Basel III Liquidity Risk Measures and Bank Failure

Faculty of Commerce & Administration, North-West University (Mafikeng), Private Bag x2046, Mmabatho 2735, South Africa

Received 18 April 2013; Accepted 30 May 2013

Academic Editor: Ivan Ivanov

Abstract

Basel III banking regulation emphasizes the use of liquidity coverage and nett stable funding ratios as measures of liquidity risk. In this paper, we approximate these measures by using global liquidity data for 391 hand-selected, LIBOR-based, Basel II compliant banks in 36 countries for the period 2002 to 2012. In particular, we compare the risk sensitivity of the aforementioned Basel III liquidity risk measures to those of traditional measures such as the nonperforming assets ratio, return-on-assets, LIBOR-OISS, Basel II Tier 1 capital ratio, government securities ratio, and brokered deposits ratio. Furthermore, we use a discrete-time hazard model to study bank failure. In this regard, we find that Basel III risk measures have limited ability to predict bank failure when compared with their traditional counterparts. An important result is that a higher liquidity coverage ratio is associated with a higher bank failure rate. We also find that market-wide liquidity risk (proxied by LIBOR-OISS) was the major predictor of bank failures in 2009 and 2010 while idiosyncratic liquidity risk (proxied by other liquidity risk measures) was less. In particular, our contribution is the first to achieve these results on a global scale over a relatively long period for a variety of banks.

1. Introduction

Liquidity describes a bank’s ability to fund asset increases and meet financial obligations, without incurring damaging losses. The role of banks in the maturity transformation of short-term deposits into long-term loans makes them vulnerable to liquidity risk, both of an idiosyncratic and market-wide nature (see, for instance, [1. 2 ]). The financial crisis that began in mid-2007 re-emphasized the importance of liquidity to financial market and banking sector functioning. Prior to the turmoil, financial markets were buoyant and funding was readily available at low cost. The subsequent reversal in market conditions leads to the evaporation of liquidity with the accompanying illiquidity lasting for an extended period of time. The banking system came under severe stress, which necessitated central bank support for both the functioning of money markets and individual institutions (see [2 ] for more details).

In response to deficiencies in financial regulation exposed by the recent spate of crises such as the subprime mortgage, global financial and ongoing Eurozone sovereign debt crises, on Sunday, 12 September 2010, the Basel Committee on Banking Supervision (BCBS) announced a strengthening of existing banking rules (see, for instance, [3 –5 ]). More specifically, Basel III was touted as a regulatory standard on bank capital adequacy, stress testing (see, for instance, [6 ]), and market liquidity risk devised by the BCBS and its subgroup Working Group on Liquidity (WGL) (see, for instance, [7 ]). In essence, Basel III builds on Basel I and Basel II and is intended to improve the banking sector’s ability to absorb shocks arising from financial and economic stress. This is intended to reduce the risk of spill-over from the financial sector to the real economy (see, [2 ] for further discussion). Another objective of Basel III regulation is to increase the quantity as well as the quality of capital, with adequate capital charges needed in the trading book. Also, the regulation aims to enhance risk management and disclosure, introduce a leverage ratio to supplement risk weighted measures, and address counter-party risk posed by over-the-counter (OTC) derivatives (see, for instance, [8 –11 ]).

In Basel III, as in this paper, the maintenance of the global liquidity as well as the standards, the liquidity coverage ratio (LCR) and nett stable funding ratio (NSFR), underlying liquidity management are important. The LCR imposes a requirement that banks maintain an adequate level of “unencumbered, high-quality liquid assets that can be converted to cash to meet its liquidity needs for a 30 calendar day time horizon under severe liquidity stress conditions specified by supervisors.” On the other hand, the NSFR standard is designed to “promote longer-term funding of the assets and activities of banking organizations by establishing a minimum acceptable amount of stable funding based on the liquidity of institution’s assets and activities over a one-year horizon. This standard should facilitate a diversification of liquid assets—hence discouraging a situation where they could be accumulated and susceptible to exposures such as those relating to sovereign debts (see, for instance, [12 ]). It will, however, be highlighted in subsequent sections of the paper that the two new Basel liquidity standards will probably not achieve their desired objectives where such standards are not coupled with other risk measures and leverage ratios (see, for instance, [3. 13 ]). To the best of our knowledge, no prior studies have attempted to calculate the LCR and NSFR using global public banking data.

This contribution also considers traditional liquidity risk measures such as the nonperforming assets ratio (NPAR), return-on-assets (ROA), London Interbank Offered Rate-Overnight Indexed Swap Spread (LIBOR-OISS), Basel II Tier 1 capital ratio (BIIT1KR), government securities ratio (GSR), and brokered deposits ratio (BDR). Furthermore, we note that the traditional liquidity risk measures for asset liquidity include the GSR and LCR while funding stability is measured by the BDR and NSFR. NPAR (known as the Texas ratio under certain circumstances) exhibits robust bank failure predictive power (see [14. 15 ]). ROA relates to a bank’s ability to generate a positive nett income from its investment in its assets. A positive correlation exists between ROA and bank liquidity (see, for instance, [16 ]). LIBOR is the rate at which banks indicate that they are willing to lend to other banks for a specified term of the loan. The OIS rate is the rate on a derivative contract on the overnight rate. In the US, the overnight rate is the effective federal funds rate. In such a contract, two parties agree that one will pay the other a rate of interest that is the difference between the term OIS rate and the geometric average the overnight federal funds rate over the term of the contract. The OIS rate is a measure of the market’s expectation of the overnight funds rate over the term of the contract. There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the nett interest obligation to the other. The LIBOR-OISS is assumed to be a measure of bank health because it reflects what banks believe is the risk of default associated with lending to other banks. It is a measure of market-wide liquidity risk. The capital adequacy ratio BIIT1KR is described in [17 ] (see, also, [3 ]) while GSR (proxy for asset liquidity) and BDR (proxy for fund stability) are discussed in [14 ].

1.1. Theoretical Perspectives on Basel III Liquidity Risk Measures

The difficulties experienced by some banks during the financial crisis—despite adequate capital levels—were due to lapses in basic principles of liquidity risk management (see, for instance, [2 ]). In response, as the foundation of its liquidity framework, the BCBS in 2008 published “Principles for Sound Liquidity Risk Management and Supervision” known as “Sound Principles” for short (see [1 ] for more details). These principles provide detailed guidance on the management and supervision of liquidity risk and is intended to promote improved liquidity risk management in the case of full implementation by banks and supervisors. As such, the BCBS coordinates follow-ups by supervisors to ensure that banks adhere to “Sound Principles” (see [1 ] for more details). To complement these principles, the BCBS has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. They are described in the ensuing discussions (see, also, [2 ]).

1.1.1. Liquidity Coverage Ratio (LCR)

The LCR aims at increasing the resilience of banks under severe stress over a 30-day period without special government or central bank support (see, for instance, [3. 17 ]). The LCR is a minimum requirement and, as such, pertains to large internationally active banks on a consolidated basis. The severe stress scenario referred to earlier combines market-wide and idiosyncratic stress including a three notch rating downgrade, the run-off of retail and wholesale deposits, the stagnation of primary and secondary markets (repo, securitization) for many assets, and large cash-outflows due to off-balance sheet items (OBS).

The LCR embellishes traditional liquidity “coverage” methodologies used internally by banks to assess exposure to stress events. This liquidity standard requires that a bank’s stock of unencumbered high quality liquid assets (HQLAs) be larger than the projected nett cash outflow (NCOF) over a 30-day horizon under a stress scenario specified by supervisors such that