To HQLA, With Reluctance : Effectiveness of Liquidity Coverage Ratio under Stress
Dr. Sunando Roy
Advisor @ Central Bank of Bahrain | Risk Leader, PRMIA ?Audit Leader Network Member , Institute of Internal Auditors (IIA), ? Fellow , International Compliance Association(FICA) ? Fellow, UC Irvine I Published Author
The 2023 banking turmoil revealed significant insights into liquidity risk and banks' hesitation to deploy High-Quality Liquid Assets (HQLA) in times of stress. Despite regulatory frameworks like the Basel III Liquidity Coverage Ratio (LCR) aiming to ensure liquidity resilience, practical challenges appeared to constrain the role of LCR is tackling immediate liquidity concerns.
The global financial crisis of 2007 -08 is often described as a liquidity crisis when banks did not hold adequate quantity of sufficiently liquid assets and could not survive a severe liquidity crunch. In response, the Liquidity Coverage Ratio (LCR) was introduced to promote the short-term resilience of the liquidity risk profile of banks. A net stable funding ratio (NSFR) was also introduced to ensure that banks maintain a stable funding profile over a longer horizon in relation to the composition of their assets and off-balance sheet activities.
Role of HQLA in liquidity management
The High Quality Liquid Assets (HQLA) are defined as assets unencumbered by liens and other restrictions on transfer which can be converted into cash easily and immediately, with little or no loss of value, including under the stress scenario. HQLA are determined on the basis of pretty stringent eligibility criteria intended to ensure that a bank’s HQLA stock has the ability to generate liquidity fairly quickly , through sale or secured funding in a stress scenario. The assets are required to meet fundamental and market-related characteristics, particularly in terms of low risk, ease and certainty of valuation, low volatility and instant usability . A significant chunk of HQLA is also eligible for intraday and overnight liquidity facilities offered by Central Banks.
The HQLA are divided into two main categories or levels: Level 1 and Level 2. Level 1 assets are the safest and most liquid and are not normally subject to a haircut ( not discounted when calculating the Liquidity Coverage Ratio (LCR). Level 2 assets are less reliable in times of crisis and are therefore applied with significant haircuts , to the point that the loss of their potential value in stressed conditions are already built in within the reporting metric.
Assets meeting the fundamental and market-related characteristics of reliable liquidity cannot automatically be recognized as HQLA. The assets are subject to operational requirements ( such as periodic ‘proof of the pudding’tests) designed to ensure that the stock of HQLA is managed in such a way that a bank can, and is able to demonstrate that it can, immediately use the stock of assets as a source of contingent funds that is available to convert into cash through repurchase (repo) transactions within the LCR window.
The stringent conditionality of HQLA ensures, to a great extent, usability in times of liquidity crisis. Drawing upon this pool of liquid assets thus ensures immediate survival.
Evidence of HQLA Usability
The impact of financial crisis was so great that the regulators vowed in the aftermath to ensure systemic liquidity by doing “whatever it takes “ . This not only involved unprecedented liquidity regulations ( including but not confined to Metrics of LCR and NSFR) but also expressed its readiness to use its balance sheet to provide liquidity insurance to the financial system as appropriate. Taking the two together, banks can access significantly more liquidity, in a more reliable and timely manner, to withstand severe stress.
During the recent severe stress scenario played out during the COVID-19 pandemic, the liquidity framework of the financial system was put to stress. Global experience during the COVID-19 period brought forward the regulatory authorities resolve in a number of jurisdictions to support HQLA usability through public statements and special financing windows.
At the same time, surveys by central banks ( such as the Liquidity Biennial Exploratory Scenario (LBES) of Bank of England) observed that banks , on the whole, were unwilling to allow their LCRs to fall below 100%, even in a very severe stress, if they had ways to shore up liquidity drawing upon the measures available in the liquidity contingency plan.
Banks were generally vigilant to keep LCR above the regulatory minimum (and preferably with a buffer) due to reputational risk concern. Disclosure of below 100% LCR can create adverse market sentiments and can set up a case for social media driven bank run. There is a stigma attached to below par liquidity coverage ratio and thus the Asset Liability Committee in Banks are keen to address the falling HQLA at the earliest, imparting stability to the HQLA number.
To HQLA, with Reluctance
Recently , several reasons for this reluctance was discussed by the Basel Committee on Banking Supervision . ( Basel Committee on Banking Supervision. The 2023 Banking Turmoil and Liquidity Risk: A Progress Report. Basel, Switzerland: Bank for International Settlements, October 2024)
1. Operational Constraints and Misalignment with Stress Needs
Banks often allocate portions of their HQLA for operational and intraday liquidity needs, limiting their availability to cover stress-related outflows. For instance, Credit Suisse (CS) faced criticism during the 2023 turmoil for reserving much of its HQLA for purposes other than stress scenarios. As the report noted:"A large part of CS’ HQLA held to meet its minimum LCR requirement was reserved for purposes other than to cover the outflows in a 30-day stress scenario as foreseen in the LCR framework" . This misalignment highlights the need for more practical calibration of liquidity requirements to reflect modern financial realities.
2. Perceived Negative Signaling
Drawing down HQLA can inadvertently signal distress to the market, triggering further scrutiny and stress. For Credit Suisse in particular, this concern became a significant barrier: "Supervisory and market scrutiny were considered by CS as an impediment to the use of its LCR buffer. CS was of the view that 'breaches' of Pillar 1 or Pillar 2 liquidity requirements needed to be communicated, which in turn may have affected its willingness to draw down the LCR buffer." This highlights a key challenge: striking a balance between regulatory transparency and the unintended consequences of signaling vulnerability.
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3. Regulatory and Supervisory Factors in Transfer Risk : The above report is a reminder of a known risk, i.e., transfer risk. Jurisdictional differences and regulatory limitations often hinder the effective use of HQLA across banking groups. As the Basel Committee observed:"Supervisors should also take into account possible limitations to the free transferability of capital and liquidity resources within banking groups that may arise... as these can limit or restrict actions by banks or supervisors in stress." These trapped liquidity scenarios emphasize the importance of streamlined, global regulatory coordination.
4. Social Amplification of Risk: Advances in digital banking and the prevalence of social media have accelerated the speed of liquidity outflows, challenging traditional risk frameworks. The report notes:" Advances in the digitalization of finance – including faster payment/settlement services and on-demand access to banking services – are removing many of the frictions that may have previously slowed down the magnitude of liquidity outflows." This modern dynamic necessitates incorporating digital and media risk into liquidity stress models.
While supervisory tools are generally robust, their implementation needs refinement to keep pace with evolving risks. The Basel Committee highlighted:
"The assessment concludes that the Basel monitoring tools are generally fit for purpose provided they are properly implemented and extensively used to address vulnerabilities of banks." (Page 11)
Conclusion: Building Resilience in an Evolving Landscape
The reluctance of banks to deploy HQLA during stress reflects a complex interplay of operational, regulatory, and market dynamics. Addressing these issues requires a combination of refined regulatory frameworks, enhanced supervisory practices, and a modernized understanding of liquidity risks.
As we adapt to these challenges, the lessons of 2023 serve as a reminder of the need for resilience in an increasingly interconnected and fast-paced financial world. By aligning policy and practice with modern realities, the global banking sector can better prepare for future uncertainties.
To this end, the Basel Committee offers a significant bucket list of reform in the October report. This , in my view, will shape the future of liquidity risk management in financial sector. The recommendations include:
First, supervisory effectiveness must be enhanced - increasing the frequency of liquidity monitoring, especially during periods of stress, and leveraging high-frequency data sources, including market intelligence and social media trends.
Second, the design and calibration of liquidity standards must be revisited. The Committee advocates for a reevaluation of the LCR and NSFR to better capture immediate and structural liquidity risks. Complementary metrics, such as survival periods and non-risk-based liquidity indicators, could provide additional layers of resilience.
Third, the report underscores the importance of operational preparedness. Banks must develop robust contingency funding plans and ensure operational readiness to access central bank liquidity facilities. Supervisory stress testing should supplement internal stress tests to identify potential weaknesses in liquidity management.
Lastly, the Committee calls for greater attention to the challenges faced by internationally active banks. These institutions must improve the allocation and management of liquidity across legal entities, considering the limitations imposed by national laws and internal practices. Monitoring liquidity risks at both the group and entity levels is critical for maintaining overall financial stability.
References
Basel Committee on Banking Supervision. The 2023 Banking Turmoil and Liquidity Risk: A Progress Report. Basel, Switzerland: Bank for International Settlements, October 2024.The 2023 banking turmoil and liquidity risk: a progress report.
Basel Committee on Banking Supervision. “Basel III: The Liquidity Coverage Ratio and Liquidity Risk Monitoring Tools.” Bank for International Settlements, January 2013. https://www.bis.org/publ/bcbs238.pdf
Basel Committee on Banking Supervision. “Basel III: The Net Stable Funding Ratio.” Bank for International Settlements, October 2014. https://www.bis.org/bcbs/publ/d295.htm
Federal Reserve Board. “The Liquidity Coverage Ratio and Corporate Liquidity Management.” FEDS Notes, February 26, 2020. https://www.federalreserve.gov/econres/notes/feds-notes/the-liquidity-coverage-ratio-and-corporate-liquidity-management-20200226.html
Federal Reserve Bank of Richmond. “Understanding the New Liquidity Coverage Ratio Requirements.” Economic Brief, January 2016. https://www.richmondfed.org/-/media/RichmondFedOrg/publications/research/economic_brief/2016/pdf/eb_16-01.pdf
Senior Bank Management Consultant
1 个月An excellent paper. I have nothing to add to your comments from a regulatory perspective. From a business perspective, banks must develop internal rules specific to them and their markets and make them available and transparent i.e. they should explain the rationale in their RAS for example. The problem with regulatory rules is that they apply to all whatever the specific situation of a bank. In parallel communication must be an ongoing process. If CS was facing the question of using their HQLA cushion it is probably because of their lack of risk strategy before the fact.
Advisor @ Central Bank of Bahrain | Risk Leader, PRMIA ?Audit Leader Network Member , Institute of Internal Auditors (IIA), ? Fellow , International Compliance Association(FICA) ? Fellow, UC Irvine I Published Author
2 个月The good thing is that regulators are discussing this. in future we may see a much more flexible LCR floor. The Basel Committee on Banking Supervision (BCBS) acknowledges that during financial stress, banks may need to use their HQLA, causing the LCR to fall below the standard minimum. Supervisors are expected to provide guidance on HQLA usability in such circumstances, emphasizing that the LCR is a minimum requirement in normal times and can be breached during stress periods without immediate penalties. PRA has initiated discussions on improving the usability of HQLA during stress periods. Proposals include enhancing communication and guidance to ensure banks feel confident in drawing on their liquidity buffers when necessary, without fear of undue market or regulatory reactions.
Credit Risk | Strategy | Pricing | Products | Innovation
2 个月I thik usage of HQLA by bank supervisors under “Sound Principals” should be guided by consideration of core objective and definition of LCR. They should consider prevailing microfinancial conditions and forward looking assessment. Their response should be differential and proportionate to drivers , magnitude , duration and frequency. However what is key for stress test is to ensure that HQLA asset is really liquid to meet the shortfall of cash flow .
Advisor @ Central Bank of Bahrain | Risk Leader, PRMIA ?Audit Leader Network Member , Institute of Internal Auditors (IIA), ? Fellow , International Compliance Association(FICA) ? Fellow, UC Irvine I Published Author
2 个月In the UK, the PRA has been concerned for a number of years that banks may be reluctant to draw on their HQLA in periods of unusual liquidity pressures, possibly to such an extent that it is limiting the benefits of the flexibility built into the framework. Evidence from the last few years has reinforced these concerns. For example, during the Covid-19 stress, a range of banks in the UK and internationally took defensive actions to protect and bolster their liquidity positions. This was due to the fear of being penalised through adverse market perceptions and enforcement actions from regulators. This harms bank asset creation, say loan growth and have negative .acro economic consequence through lower growth. This can be tackled by regulators through periodic timely calibration of LCR threshold, say lowering it temporarily to 70 per cent and enabling in this way the use of HQLA for the very purpose it exist, to serve as source of liquidity in need. Thanks for your comment on a topic that will be part of future liquidity risk framework
GENERAL MANAGER ( now Retd.)at Reserve Bank of India
2 个月If in stressed liquidity situation bank is able to tide over the situation without using HQLA there should be no issue if HQLA is left untouched or sparingly deployed as measure of abundant precaution for possible emergence of graver liquidity constraints. HQLA when turn illiquid due to generalised stressed market liquidity condtion central bank liquidity support would be the last resort.