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Basel III Liquidity Coverage Ratio standards: The Fed raises the bar

The U.S. Federal Reserve (FED) is proposing a rule to raise the requirements, but narrow the time-frame, for the completion of the new Basel III liquidity coverage ratio (LCR) requirements.

The Basel III LCR requirements were initially released on 2010, but a more final draft was presented in early 2013. The brief explanation of LCR is that it aims to secure banks in the wake of short-term liquidity problems by requiring that they hold funds adequate to a thirty-day stress scenario. The plan to raise liquidity standards has taken an active role in the BCBS proposals following the crisis, but the U.S. seems to be making liquidity an even higher priority than the Basel Committee. Outgoing Chairman of the FED Ben Bernanke stated that these additional standards are a leap forward for the U.S. because ‘[they] put in place a quantitative liquidity requirement that would foster a more resilient and safer financial system in conjunction with other reforms.’

Within the 100-page release on LCR, Liquidity Risk Measurement, Standards and Monitoring there were three key changes: the amount of LCR funding and the timeline for implementation, the qualification standards of assets being counted as high-quality liquid assets (HQLA), and assumed rates of outflows on certain kinds of funding.

Beginning with the HQLA standards, the changes here are fairly minimal. Basel III states that in order to qualify as a HQLA the asset has to be low risk, have an ease and certainty of valuation, low volatility, and the like. The U.S. has added that in addition to all of the characteristics that Basel III has already established, the asset must qualify under a tighter definition of what is ‘liquid’ and ‘readily-marketable’. For an asset to be considered ‘readily-marketable’ under the new U.S. guidelines, it must be ‘…traded in an active secondary market with more than two committed market makers, a large number of committed non-market maker participants on both the buying and selling sides of transactions, timely and observable market prices, and high trading volumes.’

A more noticeable change than the HQLA definitions is the proposal to reduce transition time for banks to implement the new LCR requirements. Under the new rules, implementation would begin on 1 January 2015 with full compliance by 1 January 2017, not the 2018 date established in the Basel III provisions.

This ‘gold-plating’ of the rules raises concerns for the success of Basel III as a whole. The EU has already shown its drive to gold-plate the standards in other areas, such as requiring greatly increased numbers of liquidity reports from banks. But why is one approach safer for banks than the other? In reality, rule fragmentation will only lead to market and thus liquidity fragmentation, increasing rather than decreasing the risk of a liquidity shortage.

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