LIQUIDITY RISK: LCR vs PRA110

Dear Followers,

“LCR and PRA110 both address liquidity risk within financial institutions. It is crucial to understand the key differences between them and explore why regulators introduced the PRA110 reporting requirement. This step aims to address any limitations in the LCR guidelines, ensuring liquidity resilience and maintaining stability in the financial system.”

A) LCR (Liquidity Coverage Ratio):

Background:

The Liquidity Coverage Ratio (LCR) is a Pillar 1 regulatory requirement provided in the Capital Requirements and Regulation (CRR) established by the Basel Committee on Banking Supervision (BCBS) to assess a bank's resilience to short-term liquidity stress event such as the 2008 Global Financial Crisis (GFC) over a 30-day period.

LCR evaluates the adequacy of a bank's High Quality Liquid Assets (HQLA) in relation to its potential Cash Outflows during this timeframe and shall be expressed as a percentage and reported on a monthly basis.

As an integral component of the Basel III framework, the LCR is widely implemented globally, mandating banks to uphold a minimum LCR of 100% and to be reported in the reporting currency irrespective of the actual transaction currency. However, the LCR need to be reported separately in individual currencies if the aggregate amount of liabilities denominated in these currencies exceeds 5% of the credit institution’s total liabilities, excluding regulatory capital and off-balance sheet items.

LCR considers both Inflows and Outflows, to ensure a balanced liquidity position. The LCR weight reflects the typical composition of cash flows within this specified 30-day window.

i) The numerator: HQLA

To qualify as a HQLA, the asset need to comply with below requirements,

• Unencumbered assets:

“Unencumbered” means free of legal, regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or assign the asset. An asset in the stock should not be pledged (either explicitly or implicitly) to secure, collateralise or credit-enhance any transaction, nor be designated to cover operational costs (such as rents and salaries).

Assets received in reverse repo and Securities Financing Transactions (SFTs) that are held at the bank, have not been rehypothecated, and are legally and contractually available for the bank's use can be considered as part of the stock of HQLA. In addition, assets which qualify for the stock of HQLA that have been pre-positioned or deposited with, or pledged to, the central bank or a Public Sector Entity (PSE) but have not been used to generate liquidity may be included in the stock.

• Listed on a recognized exchange or tradeable in active markets

Being listed increases an asset’s transparency.

• Low risk:

Assets that are less risky tend to have higher liquidity. High credit standing of the issuer and a low degree of subordination increase an asset’s liquidity. Low duration, low legal risk, low inflation risk and denomination in a convertible currency with low foreign exchange risk all enhance an asset’s liquidity.

• Diversification:

HQLA diversification shall be assessed by asset class, issuer, location and currency.

• Always available for an access to HQLA:

Liquid assets must be readily accessible to qualify as HQLA, which is a part of operational requirement. It may not be able to monetise 100% of its Liquid Asset Buffer (LAB) on Day 1, which is a risk assessed separately in the PRA110 granular LCR stress.

Categories of Liquid Assets:

Liquid Assets have been classified into two categories according to their quality,

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

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

• Level 2A: Securities guaranteed by sovereigns, central banks, PSEs and MDBs, corporate debt securities with highest credit quality and covered bonds that meet certain conditions.

The treatment of?covered bonds?is intricate. To gain deeper insights, I recommend exploring the article below:

https://www.dhirubhai.net/pulse/liquidity-risk-intriguing-treatment-covered-bonds-sathyanarayanan-pykjc/

• Level 2B: Residential mortgage-backed securities, corporate debt securities and common equity shares that satisfy certain conditions subject to a 50% haircut.

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.

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

Explore further about HQLA by visiting the below article,

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

ii) The denominator: Total Net Cash Outflows

The term “Total Net Cash Outflows” is defined as the total expected cash outflows minus total expected cash inflows in the specified stress scenario for the subsequent 30 calendar days.

Total expected cash outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run off or be drawn down. Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables by the rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of total expected cash outflows.

iii) The denominator: Cash Inflows:

When considering its available cash inflows, the bank should only include contractual inflows (including interest payments) from outstanding exposures that are fully performing and for which the bank has no reason to expect a default within the 30-day time horizon. Contingent inflows are not included in total net cash inflows.

Cap on total inflows: In order to prevent banks from relying solely on anticipated inflows to meet their liquidity requirement, and also to ensure a minimum level of HQLA holdings, the amount of inflows that can offset outflows is capped at 75% of total expected cash outflows as calculated in the standard. This requires that a bank must maintain a minimum amount of stock of HQLA equal to 25% of the total cash outflows.        

B) PRA110 (Prudential Regulatory Authority):

Background:

This is a specific Pillar 2 reporting template mandated by the Prudential Regulatory Authority (PRA) in the U.K. It builds upon the LCR concept but goes into much greater detail.

PRA110 reporting template is associated to the Cashflow Mismatch Risk (CFMR).

PRA110 - Liquidity Risk Assessment for UK Financial Institutions:

The PRA110 return is applicable to various financial entities in the UK, including banks, building societies, PRA-designated firms, and UK branches of EEA (European Economic Area) firms. Its purpose is to enable the regulator to assess liquidity risk in a more detailed manner than previously.

Key points:

• Frequency: Larger firms with assets totaling €30 billion or more are required to submit the PRA110 return on a weekly basis.
• Smaller firms fall under a monthly reporting requirement for the same return.

Key features of PRA110:

• Captures the maturity mismatch of an institution’s activities (referred to as the “Maturity Ladder”).
• Covers contractual cash flows (both inflows and outflows) from on- and off-balance sheet items.
• Reports the stock of unencumbered assets or other funding sources available to cover potential contractual gaps (counterbalancing capacity).
• Requires reporting across 108 time buckets based on residual maturity.
• PRA110 also calculates a blended LCR weight for certain rows.

Sections of the PRA110 report template:

• Outflows
• Inflows
• Counterbalancing Capacity (CBC)
• Contingencies
• Memorandum items
• Monetisation actions
• Cumulative liquidity resources post firm actions

Explore more about the PRA110 report by visiting this link,

https://www.dhirubhai.net/posts/babusathyanarayanan91_pras-approach-to-assessing-calibrating-activity-6887046442565951489-HdMY?utm_source=share&utm_medium=member_desktop

Comparison of LCR vs PRA110:

• While both LCR and PRA110 address liquidity risk, PRA110 provides more granular data and focuses on the specific contractual cash flows and counterbalancing capacity.
• LCR is a global standard, whereas PRA110 is specific to the UK designated firms.
• PRA110’s reporting requirements are more detailed and can be challenging due to the sheer volume of data needed.
• Low point risk - Low point risk refers to the potential of not having adequate?High-Quality Liquid Assets (HQLA)?to cover cash flows that are categorized on a?daily basis. Unlike the?cumulative 30-day needs?assessed by the?Liquidity Coverage Ratio (LCR), low point risk considers the granularity of daily liquidity requirements. Specifically, the?PRA110?reporting requirement mandates that financial institutions maintain?92 daily buckets?at the near end of the liquidity ladder. These buckets help manage liquidity risk effectively.
• Cliff risk - Cliff risk refers to the possibility that banks may experience significant liquidity outflows immediately following the traditional 30-day window assessed by the Liquidity Coverage Ratio (LCR). To address this, the PRA110 requirement extends the granularity of daily liquidity assessment to 92 days. By doing so, financial institutions can better manage the risk associated with sudden liquidity needs.
• HQLA Monetisation risk - Banks may not be able to monetise sufficient non-cash HQLA to cover cumulative net outflows under the LCR stress on a daily basis. PRA110 has a separate section to assess HQLA monetisation.
• FX Mismatch risk - Banks may not be able to access FX markets as normal in times of stress. PRA110 requirement includes material currency reporting.

In summary, LCR is a broader liquidity risk measure, while PRA110 provides a more detailed view of contractual cash flows and counterbalancing capacity within the UK regulatory context. Both play critical roles in ensuring banks’ liquidity resilience.        

Feel free to share any additional differences you’ve noticed between the LCR and the PRA110 report in the comments section!

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