IRL Summary – An adaption of the Basel III Liquidity Coverage Ratio to the Colombian Market

Background – Basel III & The Liquidity Coverage Ratio

The depth and breadth of the subprime crisis at the end of the last decade exposed deep-rooted weaknesses in market risk framework standards and regulations, above all those of liquidity risk. As a consequence, international financial regulators agreed to rebuild this framework a process culminating in what is now known as Basel III, a collection of updated recommendations, principles and standards seeking to align international financial markets through more prudent management of their balance sheets, particularly over the short term, in order to avoid similar crises in the future.

One of the most significant reports to surface from Basel III is the Liquidity Coverage Ratio, or LCR Report, which came into effect at the beginning of 2015. This report was created with the express intention of guiding financial entities with regards to the dynamic, risk adjusted management of their short-term liquidity positions.

For a detailed description of the LCR, we recommend reading the following articles from our blog: Ratio de Cobertura de Liquidez y LCR Basilea – Preguntas frecuentes.

IRL – Adapation to the Colombian Market

One of the key conclusions that can be taken from the new Basel III framework is that the recommended reports, be they for liquidity, interest rate or foreign exchange risk, should be considered as guidelines only. Specific reports should therefore be adapted by their respective regulators to the specific country, region and market in which they operate.

Consequently, Colombia’s local financial market regulator, the SFC, asked each of its regulated entities to develop and implement an internal Liquidity Risk Management System, or SARL, a system which would allow them to follow Basel III guidance within a framework adapted to the realities of the local market. From this framework the SFC created two liquidity risk reports which every entity must send to the regulator on an ongoing basis -the IRL or Liquidity Risk Index and the CFEN or Net Stable Funding Ratio- Below, we explain the most important concepts for the calculation of the IRL.

The general concept of the IRL is very similar to that of the LCR, that is:

  • Define the outstanding amounts and respective adjustment factors of the entity’s most liquid assets.
  • Calculate the net cash inflows over the next 90 days, weighted by a probability of payment / receipt factor.
  • Divide the results to obtain the IRL ratio.

 ALM – Liquid Assets adjusted for Market and Exchange Rate Risk.

The numerator of the IRL is called ALM or Liquid Assets adjusted for Market and Exchange Rate Risk. ALM is calculated by summing the entity’s High-Quality Liquid Assets or ALAC and its Other Liquid Assets (OAL). The calculation is as per below:

ALAC = DML + DME*(1-HRC) + PJIInvML(ac)*(1-HLM) + PJIInvME(ac)*(1-HLM)*(1-HRC)

Where DML is Local Currency Cash and Equivalents, DME is Foreign Currency Cash and Equivalents, PJIInvML(ac) is the fair value of high quality local currency marketable securities, and PJIInvME(ac) is the fair value of high quality local currency marketable securities.

The resulting number should, at all times, represent a minimum 70% of total ALM. If this is not the case, the Other Liquid Assets figure is discarded and 3/7 of the same ALAC figure is added to the total.

OAL = PJIInvML(oa)*(1-HLM) + PJIInvME(oa)*(1-HLM)*(1-HRC)

Where PJIInvML(oa) es is the fair value of other local currency liquid investments and PJIInvME(oa) es is the fair value of other foreign currency liquid investments.

With the exception of Local Currency Cash and Equivalents, each of the above figures is multiplied by a respective liquidity risk factor and/or a foreign exchange risk factor. These so-called “haircuts” reflect the possibility of the entity having to accept a lower market value of its liquid assets at sale and a weaker exchange rate during a period of liquidity stress.

Looking at the two formula, we can conclude that the keys to a correct calculation, in line with Basilea III recommendations, are:

  1. The correct classification of liquid assets into their respective “quality” categories.
  2. The correct application of the “haircuts’ or recommended risk factors.

With regards to the first point, a large % of marketable securities considered ALAC can be found in the “Classification Code” list which the SFC provides entities for such effect. Regarding the second point, for the most liquid assets, the entity should apply the same “haircuts” applied by the Central Bank of Colombia to the different securities eligible for the local repo market. These factors are regularly updated and published on its web site.  In the case of the entity holding liquid assets not appearing on the list, the SFC applies a factor to each asset depending on its credit rating.

 RLN – Net Liquidity Requirement

The denominator of the IRL is the RLN or Net Liquidity Requirement. This figure summarises the difference between the forecasted and adjusted inflows and forecasted and adjusted outflows of cash over a 30 day period, and its formula is:

RLN = FEVC + FNVNC – min[75%(FEVC + FNVNC); FIVC]

Where FEVC represents Contractual Outflows and FNVNC represents Non-Contractual Outflows. FIVC represents the cash inflow which the entity reasonably can expect to receive during the 30day time period.

Contractual Outflows should be reported as such, in other words the SFC does not allow for any type of adjustment to cash flows whether they be seasonal, prepayment, delay or renewal adjustments, the exception being those debt instruments possessing an embedded “call option” and some specific products stipulated by the SFC*. The SFC also requires that entities inform them of the actual cashflows from these assets the week before, in order to allow them to conduct their own analysis of asset and liability maturities and renewals.

With respect to the FNVNC, the SFC recommends applying a Net Withdrawal Factor for demand and sight deposits in each category. The calculation of the FRN is an average depending on the historical behaviour of different products in terms of amortization and specific withdrawal factors provided by the SFC. The calculation is:

FNVNC = FRN x DENC

Where DENC represents the stock of Non-Contractual Demand and Sight Deposits available on the report date.

By dividing ALM by RLN, we end up with the IRL ratio for the entity.

*Products in columns 8 to 19 in the 458 format.

Other Considerations

The generic IRL report must be reported to the SFC on a weekly basis and at the end of each month. All cash inflows and outflows must be separated into the following time buckets: 1-7 days (in 7 sub-buckets), 8-15 days, 16 to 30 days, and 31 to 90 days, although the last time bucket is not considered for the final calculation of the ratio. Finally, the ratio should be calculated in an aggregated format, including both local and foreign currency flows.

Although the entity is obliged to report its IRL to the SFC on a weekly basis in the aforementioned format, the entity itself should be proactive regarding the management of liquidity on its balance sheet, ensuring the existence of stricter and more frequent internal reporting when required.

Note: At Mirai we use MAT, our taylor-made end-to-end ALM tool. MAT allows our clients to generate future balance sheet cash flows at contract level, the results of which can be used to create the regulatory IRL report. For more information contacts us via https://www.miraialmtool.com/en/.

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