The need to strengthen the Basel II framework had become apparent even before the collapse of Lehman Brothers in September 2008. The global financial crisis saw the US and European banking sectors taking on too much leverage without adequate liquidity buffers. This got amplified because of poor governance, inadequate risk management and inappropriate incentive structures, leading to mispricing of credit and liquidity risks, and excessive credit growth. Reflecting on these factors, the Basel Committee had issued a guidance paper, ‘Principles for sound liquidity risk management and supervision’, the month Lehman went kaput.
The paper flagged the following four areas for strengthening liquidity risk management and governance:
Importance of quantifying liquidity risk tolerance
Design and use of extreme stress-test scenarios
Need for a robust and operational contingency plan, and
Management of intra-day liquidity risk and collateral.
However, the emerging consensus was that a more comprehensive global regulatory framework was needed for banks to make them very resilient and banking systems needed to comply with the four aforesaid areas.
In December 2010, the Basel Committee of Banking Supervision (BCBS) issued the ‘Basel III: International framework for liquidity risk measurement, standards and monitoring’. Its objective was to improve the global banking sector’s ability to absorb shocks arising from financial and economic stress and reduce the risk of spill-overs into the real economy.
The policy earmarked minimum regulatory standard to measure and monitor liquidity risk through two new ratios - the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). Additionally, metrics to be used as consistent monitoring tools were also introduced.
Banks need to fully comply with LCR and NSFR rules by January 1, 2019, according to the Capital Requirements Directive & Capital Requirements Regulation (CRD IV & CRR) rules. But these rules are likely to undergo some revisions due to a proposal by European Union (EU), so implementation horizon could go being beyond 2019.
Given the robust governance and disclosure requirements, compliance is a challenge for financial institutions. This needs to be mitigated through integrated solutions and proactive risk management – and not by reacting to liquidity risk-induced events.