In this second article we are going to give continuity to the previous one in which we analyzed the results of the EBA examination on the LCR of different European banking entities. To provide some context, this exercise was carried out in June 2020 in a very complicated situation both at health and macroeconomic levels, marked by the coronavirus crisis. From a financial point of view, the entities were strongly supported by the central banking authorities to provide sufficient liquidity to face the crisis through the purchase of financial assets throughout this period.
In the first article we broke down the analysis of the ratio based on its components (liquid assets, cash inflows and outflows) as well as its evolution with respect to the previous year carried out by the EBA (December 2019). In this second section, the impact of the metric will be studied considering the different types of businesses that the entities own, since this affects the financing plans.
To begin with, we are going to list and give a short description of each type of bank that has been defined in the analysis to have a clearer picture of the situation:
- Cross-border universal Banks: financial institutions that encourage or incentivize the use of their products by foreign customers.
- Local universal Banks: banks that offer comprehensive financial services. They are common banks where you can find retail products, investment, etc.
- Building societies: financial entities that mainly offer savings products and mortgage loans. These types of entities are very common in Great Britain.
- Locally active savings and loan associations / cooperative Banks: smaller financial institutions whose financing is based on retail deposits and lend to local clients and businesses.
- Private Banks: financial entities that act as intermediaries between economic agents with a high capacity for saving and investment.
- Mortgage banks including pass-through financing mortgage Banks: banks with a large volume of securitizations and little business in deposits.
- Public development Banks: banks dedicated to financing public sector projects for the development of a country or region.
- Other Specialized Banks: promotional banks or ethical banks whose products / business is not exclusively intended for profit maximization.
- Auto and consumer credit Banks: banks whose primary business is consumer loans and / or auto loans to retail customers.
Broadly speaking, these are the main categories of entities that are analyzed during this article and which we will refer to in one way or another throughout the analysis.
The following table shows the classification made for this study based on the most significant types of banks associated in turn with the most characteristic type of funding for each of them.
In the case that a typology appears with an X, it does not mean that that specific bank does not use that financing, but that it is less frequent. This analysis is very interesting since the funding strategy of the entities will generate differences in the ratio values due to the liability part of the balance sheet (due to the cash outflows, part of the denominator of the metric). In fact, for two financial entities with the same size and type of assets, they will show different LCRs if their liability structure is not similar. It is not the same, for example, that a bank finances itself with deposits to retail clients whose run off rate is substantially lower (around 0.26) than it does with wholesalers since the haircuts applied to the latter are higher, especially for non-operational deposits (0.65 on average) and penalize the ratio more.
In the case of the analysis by business type, a total of 118 banks have been studied and as happened previously, all the models exceed the required minimum of 100%.
Mortgage banks have the highest ratio, going from 332% in December 2019 to 330% in June 2020. On the contrary, cross-border banks have the lowest LCR of the whole set on average, going from 140% to 158% in June 2020.
However, focusing the study only on the LCR levels does not allow a good understanding of how the different business models affect the ratio.
In order to achieve this, we are going to focus on how the cash outflows are made up for each type of bank. For the so-called universal banks and savings banks (the so-called saving Banks in the list above), deposits to retail customers are the largest component of outflows, that is, their main source of financing (reaching 40% approximately of the total). Similarly, for cross-border banks, retail deposits also have an important weight within the funding profile, this being slightly less than the previous ones (around 25% of total outflows).
On the other hand, in both cases, wholesale financing is mostly represented by non-operational deposits (10% of total outflows). Deposits that, as we have commented previously, have a runoff rate that is substantially higher than the other types, and that consequently penalizes the ratio very significantly. In fact, it could be concluded that these deposits are the largest source of outflows for this type of entity.
On the opposite side to the previous situation are the public development banks. These banks present a greater flow of cash outflows once the haircuts are applied since their financing model does not consider deposits (both retail and wholesale) and focuses on another type such as credit facilities whose run off rate they are high and do not reduce outputs.
The above described is a clear example of how the type of business of banks and their financing profiles directly influence the calculation of the LCR ratio and how they have to adapt their strategies in order to comply with the requirement.
From the side of cash inflows, the study shows that these stand at around 5% of total assets for practically all types, and in turn, shows us a significant reduction in inflows for entities of savings going from 3% in December 2019 to just 2% in June 2020.
If we look at the numerator of the ratio, that is, the composition of liquid assets, we can see that in all entities this is made up of assets of high credit quality, mostly reflected in cash and bank reserves central assets, as well as level 1 assets (covered bonds or treasuries, for example). The mortgage banks in contrast are those that show a lower level of HQLA’s on total assets (around 8%).
In the following graph you can see the composition of liquid assets based on the typology collected by the rule for each type of business.
As we have seen, it is very interesting to analyze the ratio from the perspective of the different types of business that banks have since it makes you see the different strategies and products with which they operate and how risk managers use different tools not only to maximize the benefit of the entity but also to comply with the different regulatory requirements; in this case, the LCR, the metric par excellence to diagnose financial health in terms of liquidity in the short term.
With this we conclude this round of two articles in which we have analyzed the EBA’s publication on the results of the Liquidity Coverage Ratio as of June 2020. We will continue to publish more articles with different current affairs.
