The decision to ease the Basel III Short-Term Liquidity Coverage Ratio (LCR) came as a surprise. The announcement on 6 January 2013 by the Basel Committee on Banking Supervision (BCBS) included significant revisions to the original draft published in 2010. While capital requirements for banks and insurers are considerably different, the underlying reasons cited by regulators for amending the rules could be instructive for the Solvency II capital requirements. They also reveal worrying signs that the interaction between banking and insurance regulation is not being properly examined.
Easing the Basel III liquidity rules
Basel III introduced liquidity buffers in response to the liquidity freeze in global financial markets following the collapse of Lehman Brothers in 2008. It specifies the amount and type of capital banks must hold to ensure short-term liquidity, using a 30 day stress scenario. The BCBS’s work programme on the LCR is now complete and paves the way to finalising the next stage of the Basel III Accord – the Long-Term Net Stable Funds Ratio (NSFR), a one year liquidity stress. Together they will be the first set of global liquidity standard for banks. Several changes have been introduced to the LCR since the first draft was published in 2012. They include:- Definition of High Quality Liquid Assets (HQLA) expanded, subject to higher haircuts and a limit. The new assets (and their associated haircuts) will now include:
- Corporate debt securities rated A+ to BBB– (50% haircut);
- Certain unencumbered equities (50% haircut); and
- Certain residential mortgage-backed securities (MBS) rated AA or higher (with a 25% haircut).
- A phasing in of the new rules. The minimum LCR in 2015 would be 60% and increase by 10 percentage points per year to reach 100% in 2019.
- Complete flexibility on applying the LCR in countries with distressed banking systems.
Regulating your way out of a crisis
When announcing the rules, Mervyn King, Chairman of the Governors and Heads of Supervision (GHOS), explained some of the BCBS’s reasons for the amendments. Referring to the decision to delay the full introduction of the LCR, Mr King said, “This will ensure that the new liquidity standard will in no way hinder the ability of the global banking system to finance a recovery.” A clear indication that regulators are giving more weight to the potential economic impact of the rules.
Banking and insurance is different
Banking and insurance are not the same. Accordingly, the differences between their funding models and regulation are significant, as a recent Groupe Consultatif paper, Comparison of the Regulatory Approach in Insurance and Banking in the Context of Solvency II, demonstrates. Liquidity risk is built into the business model of banks as they borrow short and lend long. In contrast, insurers (especially those offering long-term guarantee products) carry decades-long liabilities that they back with a portfolio of assets with the similar duration and expected returns. In other words, their assets are first and foremost driven by their liabilities. The requirement for market consistency under Solvency II is forcing these insurers to consider short-term market volatility despite their long investment horizon. “Essentially, banks are being forced to hold certain liquid assets because of the nature of their liabilities whereas LTG insurers are being forced to do so in spite of them,” Mr Kawasaki, said.Potential impact on Solvency II
While the direct impact of the changes to the LCR on Solvency II capital requirements may not be immediately clear, the need for rule makers to consider economic growth – or at least not impede it – is more relevant than ever. The Commission has already made this explicit.
