Banking Features

The Basel III’s Liquidity Coverage Ratio and Its Application on Islamic Banks

A Brief Overview  

 The Group of Central Bank Governors and Heads of Supervision, the governing body for the Basel III Committee, have endorsed the duly revised Liquidity Coverage Ratio (LCR). The importance of LCR on the banking community is of three folds. Firstly it is issued by Basel III Committee, a body which sets the international regulatory framework on bank capital adequacy and liquidity and is duly endorsed by the G20 Leaders (Bank for International Settlement, 2013). Secondly, it is issued after the global regulatory bodies took stock of what went wrong in the financial crisis which hit the world economy in the 2007-2008.  It was found that the financial crisis was a result of inadequate liquidity risk management in the financial institutions which caused substantial liquidity outflows and strain on profitability. Finally, as banking community plays a significant role in the financial intermediation process particularly in its deposit-taking capabilities, a rigorous liquidity risk management framework is warranted (Islamic Financial Services Board, 2015).

The Reform under LCR

Hence the key contribution of LCR in the liquidity risk management is in its structure to promote short-term resilience to the bank’s liquidity risk profile. Its overall aim is to ensure that a bank has adequate stock of unencumbered high quality assets (HQLA) which consists of cash or assets that can be converted into cash, a little or no loss of value in private markets to meet its liquidity needs for a 30 calendar day liquidity stress scenario (Bank for International Settlements, 2014) .

In ensuring that the Bank meets the required LCR, the bank would need to have the right value of these two important components of LCR namely (i) the value of the stock of HQLA and (ii) the total net cash outflows, which is expressed as follows:

Stock of HQLA

——————————           >     100%

Total net cash outflows

 

For an asset to be qualified as a HQLA asset, such asset must be easily liquidated in the market during a time of stress. It would be ideal if such asset would be eligible for use in the central bank operations. As assets have their own weight there will be certain assets under the HQLA that would be subjected to a range of haircuts. To know the range of haircuts, the HQLA assets are divided into Level 1 and Level 2 assets. Level 1 assets are typically of the highest quality and the most liquid. Due to their quality and liquidity there is no limit on the extent to which a bank can hold these assets to meet the LCR. While assets at Level 2 comprised of two sets, Level 2A and Level 2B assets. For Level 2A the assets includes for example certain government securities, covered bonds and corporate debt securities. While Level 2B assets include lower rated corporate bonds, residential mortgage backed securities and equities that meet certain conditions. Due to their lower level of asset quality and liquidity, Level 2A assets may not in aggregate account for more than 40% of a bank’s stock of HQLA. Similarly, Level 2B assets may not account for more than 15% of a bank’s total stock of HQLA (Bank for International Settlement, 2014).

 

As for the requirement of the total net cash outflows, the bank is required to ensure that it has such amount in the specified stress scenario for the subsequent 30 calendar days. Thus to quantify such amount, the bank would have to deduct its total cash inflows from the total expected cash outflows. The total expected cash outflows are calculated by multiplying the outstanding balances of various categories or types of liabilities and off-balance sheet commitments by the rates at which they are expected to run-off or be drawn down. Total expected cash inflows are calculated by multiplying the outstanding balances of various categories of contractual receivables at the rates of which they are expected to flow in. Total cash inflows are subject to an aggregate cap of 75% of total expected cash outflows, thereby ensuring a minimum level of HQLA holdings at all times (Bank for International Settlement, 2014).

Total Net Cash Outflows  = Total expected cash outflows – Total cash inflows

To implement the above LCR requirement, the banking industry across the globe is given four years to gradually phase in the LCR reform, from January 2015 till January 2019.

The Application of LCR framework onto Islamic Banks

After more than a year of waiting for guidance on how Islamic banks would be expected to apply the Basel III’s requirement of LCR, finally in April 2015, the Islamic Financial Services Board (IFSB), an international standard-setting body of regulatory and supervisory agencies, released its final guidance on quantitative measures for liquidity risk management for Islamic banks. Through its Guidance Note 6 (GN-6), the formula in calculating LCR is re-expressed as follows:

Stock of Shariah-compliant HQLA

——————————————                 >      100%

Total net cash outflows

More importantly the GN-6 clarifies the tools that Islamic banks could use in meeting the LCR requirement. It defines the types of HQLA assets that Islamic banks can hold and the weights or run-off rates that should be assigned to Islamic deposits (Vizcaino, 2015).

Table A below shows in detail the type of Shariah compliant assets eligible under HQLA.

Table A. Stock of High Quality Liquid Assets (HQLA)

Category Asset Factor
Level 1 ·         Coins and banknotes

·         Qualifying central bank reserves (including required reserves)

·         Qualifying Sukūk and other Sharī`ah-compliant marketable securities issued or guaranteed by sovereigns, central banks, public-sector entities (PSEs), multilateral development banks or relevant international organisations assigned a 0% risk weight for credit risk under IFSB-15

·         Qualifying domestic currency Sukūk and other Sharī`ah-compliant marketable securities issued by sovereign or central banks that have a non-0% risk weight

·         Qualifying foreign currencies’ Sukūk and other Sharī`ah-compliant marketable securities issued by sovereign or central banks that have a non-0% risk weight

 

 

 

 

 

 

 

 

 

 

 

 

 

100%

Level 2A

(maximum of 40% of HQLA):

·         Sharī`ah-compliant marketable securities issued or guaranteed by sovereigns, central banks, PSEs, multilateral development banks or relevant international organisations, qualifying for a 20% risk weighting for credit risk under IFSB-15.

·         Qualifying Sharī`ah-compliant securities (including commercial paper) and Sukūk that satisfy all of the conditions

 

 

 

 

 

 

85%

Level 2B

(maximum of 15% of HQLA)

·         Qualifying Sukūk and other Sharī`ah-compliant securities

·         Qualifying Sharī`ah-compliant equity shares

·         Qualifying other Sharī`ah-compliant liquidity instruments that are widely recognised in the jurisdictions of the home country

75%

 

 

50%

 

 

50%

Source: Islamic Financial Services Board, 2015.

While Table B below shows the weights given to funding sources, focusing particularly on deposit. The reason is that the deposits obtained by Islamic banks are mostly through profit sharing investment account (PSIA) which is generally considered to be more volatile than the conventional deposit. Hence under the LCR requirement, the riskier the funding sources, the larger the amount the of HQLA needed to cover it as the bank would  be required to hold enough HQLA to cover net cash outflows for a 30 day period under a high stress scenario (Vizcaino, 2014).

Table B. Total value of stock of HQLA

Item Factor
Cash Outflows : A. Retail deposits:  
Demand deposits and term deposits (less than 30 days’ maturity)  
• Stable deposits (Sharī`ah-compliant deposit insurance scheme meets additional criteria)

• Stable deposits

• Less stable retail deposits

3%

 

5%

10%

Term deposits with residual maturity greater than 30 days 0%
Cash Outflows :B. Unsecured wholesale funding:  
Demand and term deposits (less than 30 days’ maturity) provided by small business customers:  
• Stable deposits

• Less stable deposits

5%

10%

Operational accounts generated by clearing, custody and cash management activities

• Portion covered by deposit insurance

25%

 

5%

Cooperative IIFS in an institutional network (qualifying deposits with the centralised institution) 25%
Non-financial corporates, sovereigns, central banks, multilateral development banks and PSEs

• If the entire amount fully covered by deposit insurance scheme

40%

 

 

20%

Other legal entity customers 100%

Source: Islamic Financial Services Board, 2015.

Challenges in Applying LCR in Islamic Banking Industry

GN-6 describes three main characteristics of HQLA: low correlation with risky assets; an active and sizeable market; and low volatility. These three characteristics loomed the Islamic banking industry with challenges due to its present market conditions and its state of liquidity infrastructure. Firstly in terms of source of funding, the Islamic banks are restrained from dealing with interest-based financing from the interbank market or other sources. In most jurisdictions, Islamic banks are not allowed to transfer their debts other than on their face value. Secondly the current market is short of Shariah compliant securities or sukuk globally. The institutions are thus compelled to maintain a higher level of cash and non-earning liquid assets compared to conventional institutions. Thirdly while Shariah compliant securities or sukuk may be available in some jurisdictions, they are not actively traded nor involved in repurchase (repo) markets. Fourthly in most jurisdictions deposits and PSIA are not covered by reliable Shariah-compliant deposit takaful scheme. Similarly a Shariah compliant scheme of lender of last resort is not available in many jurisdictions as one of the means to protect the soundness and stability of the industry in the case of serious liquidity stress (Islamic Financial Services Board, 2015).

The Way Forward

Moving forward, to apply the HQLA liquidity risk management regime the current market condition and liquidity infrastructure need to be improved. A sufficient and regular supply of HQLA is needed. Thus to build the market liquidity, regular issuance of sufficient volume of Shariah compliant HQLA by governments or relevant authorities are needed (Islamic Financial Services Board, 2015). More sukuk should be listed on developed and liquid exchanges or actively traded. This is to ensure that Islamic banks could easily get them. For example Dubai is actively trying to list sukuk on its exchange and encourage its state-link firms to issue tradable sukuk. Importantly for bank deposit to be deemed stable they need to be protected by takaful deposit scheme which help in reducing by half the run-off rates (Vizcaino, 2014).

 

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  1. Thank you for the information

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