Liquidity Risk - Is HQLA effective in fulfilling its intended role?

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Background:

Understanding HQLA (High-Quality Liquid Assets) refers to assets that can be easily converted into cash without significant loss of value, even in times of financial stress. These assets have low credit risk, and low volatility and are easily tradeable in liquid markets.

Liquidity management:

Acts as a buffer during a financial stress period and unforeseen liquidity needs, if any.

Regulatory compliance:

Financial oversight authorities mandate that banks retain an adequate level of High-Quality Liquid Assets (HQLA) to ensure the resilience of the financial system amidst economic contractions.

Fundamental Characteristics:

– Low risk: high credit quality and seniority increase an asset’s liquidity, as well as low duration (referring to interest rate risk) and low foreign exchange risk.

– Ease and certainty of valuation: standardized and simply structured assets are more fungible, which promotes liquidity. Pricing formulas for HQLAs must not depend on strong assumptions.

– Low correlation with risky assets

– Listed on a developed and recognized exchange.

- They need to be unencumbered by the entity relying on them.

Methodology: The other side of the setting of risk limits in the risk appetite statement is how the need for liquidity should be adequately covered, which brings the size and composition of the liquidity buffer into play, usually referred to as HQLA.

There are two major aspects of the liquidity buffer or reserves: its size and its composition.

Size:

The top-down approach will tell us to look at the maturity transformation within the bank. The larger the maturity transformation the higher is the liquidity risk and hence we should cover that with an appropriate liquidity reserve.

Composition:

It can be useful to follow the BCBS guidance and allocate the reserve assets to different levels according to the Basel III LCR criteria.

Liquid Assets are classified into three levels according to their quality,

– Level 1 is limited to cash, central bank reserves and high-quality sovereign Bonds.

– Level 2 consists of two sublevels and must not be more than 40% of the overall stock after haircuts applied.

• Level 2A: Securities guaranteed by sovereigns, corporate and covered bonds that meet certain conditions.
• Level 2B: Residential mortgage-backed securities, corporate debt and common equity shares that satisfy certain conditions, as well as certain additional assets subject to the discretion of the national authorities.

Haircut - Refers to a discount applied to the market value of an asset when calculating its contribution to the High-Quality Liquid Assets (HQLA). The haircut reflects the potential decrease in the asset’s value during a liquidity crisis, ensuring that banks do not overestimate their liquid assets.

Noteworthy: Level 1 assets are not subject to haircuts, but on Level 2A (15%) and 2B (25 – 50%) haircuts are applicable.

Liquidity Stress Testing:

Asset Liability Committee (ALCO) approves several triggers across different scenarios. Widely used scenarios are,

1. HQLA DoD decrease in NPV – Haircut
2. HQLA WoW decrease in NPV – Haircut
3. HQLA MoM decrease in NPV – Haircut

Each of them again assessed across probabilities such as DoD decreased by 3% or 5% or 10%.

[ DoD – Day on Day, WoW – Week on Week, MoM – Month on Month , NPV – Net Present Value ]

Furthermore, High-Quality Liquid Assets (HQLA) is the numerator when determining the Liquidity Coverage Ratio (LCR).

Fun fact: Basel III introduced several criteria for HQLA however retrospectively, it was called as ‘Liquidity Reserve’ or ‘Liquidity Buffer’ or ‘Liquid Asset Buffer (LAB)’.        

In summary, High-Quality Liquid Assets (HQLA) are proving to be a significant aid to banks during periods of financial strain.

#LiquidityRisk #HQLA #Basel3 #Haircut #LCR