In July 2019 the EBA published its first report on monitoring liquidity coverage ratio (LCR) implementation in the EU. This first report identified areas with material differences in implementation across jurisdictions and banks where further guidance was deemed useful for banks and supervisors.
In this entry, we will summarize the main conclusion of the March 2021 second report.
Review of the effects of past guidance
Specifically, the first report included guidance for:
- Identification of excess operational deposits, that would follow the treatment for non-operational deposits.
- Assessment of a material early withdrawable penalty in term retail deposits maturing beyond 30 days, that could allow them to be excluded from outflows.
Non-operational deposits and excess operational deposits
The first EBA report provided policy guidance in the form of a couple of possible prudent approaches and good practices for estimating the ‘excess operational deposits’, which need to be treated as non-operational. Clearly (see the next graph), the amount of non-operational deposits reported decreases from April 2020. This is due to the segregation of the amount of excess operational deposits following the update of the ITS on LCR reporting applicable since thata date. The amount of excess operational deposits was reported within non-operational deposits until March 2020.
Retail deposits excluded from outflows
The first EBA report, provided guidance for the identification of a material early withdrawal penalty in retail deposits maturing beyond 30 days that would allow them to be exempted from outflows.
From September 2019 (see the next graph) there has been a decreasing trend in the amounts reported. The policy guidance provided to identify early withdrawal penalties was considered to be prudent and more conservative than the approaches previously followed in practice in many cases. From this perspective, a reduction of the amounts reported under exempted retail deposits is consistent with the application of the guidance.
In the first report, EBA included too guidance to clarify some products and services that could trigger additional outflows not specified in the LCR Delegated Regulation (LCR DR). Additionally, the EBA intended to draw supervisors’ attention in their ongoing supervision as regards existing liquidity risks particularly related to the time dimension of the LCR (comparison between end-of-month LCR and intra-month LCR values) and to cases in which banks are swapping some retained own securities.
The EBA has continued and will continue developing, this monitoring exercise with new guidance on other areas of attention (the policy guidance included in the report is not formally legally binding although the EBA expects that banks and competent authorities will follow it), particularly the LCR by significant currency and HQLA diversification, and extend the monitoring to the implementation of NSFR.
COVID-19 on LCR and additional guidance
In this second report the EBA has observed the LCR in the context of the current COVID-19 pandemic crisis:
- Usage of liquidity buffer
- Unwinding mechanism waivers
- Recourse to central bank support
- Additional outflows from derivatives.
Finally, the report provides additional guidance about some specific approaches about the treatment of fiduciary deposits, the LCR optimization risk, the interdependent inflows and outflows for LCR purposes, and the treatment of DGS deposits, which we will summarize in the second part of this entry.
1. Usage of the LCR Liquidity buffer
The liquidity buffer in the LCR is designed to be used to meet net outflows under stress, so these discussions build on the observations raised by some supervisors on the reluctance of banks to use their buffers during the COVID-19 episodes even though these buffers are very large (the average LCR is 165% as of June 2020). The EBA assumes that institutions may fear possible adverse effects of the use of the buffer in the event of market stigma if the LCR goes below 100%:
- Credit rating agencies’ assessment of LCR values and potential implications of downgrades to external funding access.
- Market reaction to public disclosures of decreasing LCR values.
- Supervisory scrutiny. The obligation of immediate notification to the competent authorities when there is a risk or expectation that LCR values could go below 100%, and design the restoration plan.
- Activation triggers of internal contingency and recovery plans due to lower LCR values.
- Optimization of economic results. Use their less liquid assets as collateral in central bank repos and obtain funding at a low cost. These monies would be used to pay for their outflows at a lower cost than would result from liquidating the liquid assets either via private repos or sale.
Best practices to encourage. The Regulation allows banks’ LCRs to fall below 100% under stress and requires them to issue a communication to the relevant competent authorities as well as to submit a restoration plan in due course.
- This situation should not be necessarily perceived by supervisors as liquidity mismanagement.
- Regulatory LCR public disclosure should not be a big concern for the usability of the buffer, in particular in the case of market-wide stress where various institutions would disclose an LCR of less than 100%, thus reducing the stigma for individual institutions.
- Banks should avoid any reluctance to internally escalate any required communication of lower LCR values to ensure due control by senior management. These situations should be reflected and described in the relevant liquidity contingency plans of the institutions.
- Credit rating agencies and market participants should not penalize banks in the course of their assessments if banks’ LCR values fall below 100% under stress.
2. Unwinding waivers
In order to avoid unintended consequences, and only in exceptional circumstances which could go with systemic risk, the LCR DR envisages the possibility of applying exceptional measures. In this regard, banks might benefit from some preferential treatment in the LCR as regards central bank support, via a waiver of the ‘unwind mechanism’ in the context of the calculation of the caps on HQLA in the computation of the liquidity buffer. The unwind mechanism discounts the cash and other liquid assets up to 30 days SFTs (Securities Financing Transactions) to reflect an adjusted value of the liquid assets held by banks. The waiver here avoids a reduction of the LCR value particularly if the monies received from central banks are used and not reinvested in liquid assets.
Recital 5 of the LCR amending Act and paragraph 4 of Article 17 of the LCR DR envisage the possibility that competent authorities may waive the unwind mechanism, on a case by case basis, of repos of up to 30-days, reverse repos and collateral swaps (where the counterparty is a central bank and where at least one leg is a liquid asset); hence including repos or reverse repos collateralized by non-liquid assets. On the other hand, in a normal scenario, the LCR unwinding waiver is not expected to be granted as there are no exceptional circumstances that pose a severe systemic risk to the banking sector of one or more Member States, which is actually a pre-condition for granting this waiver.
3. Central bank support
The injection of liquidity solely via the TLTRO in March, June and September comes to EUR 1.6 trillion (see the next graph). From a supervisory and policy perspective, it is interesting to establish how much of the LCR values correspond to liquidity received from the central bank and how the current values of the LCR reported by banks could be interpreted.
Two estimates-based approaches have been followed for this analysis based on a sample of banks in September 2020, using as a starting point:
- the variation of non-level 1 sovereign collateralized repos as reported in the COREP maturity ladder between 2 and 5 years, and
- the variation of central bank assets and withdrawable reserves as reported in the LCR templates.
Both approaches have shown that the average LCR reported, adjusted for central bank support, decreases by roughly 40 percentage points but remains substantially above the minimum (roughly 30 percentage points above the minimum of 100%).
In the long-term, 3 years TLTRO tranches represent on average 7% of the total funding maturing at over one year plus all retail deposits with maturities of less than one year. This percentage is 12% if only funding maturing at over one year is considered. Supervisors should monitor particular cases where these percentages might be significantly higher. Dependency on central bank long-term funding could potentially trigger elevated refunding costs in a future scenario to maintain a potential long-term assets/funding balance. Monitoring the use of the funding received, particularly if reinvested in long-term assets, and the capacity to access private stable funding, in the absence of a renewal of central bank funding in the long term under normal scenarios, seems relevant in these cases.
4. Additional outflows from derivatives
In the earlier weeks of the crisis (March-April 2020), and particularly in funding markets, margin calls increased drastically. This increase in collateral required in funding markets could trigger LCR implications for the following two years, with the risk of some procyclicality effects.
The Regulation requires the computation of the relevant additional outflows due to collateral needs, if the derivatives transactions are material, and measured as such if the notional amount exceeds 10% of the net outflows at any time in the previous two years. Also, the relevant outflows in these cases are defined as the largest absolute net 30-day collateral flow realized during the previous 24 months. This means that the episode affecting the markets in March/April could trigger material outflows under this item during the next 2 years, irrespective of the future volume of the derivatives portfolios in banks and of the future behavior of the markets. Between February and April 2020, the amounts reported as additional outflows increased on average by 24% (also 24% between February and September 2020).
The EBA will assess potential procyclicality effects and will act as necessary in due course. On the one hand, such exceptional picks may not be usefully taken on board in all their impact, and on the other hand, markets may indeed navigate a quite uncertain period, which would warrant that the increased potential outflows are well reflected.
