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The New Basel Liquidity Requirements: Implications and Impacts
Mr. Fai Y LAM, CT Risk Solutions Limited
and Dr. Michael C S Wong, City University of Hong Kong
(Published in Volume II, Issues II & III, Summer/Autumn 2010
JOURNAL OF REGULATION & RISK NORTH ASIA)
The Basel Committee on Banking Supervision (“Basel Committee”) published in December
2009 a consultative paper, "International framework for liquidity risk measurement,
standards and monitoring". This consultative paper aims to strengthen and standardize
banks’ liquidity measurement framework by setting out the following requirements:
a) a liquidity coverage ratio (LCR) which aims at measuring banks’ short term liquidity
sufficiency;
b) a net stable fund ratio (NSFR) which aims at measuring banks’ short term liquidity
sufficiency; and
c) a set of common monitoring tools to be used by supervisors in their monitoring of
banks’ funding liquidity at individual institutions.
The new guidelines will have far-reaching implications and impacts on banks, especially
those banks in Asian economies. This paper will firstly summarize the new rules and then
discusses their impacts.
New Liquidity Rules
Liquidity Coverage Ratio (LCR)
The Basel Committee defines LCR, under an acute stress situation, as
High quality liquid assets
LCR = ------------------------------------------------------------------------------------------------------------
Total cash outflow over a 30-day period – total cash inflow over a 30-day period
If a bank estimates that the total cash outflow will exceed the total cash inflow over a 30-
day period, the bank must hold sufficient high quality liquidity assets to meet the net cash
outflow, i.e. LCR ≥ 100%. This requirement aims to maintain a buffer of high quality liquid
assets for banks to meet with liquidity demand under stress conditions. The Basel
Committee defines high quality assets with the following fundamental characteristics:

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• low credit and market risks;
• ease and certainty of valuation;
• low correlation with risky assets; and
• listed on a developed and recognized exchange market.
Also, the Basel Committee requires high quality assets to have the following market-related
characteristics:
• active and sizable market;
• presence of committed market makers;
• low market concentration; and
• flight to quality.
Cash inflows are limited to the following items:
• amounts receivable from retail counterparties;
• amounts receivable from wholesale counterparties;
• receivables in respect of repo and reverse repo transactions backed by illiquid
assets and securities lending/borrowing transactions where illiquid assets are
borrowed; and
• other cash inflows, including planned contractual receivables from derivatives.
Cash outflows cover a board spectrum of cash consumption activities arising from the
following exposures:
• retail deposits, covering stable deposits and less stable retail deposits;
• unsecured wholesale funding, covering stable small business customers and less
stable small business customers, non-financial corporates, sovereigns, central
banks and public sector entities with operational relationships, non-financial
corporates with no operational relationship, and other legal entity customers
and sovereigns, central banks, and PSEs without operational relationships;
• secured funding, covering funding from repo of illiquid assets and securities
lending/borrowing transactions illiquid assets are lent out;
• liabilities from maturing ABCP, SIVs, SPVs, and term asset backed securities
including covered bonds;
• liabilities related to derivative collateral calls subject to a downgrade of up to
three-notches;
• market valuation changes on derivatives transactions;
• valuation changes on posted non-cash or non-high quality sovereign debt
collateral securing derivative transactions;
• currently undrawn portion of committed credit and liquidity facilities to retail
clients, non-financial corporates and other legal entity customers;
• other contingent funding liabilities, such as guarantees, letters of credit,
revocable credit and liquidity facilities, etc.;
• planned outflows related to renewal or extension of new loans; and

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• any other cash outflows.
Net Stable Fund Ratio (NSFR)
The Basel Committee defines NSFR as
Available amount of stable funding
NSFR = -------------------------------------------------
Required amount of stable funding
A bank is required to match its available amount of stable funding with required amount of
stable funding over a period of one year, i.e. NSFR ≥100%. Available amount of stable
funding includes:
• capital;
• preferred stock with maturity of equal to or greater than one year;
• liabilities with effective maturities of one year or greater; and
• the portion of “stable” non-maturity deposits and/or term deposits with
maturities of less than one year that would be expected to stay with the
institution for an extended period in an idiosyncratic stress event.
Required amount of stable funding includes:
• the value of assets held and funded by the institution, multiplied by a specific
required stable funding factor (RSF) assigned to each particular asset type; and
• the amount of off-balance sheet activity (or potential liquidity exposure)
multiplied by the corresponding RSF.
The RSF on different asset classes, ranging between 5% and 100%, are intended to
approximate the amount of a particular asset that could not be liquidated through sale or
use as collateral in a secured borrowing. Highly marketable assets will thus have low RSF
factors and thus require less stable funding.
Monitoring toots
In addition to the two proposed regulatory ratios, the Basel Committee also recommends
four tools for monitoring banks’ liquidity. They are:
1. Contractual maturity mismatch: This tool provides an initial and simple baseline
of contractual commitments.
2. Concentration of funding: This tool assesses the extent of liquidity risk caused by
excessive reliance on single source or several sources of funds.

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3. Available unencumbered assets: This tool help banks be better aware of their
potential capacity to raise additional secured funds.
4. Market-related monitoring tools: This covers the market data, such as asset
prices, liquidity, CDS spreads, equity prices, and others that can be easily
accessed by banks to monitor their liquidity situations.
Implications and Impacts on Banking Industry
The new liquidity ratios, together with the new regulatory framework, attempt to
supplement the framework to “Principles for Sound Liquidity Risk Management and
Supervision” published by the Basel Committee in September 2008. These new guidelines
will have long-lasting impacts and new implications on bank management, especially in Asia.
Additional Cost and Risk
The new rules require banks to increase in holding high quality liquid assets. This will be
very costly to all banks because high quality liquid assets generally provide low returns. This
will weaken the role of banks in credit rationing. Corporate borrowers, especially those
without strong credit ratings, will be more difficult to raise funds.
The definition of high quality assets is bias to US and European bonds. This is because these
bond markets are more actively-traded and their bonds are assigned with better credit
ratings. Even though many banks and corporations in emerging economies have
demonstrated a high stability during the financial crisis in 2008, their bonds are assigned
very unfavorable ratings. It is anticipated that banks from emerging economies will find it
more difficult to finance their operation via the issuance of CDs and bonds, thus increasing
their funding cost and weakening their profitability.
If banks are motivated to hold more US and European bonds to strengthen their liquidity
metrics, they will be exposed to USD currency risk, EU currency risk, and country risk
concentration in the US and Europe.
Bancassurance
The new liquidity rules will motivate banks to develop or acquire their branch of insurance
business as insurance premiums serve as a very good source of stable and diversified retail
funding. This will drive the occurrence of more bancassurance. By that time, banking risk
will be blurred with insurance risk. There will be new capital rules to deal with insurance
risk.

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Procyclical Effect of the Liquidity Measures
Both the new liquidity ratios emphasize liquid assets. The financial crisis in 2008 has given
us a good lesson on asset liquidity. In economic downturns, some liquid assets can suddenly
become illiquid. The new rules will accelerate the speed of “flight to quality” and may easily
drive those banks without strong ratings to serious liquidity problems.
Liquidity Stress
The crisis experience in 2008 indicates that liquidity problems can turn serious within a short
period of time. Most sizable banks have more than 30% funding from the interbank market
and financial institution. In case of any rumors, scandals and economic stress, their funding
from their peers may disappear in less than 30 days. This issue cannot be easily solved by
the new rules on liquidity measures.
Conclusion
The new liquidity rules may improve the liquidity situation and mitigate bank collapse in the
short run. However, they may affect the long-term profitability of banks. More importantly
they may make bank risk to be more concentrated on those high quality liquid assets，
which tend to more correlated in their risk profile. Banks in emerging economies may get
more pressure under the new rules. This is because they may find themselves harder to
issue CDs and bonds to solve their liquidity problems.
Reference
Basel Committee, International framework for liquidity risk measurement, standards and
monitoring - consultative document, December 2009.
Based Committee, Principles for Sound Liquidity Risk Management and Supervision,
September 2008.