DP1/22 – The prudential liquidity framework: Supporting liquid asset usability

Discussion Paper 1/22
Published on 31 March 2022

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Responses

Responses are requested by Thursday 30 June 2022.

Please submit responses to: DP1_22@bankofengland.co.uk.

Executive summary

The global financial crisis of 2007/2008 exposed a number of cases where banksfootnote [1] did not hold an adequate quantity of sufficiently liquid assets. In response, the Liquidity Coverage Ratio (LCR) was introduced to promote the short-term resilience of the liquidity risk profile of banks. A net stable funding ratio (NSFR) was also introduced to ensure that banks maintain a stable funding profile over a longer horizon in relation to the composition of their assets and off-balance sheet activities.

The LCR requires banks to hold a large enough stock of high quality liquid assets (HQLA) to meet their payment obligations in the case of a severe short-term stress. The Bank of England (‘the Bank’) also stands ready to use its balance sheet to provide liquidity insurance as appropriate. Taking the two improvements together, banks can draw on significantly more liquidity, in a more reliable and timely manner, than was the case going into the global financial crisis. This reduces the risk that banks experiencing unexpected liquidity needs will struggle to secure the liquidity they need for themselves and their customers. And that in turn improves depositors’ and creditors’ confidence in banks. These changes have played a central role in making the banking system safer.

The UK’s prudential framework is calibrated to ensure that banks have sufficient liquidity to continue their activities through severe stresses. But it is important that banks feel able to draw on their liquidity, as appropriate, to reduce the risk of contractionary or destabilising actions. Failure to do so could cause unnecessary adverse impacts on the wider economy and financial system, and perhaps damage banks themselves. So, while in normal times banks are expected to maintain LCRs of 100% or more, firms may draw down their HQLA, even if it may mean that LCRs decline below 100% in stress.

However, the Bank and the PRA have been concerned for a number of years that banks may be reluctant to draw on their HQLA in periods of unusual liquidity pressures, possibly to such an extent that it is limiting the benefits of the flexibility built into the framework. Evidence from the last few years has reinforced these concerns.

For example, during the Covid-19 stress, a range of banks in the UK and internationally took defensive actions to protect and bolster their liquidity positions.

In 2019, the Bank conducted the Liquidity Biennial Exploratory Scenario (LBES) stress-testing exercise that focussed on how banks and authorities would react to a severe and broad-based liquidity stress affecting major UK banks simultaneously. Banks’ submissions suggested that, on the whole, they were unwilling to allow their LCRs to fall below 100%, even in a very severe stress, if they could prevent them from doing so.

Concerns around regulatory reactions may be relevant to banks’ willingness to draw on their HQLA when facing liquidity pressures. During the Covid-19 stress, authorities in a number of jurisdictions made public statements or took public actions intended to support HQLA usability.

Concerns around market reactions may also be relevant. There may be stigma about banks disclosing falls in the LCR below 100%, with the market treating the regulatory standard as a minimum at all times. It is unclear whether and how much such a stigma could limit the effectiveness of regulatory communications to support usability. One potential factor could be uncertainty among market participants around how to interpret signals from movements in the LCR during times of liquidity pressures. In particular, the LCR metric can be volatile during periods of financial disruption, and movements in the metric may not correspond straightforwardly to changes in a bank’s liquidity position. This could result in a risk-averse preference for LCRs to remain high.

The stigma may be exacerbated for those major UK banks that disclose ‘spot’ (point-in-time) LCRs in their regular financial statements. This is because spot LCRs are particularly prone to volatility compared to averaged regulatory LCR disclosures, and so can give noisy or even misleading signals. And, in a system-wide stress, the problem may be further increased by a coordination failure in which no individual bank wants to be the first to draw upon their stock of HQLA.

This topic is relevant to banks’ safety and soundness and to wider financial stability. The Bank and PRA are publishing this Discussion Paper (DP) to seek views from banks, wider market participants, and other interested parties to continue to improve understanding of the issues around HQLA usability.

The Basel Committee on Banking Supervision (BCBS) and Financial Stability Board (FSB) identified HQLA usability as an issue that may warrant further consideration, as part of their assessments of lessons learned from the Covid-19 stress.footnote [2] This DP is therefore also intended to inform the Bank and the PRA’s contribution to the ongoing work by the BCBS on the evaluation of Basel III reforms. The Bank and PRA may publish a summary of the comments received, in an anonymised way, to stimulate further debate.

1. Introduction

This Bank and PRA DP considers the usability of banks’ stocks of HQLA, and seeks views from banks, wider market participants, and other interested parties to continue to improve understanding of:

  • to what extent banks feel constrained in their ability to draw on their stock of HQLA to meet unusual liquidity demands;
  • what factors affect this; and
  • to what extent it is desirable that banks feel more able to draw on their HQLA, and how this could be achieved.

This DP is relevant to banks, wider market participants, and other interested parties who wish to provide feedback on the topics discussed in this DP, including by providing answers to the questions posed in this paper.

Background

Following the global financial crisis, the LCR was introduced to improve the short-term liquidity resilience of banks, by ensuring they hold a large enough stock of HQLA to meet their payment obligations in the case of a severe short-term stress.

It is important that banks feel able to draw on their HQLA as appropriate to reduce the risk of contractionary or destabilising actions. Indeed the PRA emphasised during the Covid-19 stress that banks were expected to use their HQLA, even if it meant LCRs going significantly below 100%, and that the PRA expected banks to focus on continuing to service and support their customers and clients.footnote [3]

More generally, banks may experience different types of liquidity pressures, of differing severities and durations. These can range from shocks to the real economy and financial markets that result in heightened liquidity demands on banks from households, banks, and financial market participants (such as the Covid-19 stress), to retail and/or wholesale liquidity outflows that could be prompted more by concerns about a bank’s (or set of banks’) safety and soundness.

However, there is some evidence from the Bank’s 2019 Liquidity Biennial Exploratory Scenario (LBES) stress testing exercise and the Covid-19 stress that banks appear to be reluctant to draw on their HQLA in periods of unusual liquidity pressures, possibly to such an extent that it is limiting the benefits of the flexibility built into the framework. In particular, this has reinforced long-standing concerns that a focus on maintaining LCR levels could motivate banks to take defensive actions such as liquidity hoarding and reducing lending that could harm the wider economy, over and above those actions consistent with prudent liquidity management.

Discussion Paper structure

Chapter 2 summarises the prudential liquidity framework and how banks’ stocks of HQLA, combined with central bank liquidity facilities, should allow banks to remain resilient and support households and businesses in times of disruption.

Chapter 3 summarises evidence on banks’ willingness and ability to allow their stocks of HQLA to fall.

Chapter 4 explores the factors affecting banks’ willingness and ability to allow their stocks of HQLA to fall, and seeks views on whether and how the Bank and PRA might support the usability of banks’ HQLA.

Chapter 5 discusses next steps.

Chapter 6 collects together the questions set out in the Discussion Paper.

Responses and next steps

This DP closes on Thursday 30 June 2022. The Bank and PRA invite feedback on the topics discussed in this DP. Please address any comments or enquiries to DP1_22@bankofengland.co.uk.

2. The prudential liquidity framework

The fundamental role of banks in maturity transformation makes them inherently vulnerable to liquidity risk.footnote [4] Banks need liquidity to meet their payment obligations to counterparties and customers– and to do so without needing to liquidate assets at excessive private or social cost.footnote [5] Banks therefore need timely and reliable access to cash and cash-like collateral in a quantity sufficient to meet potential liquidity outflows, including in times of unusual liquidity demands and market volatility. This reduces the risk that banks experiencing unexpected liquidity needs will struggle to secure the liquidity they need for themselves and their customers. And that in turn improves depositors’ and creditors’ confidence in banks.footnote [6]

The global financial crisis of 2007/2008 exposed a number of cases where banks did not hold an adequate quantity of sufficiently liquid assets to manage the impact of their short-term funding being withdrawn. Some assets that were considered to be high quality, such as certain asset-backed securities, saw large price falls and a reduction in liquidity during the crisis, exacerbating liquidity pressures in the financial system. Banks had also increased their reliance on short-term wholesale funding in the run-up to the crisis. These factors contributed to widespread problems, including bank failures and a contraction in the supply of bank credit to the UK real economy.

In response, significant changes were made to the prudential framework as a whole. The prudential liquidity framework was re-designed to address the liquidity aspects of the crisis via two complementary channels. First, by requiring that banks have a large enough stock of HQLA to meet their payment obligations in the case of a severe short-term stress to both their funding and collateral values (via both the Pillar 1 LCR and Pillar 2 liquidity guidance). Second, by requiring that banks have stable funding profiles over a longer time period in relation to the composition of their assets and off-balance sheet activities (via the NSFR), reducing the risk of slower burn funding runs.

The prudential liquidity framework has helped to significantly strengthen the financial resilience of banks and the overall financial system in the UK. UK banks’ liquidity and funding positions have improved significantly since the financial crisis. There has been a shift towards safer and more liquid assets, partly driven by changing liquidity requirements. In the decade following the onset of the crisis, the share of large banks’ total assets accounted for by liquid assetsfootnote [7] more than doubled. In addition, banks’ reliance on short-term unsecured funding reduced substantially – falling by more than three quarters over the same period.footnote [8]

The LCR requires banks to hold a sufficient stock of HQLA in normal times to survive a significant stress scenario lasting 30 days, combining idiosyncratic and market-wide shocks. The LCR standard does not account for all of the liquidity risks that banks may face. The PRA addresses salient risks not captured in the LCR via setting ‘Pillar 2 add-ons’, including risks from intraday liquidity, franchise viability, margined derivatives, securities financing margin, intragroup liquidity and liquidity systems and controls. The LCR standard together with Pillar 2 add-ons comprise banks’ quantitative individual liquidity guidance (ILG) – the amount of HQLA the bank is expected to hold in normal times.footnote [9] In addition, supervisors monitor cashflow mismatch risks (via the ‘PRA110’ reporting template).footnote [10] Banks may draw on their HQLA when facing unusual liquidity pressures, including where this involves the LCR falling below ILG or 100% in stress. The Appendix provides further background on the key elements of the framework.

To enhance market discipline and promote consistency and ease of use of disclosures, banks are required to disclose regularly to the public a standard LCR disclosure template, which includes a breakdown of cash inflows and outflows. As discussed further in Chapter 4, ‘spot’ or point-in-time LCRs can be volatile, particularly in periods of liquidity pressures and market volatility, and signals may be difficult to interpret. To reduce volatility in disclosed LCRs, and to mitigate the risk of adverse signalling during a market stress, prudential regulatory disclosure rules require banks to disclose relevant figures as averages (spot LCR disclosures are not required as part of prudential regulatory disclosures). UK and EU prudential regulatory disclosure rules require that figures are averaged over the previous 12 month-ends; while the BCBS disclosure standard entails daily averaging over the previous quarter (typically 90 days). Major UK banks also typically disclose additional liquidity information, for example asset encumbrance, breakdown of HQLA and maturity profiles of assets and liabilities. These are all important components of a firm’s overall liquidity position.

Banks’ own stocks of HQLA are a form of self-insurance against liquidity risk. But it would not be realistic or efficient to expect them to self-insure against every conceivable shock or stress. For example, if banks were required to hold HQLA against all deposits, this would generate significant costs and constrain the availability of credit.

The Bank also stands ready to use its balance sheet to provide liquidity insurance to solvent institutions.footnote [11] Banks that meet regulatory threshold conditions for authorisation and which have the appropriate type and amount of collateral have the flexibility to use the Bank’s liquidity facilities to help manage liquidity shocks. Relative to before the global financial crisis, banks can now borrow against a wider range of collateral, including less liquid assets such as portfolios of loans; and can borrow over a longer term, where the Bank deems it appropriate. The LCR metric does not reflect the potential liquidity benefits associated with banks’ central bank eligible collateral.footnote [12] So as well as not capturing all salient liquidity risks (as discussed above), the LCR also does not fully capture the liquidity resources banks may be able to draw upon.

Banks can therefore draw on significantly more liquidity, in a more reliable and timely manner, than was the case going into the global financial crisis. This increase in banks’ resilience reduces the risk of bank failure, reducing the risk to the taxpayer and to the UK economy. It is important that banks feel willing and able to draw on that liquidity, as appropriate, to reduce the risk of contractionary or destabilising actions. Failure to do so could cause unnecessary adverse impacts on the wider economy and financial system, and perhaps damage banks themselves.

The importance of usable HQLA

As noted above, the PRA sets each bank a level of HQLA which it is expected to hold in normal times. Banks’ stock of HQLA are intended to improve their ability to absorb unexpected liquidity needs (whatever the source or cause). This improves depositors’ and creditors’ confidence in banks, and in the event of unexpected liquidity needs it reduces the risk of spillover from the financial sector to the real economy and gives banks and authorities time to take appropriate measures.footnote [13]

So holding HQLA in normal times is valuable. One reason is that HQLA is available to use in stress. And, when a bank has drawn down on its stock of HQLA, there is no requirement to rebuild it within a specific time period. The PRA will be content for banks to rebuild their stock of HQLA over a reasonable period of time, taking into account how far the bank has run down its HQLA stock and the expected duration of a stress.footnote [14] This timeframe should help reduce pressure on banks to take damaging defensive actions. There is also no expectation on banks to hold excess HQLA so as to avoid falling below their quantitative ILG in the event of a potential stress.footnote [15]

And, as discussed, the Bank stands ready to use its balance sheet to provide liquidity insurance. When and how to use market sources of funding, existing HQLA stocks, or central bank liquidity insurance is a decision for banks to make, based on their expert knowledge of their own liquidity needs and the availability and cost of options. In particular, there is no fixed order in which the Bank and PRA expect banks to use one form of liquidity over another. The existence of central bank liquidity facilities should provide banks with the confidence needed to operate for a reasonable period below the level of liquidity that the Bank and PRA expect them to maintain in normal times.

It is important that banks do not feel unduly constrained in drawing on their stocks of HQLA and in letting their LCRs fall during a stress, for a number of reasons:

  • If banks are overly reluctant or unable to let their stocks of HQLA fall when facing liquidity pressures, they may take unnecessary defensive actions that could be damaging to their counterparties, clients or themselves – and ultimately could have negative spillovers on the wider economy and financial system. This could include raising funding at increased costs.footnote [16] It could also include a constrained willingness or ability to intermediate financial markets or lend.footnote [17] This issue may be particularly acute for some banks that have limited collateral available to source alternative liquidity at a reasonable price.
  • So if banks are overly reluctant or unable to use their stocks of HQLA, their value to banks and the economy may reduce – though they are likely to still have significant value by supporting confidence of depositors and creditors. The stocks of HQLA represent low-risk collateral that could otherwise support market liquidity. There is an opportunity cost in terms of funding that banks could provide to the economy and reduction in banks’ profitability (potentially impacting on their ability to generate capital). Banks may also hold excess HQLA to avoid LCRs falling below certain levels when facing liquidity pressures, which would entail further opportunity costs.
  • While banks can monetise less liquid assets by borrowing from central banks, relying solely on this form of liquidity is unlikely to be prudent. Use of these facilities has costs, including the requirement to be able to encumber sufficient collateral in line with central bank haircuts. In addition, in extreme circumstances a bank may no longer meet regulatory threshold conditions and so may not have access to central bank facilities at the point needed. This means it is important that banks can also choose to draw on their own HQLA.

At the same time, as stocks of HQLA fall, banks may increasingly seek alternatives to further declines. Prudent liquidity management in the face of uncertainty – for example, uncertainty around how much worse liquidity pressures will become, or the probability of further future shocks – will entail a natural and appropriate degree of caution around how far to run down HQLA. And stocks of HQLA support market confidence and reduce the risk of runs on the bank. The degree to which banks may become more defensive of their HQLA as it falls may vary across banks and according to circumstances.

Banks will not always experience net outflows of liquidity in times of economic and market disruption. For example, if ‘flight to safety’ behaviour manifests in the market then some banks may receive additional stable deposits, attracting HQLA (and experiencing an increase in the LCR). Actions by authorities may also support banks’ liquidity positions in some situations. And some banks may choose to access central bank facilities to borrow HQLA against lower quality collateral during a stress, which would further support a high LCR.

As a result, it is not the case that the Bank and PRA anticipate that all banks will draw down their stocks of HQLA equally in all stresses. But the prudential framework should not in itself constrain their willingness or ability to appropriately use their HQLA in order to avoid more damaging actions during a stress.

3. Evidence on banks’ willingness and ability to draw on their stock of HQLA in stress

The UK banking system has not experienced a severe and sustained period of liquidity outflows and market volatility since the implementation of the LCR, so the Bank and PRA have limited direct evidence from actual stresses on the extent to which banks would draw down their stock of HQLA in such circumstances.

Nevertheless, results from the Bank’s 2019 Liquidity Biennial Exploratory Scenario (LBES) stress testing exercise as well as subsequent domestic and international supervisory intelligence during the Covid-19 stress have provided some evidence. They suggested that banks may be reluctant to draw on their stock of HQLA where this would result in falls in LCR, particularly to below 100%. Instead, banks may prefer taking actions that may negatively impact on financial markets and the real economy. This has reinforced anecdotal information and perceptions from banks gathered by the Bank and PRA, and internationally, since the introduction of the LCR standard.

In general, a reluctance to allow the LCR to fall will translate to a reluctance to use HQLA. The key determinant in whether and how much the LCR falls when HQLA is used to meet liquidity outflows is the extent to which those actual liquidity outflows result in a change in LCR net outflows; and so the degree to which the LCR denominator falls alongside changes in the LCR numerator (HQLA).

Suppose a bank faces outflows from a liability that has a high outflow rate in the LCR. If the bank uses its HQLA to meet these outflows, then its HQLA and net outflows – the LCR numerator and denominator – will fall by similar amounts. As a result this has a relatively small impact on the LCR. For example, if financial institutions withdraw their short-term deposits from the bank then, since those deposits are assigned a 100% outflow rate, HQLA and net outflows fall by the same amount. In this case, as long as the LCR was initially above 100%, the LCR will actually increase.

By contrast, there will be a relatively large (negative) impact on the LCR if a bank uses HQLA to meet outflows from a liability that has a small (or even 0%) outflow rate in the LCR. This is because HQLA would fall much more significantly than net outflows. For example, this would be the case for outflows of stable retail deposits, drawdowns on committed credit facilities from non-financial customers, or outflows related to a crystallisation of Pillar 2 risks (which do not contribute to LCR net outflows). So, in such situations, if a bank were reluctant to allow its LCR to fall then this could constrain its willingness to use HQLA. This dynamic is discussed further in Box 1.

Evidence from the LBES

The 2019 LBES exercise focused on the implications of a severe and broad-based liquidity stress affecting major UK banks simultaneously. It was designed to explore how the reactions of banks and authorities to the stress would shape its impact on the broader financial system and the UK economy.

The stress scenario featured a material liquidity run lasting 90 days, affecting the major UK banks simultaneously, followed by a nine month recovery period. The magnitude of the liquidity outflows were calibrated to be similar to the liquidity shocks underpinning the LCR stress scenario. In total they were equivalent to around 60% of the value of banks’ high quality liquid assets at the start of the stress.footnote [18]

Banks’ submissions to the LBES suggested that, on the whole, they were unwilling to allow their LCRs to fall below 100% even in a severe stress if they could prevent them from doing so. Participants started the exercise with liquidity buffers well in excess of regulatory buffer requirements: their aggregate LCR was around 140%. This fell to approximately 105% at the end of the stress period.

Due to the severity of the liquidity shock, banks had little choice but to run down their buffers at the beginning of the stress. But almost all banks took enough actions in response to the stress to record LCRs at or above 100% by the end of the stress period. These included drawing materially on Bank liquidity facilities. Banks also projected taking significant other defensive actions – including cutting lending to households and businesses and attracting back deposits by increasing deposit rates. These actions were used to rebuild buffers quickly towards their starting levels and to pay back borrowing from the Bank.

A key driver of banks’ desire to maintain buffers where possible in stress and to re-establish previous liquidity buffers quickly afterwards seemed to be practices and perceived obligations around disclosing their LCR ratios. Banks were keen to avoid the risk of being seen to be in liquidity difficulties relative to peers by financial market participants. Some participants also sought to guard against the possibility that the stress could worsen further.

Evidence from the Covid-19 stress

The LBES was a hypothetical stress scenario. The Covid-19 stress subsequently provided further evidence of banks’ behaviour in a real-life, but ultimately much less severe on this occasion, liquidity stress.

In general, stocks of HQLA built up as a result of the LCR framework helped banks maintain market confidence and weather the pandemic. But, as concerns around Covid-19 intensified in late February and early March 2020, banks started experiencing downward pressure on their LCRs.footnote [19] Chart 1 illustrates estimated LCR pressures arising from the most material exogenous channels through which UK banks experienced inflows and outflows. footnote [20] They are shown for a group of large deposit takers, and a group of large foreign subsidiary banks (which are concentrated in wholesale market and investment banking activities).footnote [21]

Between 28 February and 13 March 2020, large deposit takers saw outflows of retail deposits and inflows of corporate deposits (which may be attributable to seasonality). Both large deposit takers and foreign subsidiaries experienced outflows of initial margin, debt buybacks, facility drawdowns, inflows of variation margin, and flows of financial deposits due to the “dash for cash”. Between 13 and 27 March 2020, LCR outflows designed to capture the risk of stressed variation margin outflows on derivatives positions (the Historical Look-Back Approach, or ‘HLBA’) also increased for both groups of banks (due to variation margin volatility in the previous period). For the aggregate large deposit taker, inflows of retail deposits relieved LCR pressures, as they tend to have low LCR outflow rates (though these may not have been in excess of seasonality).

Chart 1: Material factors contributing to pressures on UK banks’ LCRs during the Covid-19 stress (a) (b) (c)

1a. Large deposit taker LCRs

Large deposit taker LCRs between 28 February and 13 March 2020

1b. Large foreign subsidiary bank LCRs

Large foreign subsidiary bank LCRs between 28 February and 13 March 2020

Footnotes

  • Source: PRA regulatory returns and Bank calculations. Charts showing these impacts have previously been published in the BCBS report 'Early lessons from the Covid-19 pandemic on the Basel reforms'.
  • (a) HLBA is the ‘Historical Look-Back Approach’, which captures the risk of future variation margin outflows associated with derivatives.
  • (b) Facility drawdowns include the impact from banks’ customers drawing on committed credit and liquidity facilities.
  • (c) Due to the high LCR outflow rate assigned to financial deposits, a downward pressure on LCR indicates a liquidity inflow - see Box 1 for further discussion of this dynamic.

These pressures largely abated, as timely central bank intervention in the UK and internationally meant banks had significant access to liquidity from an early stage. The actions of central banks and governments, such as launching additional central bank facilities and business loan schemes, also calmed financial markets and supported economies. So monetary and fiscal firefighting put out the fire before it took hold.footnote [22]

Nevertheless, during the Covid-19 stress, banks in the UK reported taking or considering taking defensive actions at LCRs well above 100%. Examples of these include declining to roll funding and cutting some lending, a reluctance or refusal to buy-back commercial paper, wholesale issuance and taking actions to raise deposits.

These actions may have been partly motivated by uncertainty and caution around how the stress would develop. They were also consistent with banks’ recovery plans; a review of UK banks’ recovery plans showed that some banks calibrate recovery triggers higher than 100%, meaning they would consider taking urgent measures to improve their liquidity before their LCR falls below 100%.footnote [23]

This raises the question as to why banks feel the need to maintain such high levels of LCR in stress and/or take action to prevent their LCR from falling. Anecdotal evidence from UK banks during the Covid-19 stress suggests there was significant concern around adverse market reactions to disclosing lower than expected LCRs – or sharp falls in LCR – at the end of the first quarter of 2020. There were also concerns that disclosing falls in the LCR may result in credit downgrades, contributing to a reluctance to allow LCRs to fall. Some banks raised their internal LCR targets during 2020 due to these concerns. Statements by the PRA and other regulators on buffer usability appeared to support banks in considering using their HQLA, with some banks relaxing or considering relaxing their internal LCR targets following those communications. This may suggest that at least some of the reluctance to let LCRs fall below 100% may be driven by the LCR framework and concerns around the regulatory response to such falls, rather than concerns that liquidity levels would fall below a level needed to defend against liquidity runs on the banks. Some smaller UK banks actively increased their HQLA holdings to build a larger surplus over the normal-times regulatory guidance.

The BCBS report on early lessons learned from Covid-19 found that a broad range of banks internationally also took or considered taking defensive actions to protect their LCRs, even though these were generally well above 100%.footnote [24] In some cases, this was driven by internal LCR targets. Certain defensive actions could have been damaging to the wider sector and real economy, such as limiting certain forms of lending, although the wider spillovers of such actions appeared limited in practice (in large part due to central bank policy intervention).

While the downward pressures on banks’ LCRs were limited during the Covid-19 stress, the BCBS report found that several jurisdictions believed that banks would be reluctant to allow their LCRs to fall in response to stronger pressures too. A 2019 BCBS survey had also suggested that, in a majority of jurisdictions, banks would be hesitant to draw down their HQLA in stress. This reflected concerns about the consequences of disclosing LCRs below 100%, as well as concerns in some cases about potential supervisory responses.

Interviews with treasurers of seven US banks lend further support to the concern that banks internationally may be reluctant to use HQLA where this would result in LCRs falling to below 100%.footnote [25] The treasurers reported concerns about both supervisory and wider public responses to such falls, as well as noting the importance of internal risk limits and links to recovery plans – and so “all observed that they would not use their HQLA to meet a liquidity need if doing so caused them to have an LCR below 100 percent.” Consequently, during the Covid-19 stress some banks reported taking actions such as longer-term borrowing and, in one case, selling non-HQLA assets at a discount, “solely to protect their regulatory liquidity ratios, not because they judged the steps necessary from a liquidity risk management point of view”.

Q1: How do your perceptions of banks’ willingness to draw on their stocks of HQLA compare with the evidence presented in this section?

Q2: To what extent would market participants be comfortable with banks drawing on their stock of HQLA to meet unexpected liquidity demands, and with accompanying falls in LCR?

4. How could HQLA usability be improved?

As noted in Chapter 2, as banks draw on their stocks of HQLA to meet liquidity outflows, they may increasingly seek alternatives to further declines. Such behaviour would be consistent with prudent liquidity management in the face of uncertainty. However, the evidence in the previous section reinforces longer-standing concerns that banks may be overly reluctant to draw on their stocks of HQLA when facing liquidity pressures. This may be due to concerns about both regulatory and market reactions to falls in LCR, suggesting that the prudential framework may be unduly constraining banks’ willingness and ability to draw on their HQLA. The Bank and the PRA would welcome views on the nature and extent of these concerns, to understand better if there are ways in which they could consider supporting banks in prudently using their HQLA when facing liquidity pressures in future.

Concerns around regulatory reactions

Banks may be concerned about how regulators will respond to usage of HQLA, or about known regulatory consequences of usage – such as more intensive supervisory monitoring.footnote [26] During the Covid-19 stress authorities in a number of jurisdictions made public statements and took public actions intended to support HQLA usability and alleviate uncertainty regarding the regulatory response to a bank’s LCR falling below 100%.

The PRA, for example, issued a statement reinforcing its expectation that banks should “focus on continuing to service and support their customers and clients... [and] use their liquidity buffers in doing so, even if it means LCR ratios go significantly below 100%.” The PRA also communicated that “[t]here is no requirement to rebuild liquidity buffers within a specific time period. Once this current period of stress is over, where banks have made use of their liquidity buffers, the PRA will give banks a sufficient period of time for these to be restored.” footnote [27]

The PRA also noted that the LCR is only one measure of a bank’s ability to manage its liquidity to meet customers’ needs. The PRA considers a wide range of factors in determining its regulatory response, including a bank’s broader ability to generate liquidity (including through access to central bank facilities), the stability of its funding profile, drivers of changes in its LCR ratio and other measures of liquidity adequacy a bank may use.

The BCBS also issued a statement in March 2020 reinforcing that “HQLA stocks should be used to meet liquidity demands”,footnote [28] while many other jurisdictions issued similar communications. Some authorities gave additional quantitative guidance on HQLA usage, temporarily reducing their LCR standard to a level below 100%.footnote [29] Some authorities also provided explicit forward guidance on the timelines over which banks should replenish their LCRs to 100%.footnote [30]

These actions appeared to be supportive of banks drawing on their HQLA to some extent, with banks across a number of jurisdictions reportedly lowering internal targets and/or approving temporary exemptions to internal targets following the public announcements. But more banks were reported as leaving targets and limits unchanged.footnote [31] Additionally, as discussed in Chapter 3, some banks in the UK had initially raised their internal targets during the stress. The Bank and PRA would therefore welcome views on the role of banks’ internal targets and processes in their willingness to draw on their HQLA. In particular, the Bank and PRA would welcome views on the degree to which it might be appropriate and feasible for banks to plan ahead for the possibility of applying different internal liquidity targets in different liquidity scenarios, and on the timeliness with which banks might implement such plans when facing liquidity pressures, including in response to communications and actions by authorities.

The Bank and PRA would also welcome views more broadly on the extent to which authorities’ communications supported HQLA usability during the Covid-19 stress, and might do so in future.

Q3: How do banks’ internal LCR targets affect HQLA usability? To what extent would it be feasible and appropriate for banks to adjust or tailor internal targets for different scenarios?

Q4: To what extent did authorities’ communications around HQLA usability during the Covid-19 stress support banks in using their HQLA?

Q5: What forms of communication and guidance were, and would be, most effective?

Q6: How much are banks concerned about regulatory reactions to initial falls in LCR, and how much about potential regulatory views on the timeline for rebuilding HQLA stocks?

Concerns around market reactions

Banks’ willingness to use HQLA and allow LCRs to fall may also depend on how they think the market would react to such falls.

Prudential regulatory disclosures are central to the efficacy of market discipline, supporting transparency that allows investors to observe banks that engage in excessive risk-taking.footnote [32],footnote [33] Transparency encourages a better allocation of resources through a reduction in asymmetric information, and reduces the volatility of investor behaviour responding to misinformation.footnote [34] And without any disclosure, confidence risks being undermined for all firms when the market cannot distinguish at all between strong and weaker firms. So there are clear benefits to disclosures and transparency in normal times.

In times of uncertainty and liquidity strains on banks, there are potential drawbacks as well as potential benefits to extensive and high frequency transparency. Liquidity crises can be fast-moving and self-fulfilling: concerns about an individual bank’s liquidity position may prompt a self-fulfilling liquidity crisis, which could result in a bank failing even if it is solvent.footnote [35] This could happen particularly when noisy disclosures provide misleading signals. As the BCBS has previously pointed out: “Private and public interests may not always coincide. In particular, when the market becomes aware that a bank is in a weakened position it may react more harshly than is desirable from the point of view of the authorities who have responsibilities for depositors’ protection and for managing systemic risk.”footnote [36] Liquidity disclosures that are too frequent or without a sufficient time-lag could draw attention to short-term liquidity issues facing a bank, exacerbating the situation and reducing the time available to affected banks to take mitigating actions.footnote [37] However, transparency may have the benefit of reducing the risk that the market’s fears about one bank spread to other banks, reducing the risk of contagion.footnote [38]

These factors may put pressure on banks to disclose strong liquidity positions in times of uncertainty at too high a frequency when the data can be volatile, resulting in a tension between transparency and HQLA usability. This may translate to a pressure on banks to remain above regulatory standards at all times, and so a stigma around disclosing falls in LCR, including to below 100%.footnote [39] There may also be a collective action problem – a stigma attached to a bank being an outlier compared to peers. In such situations, there may be a cost to banks of taking actions that increase their perceived riskiness – including drawing on their stock of HQLA.footnote [40] Such factors may also put pressure on banks that do allow their LCRs to fall when facing liquidity outflows to take actions to rebuild their liquidity positions quickly.

Such concerns could limit the effectiveness of communications by authorities intended to support usability – both in supporting banks to draw on their HQLA in the shorter-term to meet liquidity outflows, and in supporting banks to restore their HQLA and LCR over a reasonable time period. The PRA and Bank would welcome views from banks and market participants on what may be driving potential stigma around allowing LCRs to fall.

One potential driver could be uncertainty around how to interpret signals from movements in the LCR during times of liquidity pressure. If the market finds it challenging to more fully understand banks’ liquidity positions in times of financial and economic disruption, this could contribute to risk aversion and put pressure on banks to disclose high LCRs.

Particularly in normal times, LCR disclosures communicate useful information about banks’ resilience to a broad range of liquidity risks. But any individual liquidity metric will be an imperfect representation of liquidity risk, particularly in times of uncertainty. Potential future outflows (and inflows) in a stress are uncertain, in part due to the potential for concerns about liquidity resilience to lead to self-fulfilling outflows.footnote [41]

The LCR metric itself can be volatile and behave cyclically during periods of financial and economic disruption. Movements in the metric may not correspond straightforwardly to changes in a bank’s broader liquidity position. A given level of LCR may also represent different levels of resilience to a bank’s business model risks, for example because it does not account for Pillar 2 risks. The LCR also continues to apply the same outflow rates as shocks crystallise, such that a given level of LCR generally implies resilience against an increasingly severe stress overall as risks crystallise. Box 1 discusses how the LCR behaves during periods of unusual liquidity outflows and increased market volatility in more detail.

So focusing too narrowly on banks’ LCRs during times of liquidity pressure may not support a full understanding of banks’ liquidity positions. As noted in Chapter 2, the headline LCR metric is not the only information disclosed by major UK banks. In addition to the LCR, HQLA and net outflows, major UK banks also typically disclose information on, for example, asset encumbrance, the composition of HQLA, and maturity profiles of assets and liabilities.

The Bank and the PRA would welcome views on the degree to which market participants’ uncertainty around banks’ liquidity positions in stress may be relevant to HQLA usability. The Bank and the PRA would also welcome views more broadly on the impact that banks’ liquidity disclosures have on HQLA usability, and how regulatory liquidity disclosures might be improved.

In seeking to improve the quality of information in banks’ regulatory disclosures, it may also be helpful to consider specific sources of volatility and cyclicality in the LCR. One aspect that can behave cyclically is HLBA – the way in which the risks of future variation margin outflows associated with derivatives market volatility are captured. HLBA tends to mechanically increase LCR net outflows when market volatility increases.footnote [42] The Bank and PRA would welcome views on whether improvements to the design of the LCR to reduce its potential cyclicality could support HQLA usability, and note that any such improvements would require international cooperation.

A potential stigma attached to disclosing falls in LCR, especially to below 100%, may be exacerbated for those major UK banks that voluntarily disclose ‘spot’ (point-in-time) LCRs in their regular financial statements.footnote [43]

Spot LCRs are particularly prone to volatility compared to regulatory averaged LCR disclosures, and so can give noisy or even misleading signals.footnote [44] Disclosure of spot LCRs during a period of liquidity pressure risks shifting banks’ focus to short-term management of the LCR metric, rather than on prudent and considered management of their forward-looking liquidity position and the longer-term costs of their management actions.

Banks in a number of other jurisdictions do not appear to follow this practice of disclosing spot LCRs on a regular basis. This may be related to the averaging period used for regulatory LCR disclosures. For example, banks in the US, Japan and Switzerland do not disclose spot LCRs. Regulatory disclosures in these jurisdictions require an average of daily LCR observations over the previous quarter, typically 90 days, in line with the Basel standard. This means that their regulatory disclosures provide more up-to-date information than in jurisdictions such as the UK, where regulatory disclosures require an average of LCR observations over the previous 12 month-ends. In responses to a BCBS supervisory survey on experiences during the Covid stress, four jurisdictions indicated that averaged disclosures helped avoid adverse market reactions for banks whose LCRs fell temporarily below 100% during the Covid-19 stress.footnote [45]

The Bank and PRA note that banks have a legal obligation to disclose inside information without delay under the Market Abuse Regulation (MAR), although provisions in Article 17 allow for delayed disclosure in certain circumstances. The Bank and PRA note that disclosure requirements under MAR would remain unaffected by any potential changes to prudential regulatory disclosures, or to banks’ approaches to voluntary disclosures in their regular financial statements, that may be considered as part of the discussion above or in response to the questions below.

Q7: What may be driving a potential stigma around banks allowing LCRs to fall? How much do you think a potential stigma may be around falls in LCR in and of themselves, and how much around concerns around how quickly LCRs can be restored?

Q8: To what extent is it challenging for market participants to interpret the signals they receive from LCR-related disclosures when banks are facing liquidity pressures?

Q9: What impact do regulatory liquidity disclosures have on HQLA usability? How might regulatory liquidity disclosures be improved?

Box 1: How the LCR behaves in stress

The relationship between changes in HQLA, net outflows and LCR

If a bank experiences liquidity pressures and uses its HQLA to meet outflows, the LCR will generally fall (absent any liquidity-raising actions or other inflows). But the impact of liquidity outflows and market volatility on the LCR is not straightforward. Depending on the nature of the shock, the LCR could fall by relatively more or less than the stock of HQLA, or could even increase.

The key determinant of how the LCR will change as a result of liquidity outflows is the extent to which those outflows reduce the denominator of the LCR - the LCR net outflows. This is illustrated in Figure 1.

Figure 1: Illustrative impact of a liquidity outflow on a bank’s HQLA, net outflows and LCR (a)

Footnotes

  • (a) For illustrative purposes, the outflow of £Xi is assumed to be from a single liability category, i, with LCR outflow rate of outflow ratei

If a bank were to experience outflows of liabilities that have a high outflow rate, then net outflows would fall to a similar extent as HQLA, limiting the downward tendency of the LCR. LCR may even increase as a result of the outflows.1

By contrast, if a bank were to experience outflows of liabilities that have a low outflow rate – or are not captured at all in LCR net outflows, for example, if they are associated with Pillar 2 risks – then net outflows would fall to a lesser extent than HQLA, resulting in a more pronounced fall in LCR.

It is also possible for LCR to fall relatively more sharply than HQLA. For example, if a bank experiences unusual outflows of derivatives variation margin, net outflows can increase while HQLA falls. This can contribute to volatility and cyclicality in the LCR in times of market volatility.2

For some banks, the extent to which actual outflows translate to a fall in LCR net outflows would also be limited by the ‘inflow cap’. When calculating LCR net outflows, total expected cash inflows are subject to a cap of 75% of total expected cash outflows (see the Appendix). While the inflow cap binds, LCR net outflows would only reduce by a quarter of any reduction in LCR gross outflows, leading to larger falls in the LCR than if the inflow cap did not bind.3

Interpreting LCR scenario severity as shocks crystallise

It is also important to bear in mind that the stress scenario embodied in the LCR is a static one – it does not reduce in severity when the risks it represents start to crystallise. So a 100% LCR level when a bank has already experienced unusual liquidity demands may represent a more severe measure of (cumulative) liquidity needs than that represented by a 100% level in normal times – which is already calibrated to represent a severe liquidity stress.

For example, the LCR outflow rate for stable retail deposits is 5%. If a bank were to experience an outflow of 2.5% of its stable retail deposits, the LCR would continue to apply an outflow rate of 5% to the remaining balance – which, if it materialised, would represent a total cumulative outflow of 7.4% of stable deposits, a much more severe outcome than the LCR outflow rate of 5%.

Footnotes

  • 1 For example, if the outflows were in short-term financial deposits, which are assigned an LCR outflow rate of 100%, HQLA and LCR net outflows would both reduce by the same amount. If a bank’s starting LCR were above 100%, this would result in an increase in LCR.
  • 2 The risk of future margin outflows is calculated using the ‘Historical Lookback Approach’ (HLBA) – which uses margin flows over the previous 24 months to determine the HQLA that banks must hold against the risk of large collateral calls resulting from derivatives market volatility. If a bank experiences larger margin inflows or outflows than in the previous two years, LCR net outflows increase.
  • 3 If for example a bank has LCR outflows of £100mn, and LCR inflows of £90mn, then its LCR net outflows would be: £100mn – min(£90mn, 75%*£100mn) = £25mn. An outflow of £10mn would, all else being equal, reduce HQLA and total outflows by £10mn; but would only reduce net outflows by £2.5mn, since LCR net outflows would now be: £90mn – min(£90mn, 75%*£90mn) = £22.5mn.
Q10: How do factors that drive LCR volatility contribute to concerns around HQLA usability? Which factors are most important?

Q11: Why do some banks disclose spot LCR? How does the practice of spot LCR disclosures affect HQLA usability in times of liquidity pressure?

Q12: What would the potential costs and benefits be of changing prudential regulatory LCR disclosures to be more in line with the Basel (typically 90-day) averaging approach?

In system-wide stresses, the problem may be exacerbated by a coordination failure in which no individual bank wants to be the first to draw upon their stock of HQLA, for fear of being stigmatised as being ‘in trouble’. Even if concerns about general market stigma could be reduced, an unwillingness to be the first mover could inhibit HQLA usability.

Evidence in the UK and internationally suggests that firms with more capital headroom over regulatory buffers tended to lend more during the Covid crisis.footnote [46] If authorities communicated some form of lowering of the regulatory liquidity standard in stress, that would imply an increase in banks’ headroom to the standard. That could in turn support HQLA usability, if banks were willing to use some of that headroom. Evidence from the Covid stress suggests that this may be the case: where jurisdictions temporarily reduced or amended their LCR standard, some banks reduced their internal targets.footnote [47]

As discussed above though, many banks did not lower internal targets following authorities’ communications. It is unclear how much this relates to concerns around regulatory reactions, to those around general market stigma, to concerns around being the first mover, or indeed due to other reasons, including precautionary motives and prudent risk management.

The PRA and Bank would welcome views from banks and market participants around how, and how much, the collective action problem may constrain HQLA usability. In particular, whether such stigma is likely to operate for banks falling below levels of LCR at which they typically operate, or whether an increase in banks’ headroom of some form would support banks collectively using more of their HQLA, as appropriate.

Q13: How and to what extent may a collective action problem be a factor in limiting HQLA usability?

There are likely to be other factors that impact HQLA usability that have not been discussed in detail in this paper. The Bank and PRA would welcome your views on other factors that may be important.

There are also likely to be other suggestions for how authorities could support banks in appropriately using their HQLA. The Bank and the PRA would welcome views on other ways in which authorities could support banks in appropriately using their HQLA, including where respondents consider that suggestions in the academic and financial market literature could be helpful.

Q14: What other factors may impact on HQLA usability?

Q15: What other approaches could enhance banks’ use of HQLA in times of unexpected liquidity needs?

5. Next steps

The Bank and PRA would welcome views on this discussion paper, including answers to the questions. Responses will inform the Bank and the PRA’s ongoing thinking on the issues around HQLA usability, and whether and how the Bank and PRA could support HQLA usability. The Bank and PRA will share summary findings with international colleagues to support the BCBS Evaluation exercise. After the end of the period for receiving comments, the Bank and PRA may publish a summary of the comments received in an anonymised way to further encourage debate.

6. Questions

Q1: How do your perceptions of banks’ willingness to draw on their stocks of HQLA compare with the evidence presented in this section?

Q2: To what extent would market participants be comfortable with banks drawing on their stock of HQLA to meet unexpected liquidity demands, and with accompanying falls in LCR?

Q3: How do banks’ internal LCR targets affect HQLA usability? To what extent would it be feasible and appropriate for banks to adjust or tailor internal targets for different scenarios?

Q4: To what extent did authorities’ communications around HQLA usability during the Covid-19 stress support banks in using their HQLA?

Q5: What forms of communication and guidance were, and would be, most effective?

Q6: How much are banks concerned about regulatory reactions to initial falls in LCR, and how much about potential regulatory views on the timeline for rebuilding HQLA stocks?

Q7: What may be driving a potential stigma around banks allowing LCRs to fall? How much do you think a potential stigma may be around falls in LCR in and of themselves, and how much around concerns around how quickly LCRs can be restored?

Q8: To what extent is it challenging for market participants to interpret the signals they receive from LCR-related disclosures when banks are facing liquidity pressures?

Q9: What impact do regulatory liquidity disclosures have on HQLA usability? How might regulatory liquidity disclosures be improved?

Q10: How do factors that drive LCR volatility contribute to concerns around HQLA usability? Which factors are most important?

Q11: Why do some banks disclose spot LCR? How does the practice of spot LCR disclosures affect HQLA usability in times of liquidity pressure?

Q12: What would the potential costs and benefits be of changing prudential regulatory LCR disclosures to be more in line with the Basel (typically 90-day) averaging approach?

Q13: How and to what extent may a collective action problem be a factor in limiting HQLA usability?

Q14: What other factors may impact on HQLA usability?

Q15: What other approaches could enhance banks’ use of HQLA in times of unexpected liquidity needs?

Appendix - The prudential liquidity framework: LCR and NSFR

The Liquidity Coverage Ratio

The LCR furthers the PRA’s statutory objective of safety and soundness by promoting banks’ short-term liquidity resilience. It does this by requiring banks to hold a sufficient stock of unencumbered HQLA in normal times to survive a significant liquidity stress scenario lasting 30 calendar days.

The LCR is defined as the ratio of a bank’s HQLA to its total net cash outflows over the next 30 days. Banks may draw down their HQLA as appropriate in times of stress, including where this involves falling below 100%.

Total net cash outflows are defined as the total expected cash outflows minus total expected cash inflowsfootnote [48] over the next 30 days in the stress scenario. These are estimated by defining outflow rates at which liabilities and off-balance sheet commitments are expected to run off or be drawn down, and inflow rates at which contractual receivables are expected to flow in under the scenario.

The stress scenario entails a combined idiosyncratic and market-wide shock. It does not cover all liquidity risks, but rather incorporates many of the shocks experienced during the crisis that started in 2007 into one significant stress scenario. It does not address, for example, risks that are expected to materialise beyond 30 days or within the 30 days of the stress scenario. Salient risks not captured in the LCR stress scenario are addressed through the PRA’s Pillar 2 liquidity framework.

Pillar 2 liquidity guidance

The Pillar 2 frameworkfootnote [49] covers risks not captured, or not fully captured, in Pillar 1 (the LCR stress scenario). The PRA may set add-ons to address these risks.

Specifically, the framework addresses risks in the following areas:

  • Cashflow mismatch: the risk that a bank has insufficient liquidity from HQLA and other liquidity inflows to cover liquidity outflows on a daily basis. The PRA’s cashflow mismatch framework (CFMR) focuses on low point risk, monetisation risks, cliff risk and foreign exchange mismatch risks. The PRA uses a set of stress scenarios and tools to monitor these risks and/or set guidance.
  • Franchise viability: the risk that a bank takes actions, despite having no legal obligation to do so, in order to preserve its reputation, and where these actions cause unforeseen liquidity outflows. Failing to take these actions may damage the bank’s franchise, which could impede access to wholesale markets or cause significant outflows. It includes risks from prime brokerage, matched books, debt buyback, early termination of non-margined derivatives and settlement failure risk.
  • Intraday liquidity: the risk that a bank is unable to meet its daily settlement obligations, for example, as a result of timing mismatches arising from direct and indirect membership of relevant payments or securities settlements systems. All banks connected to payment or securities settlement systems, either directly or indirectly, are exposed to intraday liquidity risks.
  • Other: the Pillar 2 framework also consider risks arising from initial margin on derivatives, securities financing margin requirements, intragroup liquidity and liquidity systems and controls.

The Pillar 2 approach applies in a way that is proportionate to each bank’s business model and to the risk that the bank poses to the PRA’s objectives.

The Net Stable Funding Ratio

The NSFR is intended to help to ensure that banks maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. It seeks to limit overreliance on short-term wholesale funding, encourage better assessment of funding risk across all on- and off-balance sheet items, and to promote funding stability.

A sustainable funding structure reduces the likelihood that disruptions to a bank’s regular sources of funding will erode its liquidity position and increase the risk of its failure in a stress. Stability in a bank’s longer-term funding enhances the safety and soundness of banks, in line with the PRA’s objectives.

The NSFR is defined as the ratio of a bank’s available stable funding to its required stable funding. In times of market-wide or idiosyncratic stress, the PRA recognises that NSFRs may fall below 100%.

The NSFR is complementary to the LCR and other elements of the prudential framework.footnote [50]

  1. For the purpose of this Discussion Paper, ‘banks’ refers to banks, building societies, and investment firms subject to the liquidity coverage ratio (LCR) standard (including as modified by the Liquidity Coverage Requirement – UK Designated Investment Firms Part of the PRA Rulebook).

  2. BCBS and FSB

  3. Q&A on the usability of liquidity and capital buffers

  4. BCBS - Principles for Sound Liquidity Risk Management and Supervision

  5. Bank capital and liquidity

  6. On the importance of the confidence channel, see Diamond, D and Kashyap, A (2016), ‘Chapter 29 - Liquidity Requirements, Liquidity Choice and Financial Stability’, Handbook of Macroeconomics, vol. 2, pp 2263-2303.

  7. Such as cash, balances with central banks and government bonds.

  8. Financial Stability Report - June 2018

  9. PRA Supervisory Statement 24/15 ‘The PRA’s approach to supervising liquidity and funding risks’, July 2021

  10. For further information on the PRA’s approach to Pillar 2 liquidity, and the PRA110 template, see PRA Statement of Policy ‘Pillar 2 liquidity’, June 2019 and PRA PS 2/18

  11. The Bank of England’s approach to providing liquidity insurance

  12. For example, firms can ‘pre-position’ a broad range of collateral with the Bank. Pre-positioning allows the Bank  to risk assess, price, value collateral and set a suitable haircut in advance of drawdown, therefore allowing firms to use the Bank’s liquidity facilities more quickly when needed.

  13. BCBS - Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools

  14. PRA SS 24/15 ‘The PRA’s approach to supervising liquidity and funding risks’, July 2021

  15. PRA SS 24/15 ‘The PRA’s approach to supervising liquidity and funding risks’, July 2021

  16. For example, US Globally Systemically Important Banks issued long-term debt during the Covid-19 stress, conceding as many as 100-200 basis points in yield on new issuances.

  17. For example, there is evidence for the period 2016-2020 that where banks were increasing LCRs, they reduced longer-term reverse repo lending against lower quality collateral. See Gerba, E and Katsoulis, P (2021), ‘The repo market under Basel III’, Staff Working Paper No. 954.

  18. Additional detail on the stress scenario

  19. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  20. Charts showing these impacts and the explanation of what these charts show have been previously published in the BCBS report ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  21. The inflows and outflows are expressed in terms of LCR impact, and so do not correspond directly to the magnitude of inflows and outflows experienced by firms.

  22. Speech by Vicky Saporta, ‘Emerging prudential lessons from the Covid stress’, July 2021.

  23. Case study ‘LCR trigger levels for management actions: information from UK banks’ recovery plans’.

  24. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  25. Bank Treasurers’ Views on Liquidity Requirements and the Discount Window

  26. For example, in the UK a bank is expected to notify the PRA without delay if it falls, or is expected to fall, below the level of its quantitative ILG. It should also expect to discuss with its supervisors its plan for restoring compliance with the guidance. PRA SS 24/15 ‘The PRA’s approach to supervising liquidity and funding risks’, July 2021

  27. Q&A on the usability of liquidity and capital buffers

  28. Basel Committee coordinates policy and supervisory response to Covid-19

  29. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  30. FSB - COVID-19 support measures

  31. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  32. Transparency effectively underpins market discipline; and disclosures support transparency if they convey reliable information that can be appropriately interpreted and used by the market. For a broader discussion of the role of regulatory disclosures, see our 2017 Q3 Quarterly Bulletin article.

  33. For example Nier, E and Baumann, U (2006), ‘Market discipline, disclosure and moral hazard in banking’, Journal of Financial Intermediation, vol. 15, Issue 3, pp. 332-361; and see Acharya, V V and Ryan, S G (2016), ‘Banks’ Financial Reporting and Financial System Stability’, Journal of Accounting Research, vol. 54, Issue 2, pp. 277-340 for a review of the literature on banks’ disclosure and financial stability.

  34. Praet, P and Herzberg, V (2008), ‘Market Liquidity and banking liquidity: linkages, vulnerabilities and the role of disclosure’, Banque de France Financial Stability Review – Special Issue on liquidity, no. 11.

  35. Diamond, D and Dybvig, P (1983), 'Bank Runs, Deposit Insurance, and Liquidity', Journal of Political Economy, vol. 91, no. 3, pp. 401-419.

  36. BCBS – Enhancing bank transparency

  37. For example: Pillar 3 disclosures: looking back and looking forward

  38. For example: https://www.bis.org/publ/bcbsc141.pdf.

  39. In a 2019 BCBS survey on liquidity, a large majority of jurisdictions surveyed cited “the potential negative market reaction or stigma that could result from the disclosure of an LCR below 100%” as a driver of banks’ reluctance to use their liquidity. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  40. Matyunina, A, and Ongena, S (2020), ‘Has the relaxation of capital and liquidity buffers worked in practice?’ European Parliament Economic Governance Support Unit Report, PE 651.374. Regulatory requirements and buffers are often used in practice as a proxy of a bank’s standing, with banks below the ‘pass mark’ being typically perceived as less creditworthy than their peers. For example, smaller capital management buffers increase the probability of a bank receiving a lower credit rating, and may be associated with higher funding costs (see, for example, Andreeva, D, Bochmann, P and Couaillier, C, (2020), ‘Financial market pressure as an impediment to the usability of regulatory capital buffers’, Macroprudential Bulletin. Vol. 11. European Central Bank; and Behn, M, Rancoita, E and Rodriguez d’Acri, C (2020), ‘Macroprudential capital buffers – objectives and usability’, Macroprudential Bulletin. Vol. 11. European Central Bank).

  41. For example, Praet, P and Herzberg, V (2008), ‘Market Liquidity and banking liquidity: linkages, vulnerabilities and the role of disclosure’, Banque de France Financial Stability Review – Special Issue on liquidity, no. 11; and Diamond, D and Dybvig, P (1983), 'Bank Runs, Deposit Insurance, and Liquidity', Journal of Political Economy, vol. 91, no. 3, pp. 401-419.

  42. HLBA calibrates outflows to be equal to the absolute magnitude of the largest realised 30-day variation margin inflow or outflow over the previous two years. The BCBS has noted this cyclicality and the Bank of Mexico, for example, took action to mitigate it during the Covid-19 stress. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  43. ‘Spot’ LCR means the LCR at the reporting date; as opposed to prudential regulatory disclosures that entail averaging of LCRs over a longer period. Major EU banks also generally disclose spot LCRs.

  44. Higher frequency liquidity information may be prone to being misinterpreted due to its volatile nature, see Praet, P and Herzberg, V (2008), ‘Market Liquidity and banking liquidity: linkages, vulnerabilities and the role of disclosure’, Banque de France Financial Stability Review – Special Issue on liquidity, no. 11.

  45. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  46. Speech by Vicky Saporta, ‘Emerging prudential lessons from the Covid stress’, July 2021 and references therein.

  47. ‘Early lessons from the Covid-19 pandemic on the Basel reforms’.

  48. Total expected cash inflows are subject to a cap of 75% of total expected cash outflows, so in the denominator of the LCR, net outflows = outflows – min(Inflows, 75% * Outflows). This is to prevent banks from relying solely on anticipated inflows to meet the liquidity standard, and also to ensure a minimum level of HQLA holdings.

  49. For further information see our Statement of Policy.

  50. For example, Behn, M, Corrias, R and Rola-Janicka, M (2019), ‘On the interaction between different bank liquidity requirements’, Macroprudential Bulletin, European Central Bank, vol. 9; and Buckmann, M, Gallego Marquez, P, Gimpelewicz, M, Kapadia, S and Rismanchi, K (2021), ‘The more the merrier? Evidence from the global financial crisis on the value of multiple requirements in bank regulation’, Bank of England Staff Working Paper No. 905.

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