International Banking Management
What are the characteristics of Macquarie bank and how does it operate?
Main issue: How does Macquarie Group Australia (Macquarie bank) manage liquidity risk? What problems would occur in dealing with liquidity risk? Are there any differences in dealing with liquidity risks from commercial banks?
Questions should be linked with Basel II and Basel III and those readings of liquidity.
Recap06 — Liquidity Returns
We started our first lecture with a discussion of how banks transform deposits, which to depositors are instantly available at face value, into assets with longer maturities and lower creditworthiness. This transformation means that banks are intrinsically unable to meet the demands of depositors if, on a given day, every depositor demands his or her money back. If depositors get nervous about this fact, the depositors run to the bank to be first in line to withdraw, and that’s precisely what causes a run on a bank.
In the next lecture, though, we noted that most runs on the bank are triggered NOT by timing issues, but by the perceived inability of a bank EVER to honour its deposits. This occurs when the risky assets on the bank’s balance sheet suffer losses, and the assets of the bank drop below the level of its liabilities. The only way a bank can withstand losses and still pay liabilities is to hold capital, which can be written down if losses occur.
This became the focus of the next two lectures, when we discussed the first efforts of the Basel Committee on Banking Supervision to hold internationally active banks to a minimum capital standard. We then saw how Basel II evolved in response to what we later saw as the naivety and arbitrariness of Basel I. Finally, we examined the Basel III capitalinitiative, which over the next six or seven years puts into place standards for more and better capital.
(Note that Basel II replaced Basel I, keeping only the concept of risk-weighted assets. Basel III didn’t replace Basel II, because the entire mechanism — all three pillars — of Basel II are still in effect. Thus in a perfect world, maybe we should call Basel III “Enhancements to Basel II”. Too bad that name was already taken, when the Basel II risk-weights were increased for the types of investments which caused all the grief during the GFC.)
The Basel III Liquidity Initiative
In the lead up to Basel III, the BCBS examined how liquidity risk should be incorporated into the same process which is uses to price and manage interest-rate risk. (“Liquidity Risk: Management and Supervisory Challenges” (February 2008) and “Principles on Sound Liquidity Risk Management and Supervision” (September 2008).) The Basel III liquidity initiative “International framework for liquidity risk measurement, standards and monitoring” (December 2010) introduces two explicit liquidity requirements.
Liquidity Coverage Ratio
(First of all, check out the revised version at http://www.bis.org/publ/bcbs238.htm. APRA has also published a consultation paper, available at http://www.apra.gov.au/adi/PrudentialFramework/Pages/Implementing-Basel-III-liquidity-reforms-in-Australia-May-2013.aspx, which gives a pretty clear overview of the initiative.)
The Liquidity Coverage Ratio, or LCR, is focused on how the assets of a bank should be managed so as to maximise the likelihood that the bank can survive 30 days of stress. [How does a bank calculate the LCR? What are HQLAs and Level 1 and 2 Assets? What assets qualify as Level 2 HQLAs in Australia? See http://www.apra.gov.au/MediaReleases/Pages/11_03.aspx. Who determines the 30-day cash requirement? What goes into that calculation?].
[What happens if there aren’t enough HQLAs for the banking sector in any one country to meet the LCR requirement? What do you think about that solution?]
Note that the ownership of HQLAs — at least in the form of government bonds — is generally unrelated to the idea of interest-rate risk. Thus a bank can own very interest-rate risky government bonds (that is, high-duration bonds), but the presumption is that even the longest-dated bonds can be turned into cash on a moment’s notice. In fact, many European banks took advantage of roughly €1 trillion in low-interest three-year loans, offered in late 2011 and early 2012 by the European Central Bank to help spur lending into the real economy, to invest in long-dated Spanish and Italian (and Greek) sovereign bonds. Lots of interest-rate risk, but great for the HQLA!Furthermore, note that an investment in sovereign bonds carries a risk weight of 0%, so there is no drain on capital if a bank meets its LCR requirements by holding Level 1 assets.
One important understanding: The Basel III capital requirements (and the Basel II and Basel I capital requirements before them) are rigid. If you are a bank and want to stay in business, you have to keep your capital ratio above the minimum. (The one exception is the countercyclical buffer.) The purpose of the capital is to remain in place, as a condition of continuing to do business.
The Basel III liquidity initiative works slightly differently. The purpose of the LCR is to build up a liquidity buffer. But for the liquidity buffer to be useful, it has to be USED as and when necessary. Thus the Basel III framework anticipates that banks may see their LCR drop below 100%, if indeed there is a run on the bank or other liquidity “incident”. The countercyclical capital buffer works the same way, in that it can be drawn down when economic conditions would otherwise require a bank to reduce its lending to the real economy.
The only thing we don’t have in place are the rules by which banks would be allowed to make use of these buffers. [How would you write the rule?] There’s still a bit of debate going on …. But the fact remains that the purpose of having HQLAs in sufficient amounts is to allow a bank to liquidate the HQLAs rather than fail to honour its liabilities when due.
Net Stable Funding Ratio
The Net Stable Funding Ratio, or NSFR, is liability-focused, looks to “provide a sustainable maturity structure of assets and liabilities” at a one-year focus. [How is the NSFR calculated? What do “available stable funding” and “required stable funding” mean?]
The NSFR’s principal impact is on the maturity mismatch inherent in most banks’ balance sheets. In general, a bank’s assets are longer than its liabilities, which allows the bank to benefit from maturity transformation. The NSFR means that there is an absolute limit to how big the gap can be, and therefore how much maturity transformation the bank can undertake.
[Is the NSFR truly a liquidity initiative? Discuss.]
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