimistic scenario. In this case, the horizon used is 30 days. “This will result in a reduction of risk taking on bank balance sheets and bond arbitrage. We can expect greater sensitivity that favours very liquid bonds or very short-term securities. Indirectly, the downward pressures on bond rates could have an influence on the actuarial liability of pension funds,” says De Roy. He says the consequences on pension funds would be reduced if the effect is felt in the short-term segment of the yield curve.

In a broader sense, De Roy says he can envision a growth in collaboration between banks and pension funds: perhaps only in the area of facilitating arbitrage between the liquidity needs of the banks and the longer-term horizon of the pension fund managers; or perhaps only to take advantage of the higher solvency rating of these funds. “I haven’t taken a closer look at that yet, and I don’t know how these opportunities will develop, but yes, there is real potential there.”

The Caisse
The Caisse de dépôt et placement du Québec has also put some thought into the effects of Basel III. “What affects our counterparties affects us, too,” notes Dominique Vézina, vice-president of fixed income risk at the Caisse. He says Basel III will have an impact on market liquidity, on arbitrage involving securities and maturities, and thus on manager portfolio strategies—and that any increase in regulatory capital will be accompanied by an increase in the associated cost. This cost may fluctuate, depending on the categories of products, asset quality and asset liquidity. “The banks will pass on the bill to the pension funds and other institutional investors,” says Vézina.

In return, players such as the Caisse, which can rely on a Triple-A rating, will be able to monetize the quality of their solvency. Basel III devotes a great deal of attention to derivatives and other securitized assets, distinguishing between speculative and protective or hedging operations and targeting the market risks of OTC trading transactions by adding counterparty credit risk. “The counterparty quality of the banks should improve, lowering the counterparty risk accordingly,” points out Vézina. This could favour institutions such as the Caisse, as compared to insurance companies, for example. On the other hand, the transparency measures, which make compensating transactions more attractive and thus reduce the appeal of OTC trading, will exert upward pressure on costs. “OTC derivatives will become more demanding for us. It will be necessary to provide more collateral
and increase the margin,” says Philippe Tremblay, director of credit and liquidity risk management with the Caisse. It’s not hard to imagine a proliferation of collateral conversion operations that modify the reverse repurchase agreement and loan of securities landscape. “We will have to revise our strategies and identify ways of reducing costs, but also explore the opportunities available to us, optimize our power to issue at lower cost without exposure to leverage and review our liability structure—and do it all without forgetting one of the lessons of the 2007/08 crisis: that the liquidity risk is large, even for pension funds.”

With banks asked to rework their balance sheets and off-balance sheet accounts, there will be some asset housecleaning. We can expect more shares to be floated on the market and
a greater demand for bonds, with a bias in favour of government bonds, covered bonds and blue-chip corporate bonds. However, if share issues are not used, retained earnings could play a larger role in increased capitalization, which could potentially result in dividend reductions.

On the other hand, the securitization game will be less popular. “In the new environment that is in the process of being created, securitization will be very demanding of regulatory capital, and thus very expensive. The banks will want to take risk off their books, which penalizes structured products,” says Tremblay.

Real estate assets
With non-liquid assets likely to cost more, pension funds will probably be more solicited, according to Vézina and Tremblay. The same conclusion holds true for infrastructure investments. In arbitrage involving asset liquidity and cash flow matching, the bank horizon must expand to cover the whole business model, with the accent on activities that exercise pressure on the short-term segment of financing needs, such as factoring and lines of credit.

“Business relationships will become more important. We will be getting requests that we didn’t used to see. We will have to analyze new opportunities without jeopardizing our yield, in a universe where financing costs are higher than they used to be,” says Tremblay.

However, both Vézina and Tremblay emphasize that this perspective is just one analysis of the new regulatory environment banks will face in the wake of Basel III. From 2013 to 2018, the industry will find itself in a period of observation, with the goal being to understand the emerging environment in order to be ready for it.

Gérard Bérubé is a financial journalist and assistant news editor with the Montreal-based newspaper Le Devoir. This article was originally published in our sister publication Avantages.

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