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pwc.com.au Basel III liquidity risk Banking insight June 2011 Managing new regulatory burdens Why is liquidity being regulated? During a financial crisis, banks may encounter liquidity problems despite sound levels. In times of stress it is quickly turn assets into cash overall capital levels. stress, difficult to for all but the most liquid, high credit quality securities in preferred currencies. This flight to quality may force a bank in need of cash to accept substantial haircuts on held assets the immediate financial costs these haircuts may assets. In addition to costs, erode confidence in the bank’s solvency, create follow-on mark-to-market losses at other institutions, and lead to a run on a bank’s funds. Responding to this, the Basel Committee on Banking Supervision (BCBS) issued liquidity supervision guidance in December 2010. The guidance introduced metrics for monitoring a bank’s liquidity needs in times of stress. Key developments are: • The Liquidity Coverage Ratio (LCR) guards against short term (30 days) liquidity shortfalls. • The Net Stable Funding Ratio (NSFR) encourages banks to maintain high quality, long-term funding over a medium term (one year) time horizon. How will liquidity regulation affect my bank? Liquidity regulations are designed to promote bank health through periods of stress. They do this by encouraging long term, high quality funding, and by discouraging long-term, high risk business activities. The flow on effects will be: • Wholesale funding channels will become less attractive as regulators emphasise the most stable, long-term sources. • Some business practices will become nonviable due to increased liquidity requirements. • Competition will intensify for sound borrowers, and for collateral as banks seek to minimise their exposure to risky borrowers who are likely to draw down loans during times of stress. Yields on banking products and costs of funding sources will adjust in the new environment. Despite re-pricing, some products will not survive in their present form. Arbitrage opportunities may also arise, facilitated by financial institutions outside Basel III’s influence, or through alternative channels. • Compliance costs will rise as new layers of regulation impede management agility. PwC Basel III liquidity risk | Managing new regulatory burdens 2 Which products will suffer? We believe that regulatory liquidity costs will be concentrated in the following products: Product Rationale Wholesale funding Wholesale funding is more mobile than retail funding, and will therefore be subject to higher regulatory charges. Inter-bank transactions BCBS regulators are wary of reliance on other financial institutions, as stress events are felt industry-wide. High-risk loans Cash flows from low credit quality counterparties are viewed as vulnerable and illiquid during crises. Lines of credit, overdrafts, and credit cards Undrawn credit limits currently cost banks very little in terms of liquidity penalties. However, these facilities will be used during a crisis. Collateral Demand for high quality collateral will rise, lowering the yields on collateralised transactions. Looking forward The impact of BCBS funding and liquidity regulations is yet to be felt, with the standards still in draft format. What is clear is that regulators have recognised: • The need for both a long-term measure (NSFR) and a short-term measure (LCR) • That the source of funding (retail versus wholesale) has implications during a stress event. • That the level of risk within a bank’s assets will affect its ability to raise funds during a stress event. • That liquidity will need to be held for committed, undrawn lending products. All of which means that banks will need to focus on their funding programs. PwC Basel III liquidity risk | Managing new regulatory burdens 3 pwc.com.au Enhanced liquidity strategies & frameworks We: Assess, design, deliver Enhanced liquidity performance Enhanced liquidity capabilities If you require advice on this topic, please contact your PwC representative or alternatively these Partners: Sydney Melbourne Ashley Rockman Steven Lim Jason Slade +61 (2) 8266 1882 [email protected] +61 (2) 8266 8016 [email protected] +61 (3) 8603 4803 [email protected] © 2011 PricewaterhouseCoopers. All rights reserved. In this document, “PwC” refers to PricewaterhouseCoopers a partnership formed in Australia, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. PwC Basel III capital reforms | Managing new regulatory burdens 4