In this article we are going to analyze the recent publication of the EBA as of December 2020 (https://www.eba.europa.eu/eba-updates-its-report-liquidity-measures-and-confirms-banks%E2%80%99-solid-liquidity-position) analyzing the situation of European financial institutions in terms of liquidity as of June 2020. More specifically about the LCR (ratio par excellence for the measurement and detection of the banks’ financial health). This is the seventh publication by the EBA since the requirement was introduced back in 2015.
It is an interesting exercise since this analysis allows us to see the impact that the COVID 19 pandemic had on liquidity. As a summary of the article, we can advance that the average ratio for the financial institutions studied is 166%, far exceeding the limit of 100% defined by the banking regulator. To a large extent, this has been possible thanks to the incentives of the European Central Bank with its extraordinary monetary policies as a response to the more than probable liquidity deficits of the banks.
As we did in the previous article, we are going to analyze the ratio from different points of view:
- Components of the metric
- According to the business model of the entities
The sample used for this study is made up of a total of 130 banks from 27 countries of the European Union. This sample covers both systemic global entities and other important institutions within the international economic framework.
Let’s start with the analysis of the ratio and its components.
The LCR requirement dictates that banks must maintain a sufficient amount of liquid assets to cover their liquidity outflows in a period of 30 days. This metric must reach at least 100%.
As we saw in the analysis corresponding to December 2019, the average ratio of the entities analyzed was 147% (prior to the coronavirus crisis). However, this data has improved as of June 2020, going to 166%. It may seem surprising this happens given the current situation, but it is mainly due to the help provided by the banking authorities, considerably reducing the negative impact that it could have had.
(For more information on incentives during the pandemic, follow the following link: https://blog.mirai-advisory.com/nuevas-medidas-de-liquidez-del-bce/)
Additionally, it should be mentioned that during this period no institution declared a lack of liquidity, when in December 2019 there were several entities that declared significant liquidity needs.
To better understand these data, let’s review the evolution of the ratio components. From December 2019 to June 2020 a substantial increase in Liquid Assets is clearly seen. During this period, net outflows also increased, but to a lesser extent, so the trend in the ratio is very positive. This can be seen more clearly in the following graph taken from the EBA study itself.
Graphic 1: evolution of LCR numerator and denominator from 2016 to 2020.
Within liquid assets, the greatest increase occurs in minimum reserves, as well as in the cash available to financial institutions, thanks to the asset purchase programs of central banks, thus becoming the main components of the improvement in the ratio.
This increase in liquid assets is not fully reflected in the final result of the ratio since it has been partially offset by the increase in cash outflows (part of the denominator of the ratio), going from 14.3% in December to almost 16% in June this year, which in turn was netted by the increase in inflows over total assets (from 4.3% to 4.5%), although to a lesser extent.
As we have already analyzed on previous occasions, the regulation separates assets into two categories based on their credit quality:
- Level 1 assets
- Level 2 assets
- Level 2A
- Level 2B
This classification responds to the liquidity level of the assets, that is, the ease of converting them into cash in case of need for entities to sell them on the market to cover the different liquidity needs in the event of an adverse economic scenario.
If we focus on the data extracted from the study of the different entities, the liquidity buffer is mostly made up of cash and minimum reserves, followed by positions in covered bonds. In turn, this compassion for liquid assets meets the minimum requirements required by the ratio guidelines:
- Minimum of 30% of level 1 liquid assets: in the case of the entities under analysis, the average is 46%.
- No more than 40% of snow assets 2: the entities studied place this figure at only approximately 2%.
- No more than 15% of level 2B assets.
The structuring of assets is also highly related to the type of business of each entity, as well as the country they belong to. Thus, Lithuania and Latvia have around 83% level 1 assets of the total (cash and minimum reserves); while countries such as Iceland, the Czech Republic or Poland have more leverage in level 1 securities (excluding covered bonds).
Liquidity inflows and outflows
Net outflows are the denominator of the ratio and are calculated as the difference between liquidity outflows and expected inflows in the next 30 days. This difference must always be positive, and there are different cap’s that are applied to the inputs, preventing them from being greater than the outputs. In this context, and additionally to ensure that entities always have a minimum of liquid assets, a cap of 75% of inflows over total outflows is established.
At the date of the analysis (June 2020), liquidity outflows account for approximately 15.5% of total assets for the sample of entities studied. Within these, deposits to retail clients account for around 2% of total assets (14% of total outflows). From the study, it can be deduced, as was the case in the previous year, that the main component of this item of the ratio is non-operating deposits (3.4% of total assets), not only due to the large volume of transactions but also to the runoff rate that this type of deposit has, considerably higher than the rest.
Another significant factor within the outflows is the item for “additional collateral needs”, that is, possible cash outflows as collateral during adverse macro scenarios or in derivative operations.
Regarding liquidity inflows, in general terms, these represent 4.9% of total assets. The composition of these shows that the vast majority come from financial clients (in the form of loans or CTAs) followed by the heading “other entries” in which different concepts such as interest or dividends are included.
As seen in the following figure, in which the composition of the ratio is synthesized, the component that most reduces it is the outflows from unsecured financing (10% of total assets). It is not surprising, since as we have seen previously, this is where non-operating deposits are included, which are the ones that have the most impact on outflows.
Graphic 2: composition of the ratio by big blocks.
In the same way, we can see the little weight that guaranteed financing has (approx. 1% of total assets) mainly motivated by two factors:
- This type of financing is carried out with central banks, whose runoff rate is 0%.
- Financing guaranteed with counterparties other than central banks is backed by level 1 and level 2 liquid assets whose factors are very low compared to the rest.
The Covid-19 crisis has not only had a huge impact on health, but it has also been a great challenge from an economic point of view. Its impact is still taking place and noticing in different sectors, including banking as well. To control this type of situation, the LCR was defined, a ratio that measures whether banks have enough liquid assets to cover the outflows they may have during the next 30 days in a period of stress. With all this, of the 27 countries to which the analyzed entities belonged, 23 have increased the ratio from December 2019 to June 2020. The vast majority increase due to the increase in liquid assets in their cash items and minimum reserves due to the different stimuli from the central banking authorities to alleviate the negative effects of this crisis through the purchase of assets.
In a following article, we will look at the ratio from the point of view of the different types of business of financial institutions. We encourage you to subscribe to the blog and send us your comments or doubts on any related topic.