On October 2019, the European Banking Authority (EBA) published a report with the analysis of the Liquidity Ratio par excellence, Liquidity Coverage Ratio (LCR). This study was carried out from a sample of 136 European financial institutions as of December 2018 and a series of conclusions of great analytical value can be drawn.
As a general summary, the average of the ratio obtained has been 149%, the minimum required being 100%. It should be noted that since 2016, when it was published for the first time, there has been a clear improvement in the evolution of the ratio, caused mainly by a greater concentration of liquid assets by these actors, remaining on the contrary, practically stable net outflows.
Now let’s review the study from two different aspects:
- LCR and its components
- LCR by business models
LCR and its components
The LCR measures the ability of entities to deal with liquidity outflows that can occur during a 30-day stress period using their liquid assets portfolio (HQLA). The rule says that the result must be at least 100%.
Liquidity Coverage Ratio = Liquid assets / Net Outflow (Outflow-Income) ≥100%
In a historical analysis of the evolution of the metric, we can observe how it has been increasing since the launch of the rule and how banks have managed to reduce their liquid assets deficit in various ways that we will describe in detail later.
Interesting conclusions can also be drawn from the study regarding the type of entity; Although those entities classified as Global Systematically Important Institutions (GII’s) have ratios that do not exceed 145%, those classified as “Others” and that in principle don’t have a great specific weight within the system reach 180% levels.
By country, you can also see this dichotomy. The most noticeable are those that a priori don’t have top-classified financial entities, and still have very high levels of liquidity such as Estonia, Malta or Romania, with ratios of up to 300%.
We will now analyze the ratio in each of the components:
Liquid assets are those that the entity can easily sell in the market to deal with its outflows. They are classified based on their degree of liquidity in the following categories:
- Level 1 assets: the most liquid assets (cash, reserves, debt, etc.)
- Level 2 assets: assets that can be included in the numerator, but are less liquid than the previous ones (covered bonds, securitizations, etc.)
- Non-Liquid Assets
Roughly, the entities under study have approximately 82% of their level 1 assets (44% in cash and 45% in securities) and only 5% in liquid assets of level 2. At this point, we could ask ourselves a question: How have entities managed to increase their portfolio of liquid assets in recent years? Well, in order to answer this, we must focus on several factors:
First, we must look at the current environment of low rates that we have been “suffering” for a prolonged period. This situation has produced an increase in the prices of the assets that the entities have in balance, thus increasing the value of their stock of liquid assets.
Secondly, the optimal conditions have been given for central banks to apply expansive monetary policies that allowed banks to have been able to reduce minimum reserves or cash ratios in central banks, freeing up cash to be computed as liquid assets. This has also led banks to access credit incentive programs and increase their assets by offering more credit to consumers by increasing expected cash inflow.
And finally, and as obvious as it may seem, the entities have been changing their asset profile replacing those that were not eligible and computable for the ratio for higher quality and liquid assets.
The outflows are the denominator of the ratio and are calculated by subtracting the expected outflow minus the inflows the result must always be positive since the regulation establishes a cap on the expected entries of 75% over the total net outflow.
From the perspective of the outflows, these represent about 16% of total assets. By type of product, retail deposits reach 2%, while non-operational deposits are the largest component of outflows with 6% of total assets. To correctly understand these data, it should be noted that these percentages are calculated once the haircuts have been applied in each case. For example, in retail deposits the runoff rate of 3% while in operational deposits it rises to 34%.
The secured funding in Central Banks deserves a special mention since despite having to be backed by a collateral to access it, it doesn’t count as an outflow in the ratio since its runoff rate is 0. This is because it is assumed that the public entity will roll over the liquidity needs if necessary and if the collateral remains eligible.
On the contrary, the secured funding with other counterparts other than Central Banks has a runoff rate dependent on the collateral. That is, the better the collateral provided, the outflow factor will be lower and vice versa. In relation to this, and returning to the two categories of entities to which the study refers, the GSII’s have 87% of liquid assets of level 1 as collateral, while in the case of entities classified as “Others”, these are reduced 56%, which suggests that the GSII’s will have fewer outflows from secured funding than smaller banks.
Regarding liquidity inflows, the GSII’s have approximately 5.3% of total assets as opposed to 2.6% of the so-called “Others”. As in the case of the outflows, always applying the corresponding runoff.
Once the analysis of each component of the ratio is completed, it can be seen that the factor that most penalizes the metric is in the products of unsecured funding due to the great weight that non-operational deposits have within the balance sheets of the entities and that in addition, its runoff rate is one of the highest. Why? Operational deposits are those that are maintained in order to access certain banking services that allow improving the ability to use payment and settlement systems. Therefore, the non-operational ones don’t have a high relationship with the entity and their outflows are assumed to be higher. Specifically, the outflows associated with this typology are 11% of the total assets.
On the contrary, the outflows that come from secured funding only represent 1.2% for two reasons:
- Most of this funding is made with Central Banks, so its run-off is 0% and does not generate outflows for the ratio
- In the case of other counterparties, the collateral is Level 1 with rates close to 0%.
So far, this is the first analysis of the study. In a second article, we will dive deeper into the LCR depending on the business model of the entities.
If you want to leave a comment or ask a question about it, do not hesitate to do so. We will be happy to answer you.