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Causal Capital ~ The Knowledge Capital Specialists

The Flaws in LCR

Last week Causal Capital delivered a speech at the Liquidity Risk Management Symposium in Singapore and the entire presentation page can be found here [LINK].

The focus of our work was on the Liquidity Coverage Ratios LCR banks are now required to measure and while we explained how banks across the planet have been meeting the BCBS guidelines, we also highlighted substantial flaws that exist in the LCR measure. I am going to briefly talk about some of these LCR failings here but before we dive into these conundrums, perhaps we should discuss why this regulatory requirement has come into existence.

There are two terminal ways in which a bank or any business for that matter goes bankrupt. The first is a material failure of the firm's balance sheet structure. In this case the value of the entity's assets are lower than its liabilities and even if the business is able to fund itself in the short term, it is by the true definition of accounting, insolvent.

The other way a bank finds itself at its end is when it is unable to balance short term current liabilities and cash outflows with associated cash inflows. This is liquidity funding in the purist sense and banks that failed during the Global Financial Crisis suffered from both insolvency and funding liquidity risks. The Bank for International Settlements released two guidelines to address these risks; a strengthening of capital which was encapsulated in "The Regulatory Framework for More Resilient Banks" publication and the "International Framework for Liquidity Risk" that addresses funding liquidity.

The new funding liquidity brief requires banks to report, as shown in our presentation [LINK], the LCR ratio which is calculated by taking (High Quality Liquidity Assets) and dividing that number by the Total Net Cash Outflows of the bank.

The formula is utterly simple but its fresh KISS approach for measuring risk in funding liquidity has resulted in massive oversights that could possibly create a more systemic and fragile banking environment than the one we are leaving behind.

Firstly, LCR assumes that the position between High Quality Liquid Assets (HQLA) and the price to pay on Total Net Cash Outflows is stationary but that isn't likely to be the case. Banks that finance themselves cross border in the wholesale market and in currencies that differ from how their balance sheet is represented, will find a substantial market risk element in their LCR report that isn't being captured.

The second key concern is that the definition of HQLA is relatively narrow and banks have started to hold concentrated pools of assets. During a market rout banks will dispose of HQLA en masse to finance their business and in doing so, they contribute in an additive way to the market rout they are attempting to avoid. This is a systemic feedback loop that is very much a latent hazard in the LCR requirement at the moment.

An example was delivered that demonstrated a matrix calculation showing LCR ratios to be insufficient given specific confidence levels of market risk.

Finally, the LCR ratio is a floating position and for banks that report this information infrequently will quickly discover that LCR limits are a very limited measure of risk. In risk management one must always be concerned when the measure of something doesn't even encapsulate a potential reality at low levels of risk. You should be extra cautious when how you report risk is adjunct and detached from how you manage it.

Don't misunderstand me, the intentions under LCR reporting are definitely sound given what happened during the Global Financial Crisis but the way in which LCR reporting is being delivered should give rise to great concern among risk practitioners.

The deadline for compliance with LCR reporting requirements was January 2015 for a large swathe of banks and as per usual, most regulators and financial institutions are simply ticking the compliance box for LCR rather than exploring its material weaknesses. Even when banks are below the strange haircut structure proposed in the LCR reporting system, they are still being ticked off as green good to go. This is not what risk management should be about and during our presentation we demonstrated how the LCR reporting system could be improved with a co-variance matrix that supports stress testing.

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