Basel Committee introduces new regulations on liquidity, capital

MANILA, Philippines - The Basel Committee on Banking Supervision (the Committee) has issued for consultation a package of proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector.

The Committee is a working group of the Bank for International Settlements (BIS), an international body composed of majority of the world’s central banks. It is often referred to as ‘the central bank of all central banks.’

The BIS committee will receive all comments on all aspects of this consultative document by April 16, 2010. After consolidation and further review, the measures would likely be put in force by 2012.

Throughout the global financial crisis, which began in mid-2007, many banks struggled to maintain adequate liquidity. Unprecedented levels of liquidity support were required from central banks in order to sustain the financial system and even with such extensive support a number of banks failed, were forced into mergers or required resolution.

These circumstances and events were preceded by several years of ample liquidity in the financial system, during which liquidity risk and its management did not receive the same level of scrutiny and priority as other risk areas. The crisis illustrated how quickly and severely liquidity risks can crystallize and certain sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.

A key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risks.

In recognition of the need for banks to improve their liquidity risk management and control their liquidity risk exposures, the Basel Committee on Banking Supervision (the Committee) issued Principles for Sound Liquidity Risk Management and Supervision in September 2008. These sound principles provide consistent supervisory expectations on the key elements of a robust framework for liquidity risk management at banking organizations.

Such elements include: board and senior management oversight; the establishment of policies and risk tolerance; the use of liquidity risk management tools such as comprehensive cash flow forecasting, limits and liquidity scenario stress testing; the development of robust and multifaceted contingency funding plans; and, the maintenance of a sufficient cushion of high quality liquid assets to meet contingent liquidity needs.

Supervisors, for their part, are expected to assess both the adequacy of a bank’s liquidity risk management framework and its liquidity risk exposure. Supervisors are also expected to take prompt action to address the bank’s risk management deficiencies or excess exposure in order to protect depositors and enhance the overall stability of the financial system.

To reinforce these supervisory objectives and efforts, the Committee has recently focused on further elevating the resilience of internationally active banks to liquidity stresses across the globe, as well as increasing international harmonization of liquidity risk supervision.

The Committee has developed two internationally consistent regulatory standards for liquidity risk supervision as a cornerstone of a global framework to strengthen liquidity risk management and supervision. The standards also respond to recommendations of the G20 that called for the Committee to “....enhance tools, metrics and benchmarks that supervisors can use to assess the resilience of banks’ liquidity cushions and constrain any weakening in liquidity maturity profiles, diversity of funding sources, and stress testing practices.”

Furthermore, the G20 recommended that “...the BCBS and national authorities should develop and agree by 2010 a global framework for promoting stronger liquidity buffers at financial institutions, including cross-border institutions.

It should be stressed that the standards establish minimum levels of liquidity for internationally active banks. Banks are expected to meet these standards as well as adhere to all the principles set out in the September 2008 Sound Principles document. As under the Basel Accord (for capital adequacy), national authorities are free to adopt arrangements that set higher levels of minimum liquidity.

To further strengthen and promote consistency in international liquidity risk supervision, the Committee has also developed a minimum set of monitoring tools to be used in the ongoing monitoring of the liquidity risk exposures of cross-border institutions and in communicating these exposures among home and host supervisors.

The new proposals likewise hope to:

Raising the quality, consistency and transparency of the capital base. This will ensure that the banking system is in a better position to absorb losses on both a going concern and a gone concern basis. In addition to raising the quality of the Tier 1 capital base, the Committee is also harmonizing the other elements of the capital structure.

Strengthening the risk coverage of the capital framework. In addition to the trading book and securitization reforms announced in July 2009, the Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities. The strengthened counterparty capital requirements will also increase incentives to move OTC (over-the-counter) derivative exposures to central counterparties and exchanges. The Committee will also promote further convergence in the measurement, management and supervision of operational risk.

Introducing a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. The leverage ratio will help contain the build-up of excessive leverage in the banking system, and introduce additional safeguards against model risk and measurement error. To ensure comparability, the details of the leverage ratio will be harmonized internationally, fully adjusting for any remaining differences in accounting.

Introducing a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. A countercyclical capital framework will contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks. In addition, the Committee is promoting more forward-looking provisioning based on expected losses, which captures actual losses more transparently and is also less pro-cyclical than the current “incurred loss” provisioning model.