The Liquidity Coverage Ratio and the Net Stable Funding Ratio

The Liquidity Coverage Ratio and the Net Stable Funding Ratio

Updated March 22, 2021
The Liquidity Coverage Ratio and the Net Stable Funding Ratio
Issue Overview
Why Was Liquidity an Issue in the 2007-2009 Financial
Federal bank regulators have issued final rules
Crisis? Firms are unable to borrow if creditors believe,
implementing the liquidity coverage ratio (LCR) and the net
rightly or wrongly, that they will not be repaid on time and
stable funding ratio (NSFR) for large banks. This In Focus
in full. If this happens widely, market demand for liquidity
explains the rationale behind these liquidity rules and how
can exceed private supply. A key feature of the 2007-2009
they work.
financial crisis was the sudden inability of financial firms,
particularly those reliant on short-term borrowing, to access
Liquidity
private liquidity. As a result, some firms failed and others
What Is Liquidity? Liquidity is a term that can apply to
sold assets at “fire sale” prices, further depressing markets.
assets, markets, or firms. An asset is liquid if it is easily
bought and sold (i.e., converted into cash). Markets are
liquid if there are many ready buyers and sellers. A firm is
“The financial crisis provided a devastating reminder
liquid if it holds liquid assets or has ample access to cash,
that liquidity distress at a large bank can quickly
and it is illiquid if it cannot sell (or borrow against) assets to
metastasize into broader fire sales and run
raise cash.
dynamics…. [T]he resilience of the banking system
during the COVID-19 crisis can be seen as a validation
From a bank’s perspective, holding liquid assets helps
of the new capital and liquidity framework.”
ensure that it will reliably meet cash flow needs, which may
—Fed Governor Lael Brainard, October 20, 2020
be variable and unpredictable. The cost of holding liquid
assets is that they have a lower expected rate of return than
less liquid assets, holding other characteristics constant. If
Background on the Rules
the primary function of banks is to transform deposits into
Why Were These Rules Adopted? In response to acute
loans, the broader impact of requiring banks to hold more
liquidity shortages and asset “fire sales” during the crisis,
liquid assets is that they will hold fewer loans, which are
27 countries agreed in 2010 to modify the Basel Accords,
generally illiquid. By contrast, requiring them to hold more
which are internationally negotiated bank regulatory
deposits would not interfere with that primary function.
standards. “Basel III” included liquidity standards for the
first time: the LCR to ensure that banks have enough liquid
How Do Banks Access Liquidity? Banks may hold cash
assets and the NSFR to ensure that banks have reliable
outright or as reserves at the Federal Reserve (Fed).
funding sources in a stressed environment. The LCR
Alternatively, banks can sell assets to meet cash-flow
addresses the asset side of the balance sheet, and the NSFR
needs, but to do so quickly the assets must be liquid. Banks
addresses the liability/equity side.
can also borrow to raise cash, in some cases by pledging
their assets as collateral. Banks can borrow from private
Basel III also includes capital requirements that the United
investors through repurchase agreements (repos) or by
States has already implemented. In addition, P.L. 111-203
issuing commercial paper or bonds. Banks can also borrow
(Dodd-Frank Act) requires heightened prudential standards,
from other banks (e.g., through the federal funds market).
including liquidity standards, for large banks and non-banks
Short-term borrowing is inexpensive and therefore popular
that have been designated as “systemically important
but can dry up quickly in a market downturn, causing a
financial institutions.”
liquidity crisis. Alternatively, banks can borrow from public
sources, such as by obtaining advances from a Federal
Who Is Subject to the Rules? The rules apply to the
Home Loan Bank or from the Fed’s discount window.
largest U.S. bank holding companies and U.S. operations of
Borrowing from the Fed is minimal in normal conditions.
foreign banks. A more stringent version applies to the nine
most systemically important banks and any bank with over
What Is the Difference Between Liquidity and Capital?
$75 billion in weighted short-term wholesale funding
Banks hold capital to absorb unexpected losses, which
(wSTWF). A less stringent version applies to other banks
cannot be borne by deposits or debt. If capital is entirely
with over $250 billion in assets. The least stringent version
depleted, liabilities exceed assets and a bank is insolvent.
applies to banks with over $100 billion in total assets and
Banks face liquidity risk because they fund long-term assets
$50 billion in wSTWF. The less stringent versions of the
(e.g., loans) with short-term liabilities (e.g., demand
rules currently apply to 11 banks. Although regulators
deposits). Some funding sources are more stable than
examine all banks to ensure sufficient liquidity, these rules
others, and stable sources are relatively more costly,
do not apply to credit unions or community banks.
holding other characteristics constant. If a bank cannot
borrow or sell assets to meet cash needs, it is illiquid. A
When Do the Rules Come Into Effect? The LCR came
bank can be illiquid without being insolvent, although
into effect January 1, 2015, and was fully phased in January
market concerns about the latter can cause the former.
1, 2017. The NSFR comes into effect July 1, 2021.
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The Liquidity Coverage Ratio and the Net Stable Funding Ratio
Liquidity Coverage Ratio
compliance, the regulators estimate a shortfall in stable
How Does the LCR Work? The rule aims to require banks
funding of $10 billion to 30 billion, and it would cost them
to hold enough “high-quality liquid assets” (HQLA) to
$80 million to $250 million annually to come into
match net cash outflows over 30 days in a hypothetical
compliance.
scenario of market stress where creditors are withdrawing
funds. An asset can qualify as HQLA if it has lower risk,
Policy Issues
has a high likelihood of remaining liquid during a crisis, is
Are the Rules Necessary? Because banks can always meet
actively traded in secondary markets, is not subject to
their liquidity needs by borrowing from the Fed (or a
excessive price volatility, can be easily valued, and is
Federal Home Loan Bank), a case can be made that it is
accepted by the Fed as collateral for loans. HQLAs must be
unnecessary to require banks to hold liquid assets. (Only
“unencumbered.” For example, they cannot already be
depository subsidiaries can borrow from the Fed, whereas
pledged as loan collateral.
the rules also apply to the holding company. Therefore, this
argument does not apply to the holding company.)
Different types of assets are relatively more or less liquid,
Furthermore, borrowing from the Fed does not restrict
and there is disagreement on what the cutoff point should
banks’ capacity to hold loans, whereas the opportunity cost
be to qualify as HQLA under the LCR. In the LCR, eligible
of holding liquid assets is that it reduces the amount of
assets are assigned to one of three categories. Assets
loans they can hold, all else equal. Both the Fed and other
assigned to the most liquid category are given more credit
policymakers have sought to discourage Fed lending in
toward meeting the requirement, and assets in the least
normal market conditions, however. These rules reduce the
liquid category are given less credit.
likelihood that banks will need to borrow from the Fed.
What Types of Assets Can Be Used to Meet the Rule?
Should the Rules Have Been Limited to Large Banks ?
HQLAs include bank reserves, U.S. Treasury securities,
All banks—large and small—face liquidity risk, but these
certain securities issued by foreign governments and
rules apply only to the largest banks. The argument that the
companies, securities issued by U.S. government-sponsored
rules would reduce the need for Fed lending is also
enterprises, certain investment-grade corporate debt
applicable to small banks. In contrast, differences in the
securities, and equities that are included in the Russell 1000
funding structure of small and large banks mean that the
Index. Securities issued by financial institutions do not
typical small bank has more stable funding than the typical
qualify as HQLA, however, because regulators believe that
large bank. According to Federal Deposit Insurance
they are susceptible to becoming illiquid in a financial
Corporation data, small banks generally rely more heavily
crisis. Under P.L. 115-174, municipal bonds (issued by
on deposits, which are viewed as a stable source of funding,
state and local governments) that are liquid and investment
and less on “volatile liabilities” as a source of funding. (Not
grade qualify in the least liquid category.
all deposits are equally stable, however.) Further, while
banks of all sizes are susceptible to liquidity crises, crises at
How Many Banks Already Met the LCR Rule?
large banks are more likely to have spillover effects that
According to a Fed memorandum, 70% of banks subject to
could pose systemic risk. For those reasons, the benefits of
the LCR already met its requirements at the time the rule
exempting small banks from these rules may outweigh the
was finalized. The Fed estimated that, overall, banks that
costs, particularly if their compliance costs are higher. Even
did not meet the LCR faced a shortfall of $100 billion.
if policymakers agreed that small banks should be
exempted, there is the issue of whether the statutory
Net Stable Funding Ratio
exemption level should have been raised from $50 billion to
How Does the NSFR Work? The rule requires banks to
$250 billion, pursuant to P.L. 115-174. Policymakers
have a minimum amount of stable funding backing their
debated whether exempting these banks was appropriate.
assets over a one-year horizon. Different types of funding
and assets receive different weights based on their stability
Could the Rules Have Unintended Consequences?
and liquidity, respectively, under a stressed scenario. The
Failure to maintain the required ratios could trigger a run if
rule defines funding as stable based on how likely it is to be
creditors viewed it as a sign of weakness. Alternatively, if
available in a stressed environment and classifies assets by
banks felt compelled (by regulators or for reputational
type, counterparty, and time to maturity. Assets that do not
reasons) to maintain the ratios during crises, it could result
qualify as HQLA under the LCR require the most backing
in “fire sales” of illiquid assets, which could have spillover
by stable funding under the NSFR.
effects for firms holding similar assets. Finally, if the
overall supply of HQLA is limited, the LCR could cause
What Types of Funding Can Be Used to Meet the Rule?
banks to buy up a significant fraction of those assets,
Long-term equity gets the most credit under the NSFR,
thereby reducing liquidity—and perhaps increasing
insured retail deposits get the next most, and other types of
volatility—in the markets for those assets. There have been
deposits and long-term borrowing get less credit.
a few (short-lived) episodes of asset market volatility since
Borrowing from other financial institutions, derivatives, and
the rules were implemented, but observers disagree on
certain brokered deposits cannot be used to meet the rule.
whether they were caused by regulation.
How Many Banks Already Meet the NSFR Rule?
Marc Labonte, Specialist in Macroeconomic Policy
According to a Fed memorandum, almost all 20 of the
banks were already in compliance. For firms not already in
IF10208
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The Liquidity Coverage Ratio and the Net Stable Funding Ratio

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https://crsreports.congress.gov | IF10208 · VERSION 5 · UPDATED