VoxEU Column EU institutions Financial Markets

Recent studies reinforce the case for the Liquidity Coverage Ratio

Europe aims to implement Liquidity Coverage Ratio regulation by the end of 2014. This column discusses recent evidence on its impact. It finds that EU banks have not adjusted by reducing lending to the real economy, to SMEs, or to trade finance. Despite this adjustment, substantial liquidity risk exposure remains. Overall, the benefits of the LCR outweigh the costs by far.

With the underpricing of liquidity risk prior to the crisis, a return to the same pre-crisis liquidity pattern is not expected. There is widespread consensus that banks’ extensive pre-crisis reliance on deep and broad unsecured money markets is to be avoided in the future (see e.g. IMF 2013). Creating substantial liquidity buffers across the board is the explicit aim of a number of regulatory responses to the crisis, such as the CEBS Guidelines on liquidity buffers (CEBS 2009) and the LCR. As time goes on, liquidity management needs to be prepared for the materialisation of tail risks; that is, the simultaneous closure of various funding and assets markets and the tapping of off-balance sheet positions. These are strongly positively correlated in the case of solvency risks (see Schmieder et al 2012).

The implementation of the Liquidity Coverage Ratio (LCR) in the EU is due by December 31st, 2014.1 The introduction of the LCR heeds a core lesson from the financial crisis. The reform shall safeguard that banks’ liquidity risk exposure is matched by sufficient liquidity risk bearing capacity. The Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR) aim to implement the LCR in the EU.2 During the course of the political debate, it became apparent that the LCR had little political support in the EU (see e.g. Schmitz in a VoxEU piece, 2012). Unfortunately, concerns materialised, and the CRR only implemented reporting requirements for the LCR. Instead, EBA was mandated to study a substantial number of different issues, which includes the impact of the LCR on economic growth and credit supply as well as the definition of high quality liquid assets (HQLA). Both reports were published on December 20th, 2013.3 The main message is that the benefits of the LCR by far outweigh its costs.

There are many benefits from having a sound LCR in place. The LCR is meant to put banks in a position to withstand sudden funding stress for one month. Related to this, the Net Stable Fund ratio (NSFR) attempts to limit the maturity mismatch conditional on banks’ asset composition, and over-reliance on short-term wholesale funding in particular.4 Recent empirical analysis by the IMF (2013) has shown that banks that face higher currency volatility, stronger regulatory frameworks, and stricter disclosure requirements rely less on wholesale funding. Banks’ funding structures affect their stability, and although most banks have improved their funding structures since the crisis began, distressed banks remain vulnerable. More equity and less debt (in particular less short-term debt), lower loan-to-deposit ratios, and more diversified funding structures improve the stability of banks.5

Potential unintended consequences of the LCR

Critics of the LCR fear that it might have a material detrimental effect on economic growth, lending to the real economy (in particular lending to SMEs and Trade Finance), and EU financial markets. Similarly, the IMF (2013) cautions that some aspects of Basel III’s liquidity regulation may encumber more assets, thereby increasing unsecured bondholders’ potential losses. As such the LCR is complemented by the proposed EU bail-in rules. As the below figure illustrates, covered bond issuance and central bank assistance have increased encumbrance in many countries.6 The latter underscores the need to introduce an effective LCR. The EBA report discusses these fears in detail; they are rejected by the evidence.

Figure 1. Asset Encumbrance: December 2007 and June 2013 (% of Total Assets)

Source: IMF (2013).

The LCR in the EU banking sector

The CRR defines LCR reporting requirements for EU banks, but the first reporting data is expected in March 2014. As the EBA reports were to be submitted to the EU Commission by December 31, 2013, the EBA had to initiate a voluntary data exercise. The reports focus on data as of Q4 2012.7 The sample contains 357 EU banks from 21 EU countries, 50 Group 1 banks (large banks, CT1 capital of EUR 3 billion or above), and 307 Group 2 banks (CT1 capital below EUR 3 billion). Their total assets sum to EUR 33,000 billion, the aggregate HQLA to EUR 3,739 billion and their net cash outflows to EUR 3,251 billion. Since the CRR does not contain an LCR, the analysis has to be based on the Basel III baseline scenario calibration as of January 2013.

Bank in the EU feature substantial liquidity risk exposure

We first look at the plain unweighted data on banks’ net cash outflows over the next thirty days (NCOF, including contingent outflows) and their holdings of HQLA at the country level. Remarkably, banks’ net cash outflows over the next thirty days range from 40 to 85%of total assets as of Q4 2012. Regardless of the calibration of the LCR, we read this as evidence that the banks in the sample have substantial contractual obligations in the short-term. Maturity transformation is an integral function of banks. As it involves risks, society also expects banks to hold a reasonable amount of risk bearing capacity to deal with the associated liquidity risk; i.e. HQLA. The holdings of HQLA range from 7 to 17% of total assets. In two thirds of the countries the gap between unweighted net cash outflows and HQLA amounts to more than 50% of total assets. The plain data supports the case for a functional quantitative liquidity regulation (Schmitz and Ittner 2007) that aims at balancing EU banks’ liquidity risk exposure and the respective risk bearing capacity.

The recalibration of the LCR in January 2013 watered down the standard significantly

As of Q4 2012, the LCR of the aggregate sample amounts to 115% (G1 banks 111% and G2 banks 134%). Bearing in mind that the LCR is supposed to be phased-in from 2015 (60%) to 2019 (100%), the adjustment process is well advanced. Indeed, it is questionable how effective the recalibrated LCR is in steering banks’ balance sheets.8 It does seem in economic terms that the LCR does not constitute a binding constraint for many banks in the EU. The recent liquidity stress experience, the phase of the economic cycle, as well the ample liquidity injected into the system by central banks have also led many banks to increase their HQLA holdings.

The aggregate liquidity gap is sensitive to the underlying concepts of measurement.9 Assuming that liquidity is redistributed among banks and across countries in the EU, the aggregate liquidity gap is zero (net liquidity gap). Allowing for the redistribution of liquidity among banks only at the country level increases the liquidity gap in the EU to EUR 115 billion (0.35% of total assets in the sample). However, if one assumes that liquidity is not distributed among banks at all, the aggregate liquidity gap in the EU amounts to EUR 264 billion (0.8% of total assets) as compared to the 2019 objective for the LCR of 100%. Furthermore, banks report additional holdings of HQLA of EUR 45 billion which are not yet eligible due to operational requirements. These will become eligible once the LCR will be introduced, so that the country level net gaps drop to EUR 71 billion (0.22% of total assets) from EUR 115 billion.

Nevertheless, the dispersion among countries and banks is high. Out of the 21 countries represented in the sample only five feature a net liquidity gap at the country level.10 Country-level LCRs range from 85.5 to 281.1%. Out of the 357 banks in the sample 235 (66%) already have LCRs above 100%, but 60 (17%) still feature LCRs below 60%.

The relatively modest aggregate gross liquidity shortfall of EUR 264 billion is partly due to the recalibration of the LCR in January 2013.11 The data shows that without it the shortfall would have amounted to about EUR 780 billion; similarly the aggregate LCR would reached about 90% rather than the actual 115%.

To adjust to the LCR, empirical evidence suggests that EU banks did not significantly reduce lending to the real economy, to SMEs, or to trade finance

In general, banks with an estimated LCR shortfall have a number of ways in their funding plans to become compliant (e.g. lengthen the maturity of their (unsecured) wholesale funding beyond 30 days, promote deposits, reduce costly uncommitted credit lines or increase their proportion of liquid assets in their balance sheets.

Between Q2 2011 and Q4 2012 banks adjusted their balance sheets by mainly by increasing their holdings of HQLA (especially drawable central bank reserves, sovereign bonds, and covered bonds). Reductions of net cash outflows played a lesser role. In order to examine the main drivers of banks adjustment the report provides a multivariate analysis based on two approaches.12

In the first approach, changes of the LCR between Q2 2011 and Q4 2012 (in percentage points) are regressed on a number of balance sheet components (unweighted LCR, leverage ratio (LR), and NSFR data normalised as shares of total assets), country level control variables (real GDP growth rates, a dummy for Eurozone banks), and data from the respective bank lending surveys (where available). The second approach studies which variables explain the transition from non-compliance (LCR<100% in Q2 2011) to compliance (LCR≥100% in Q4 2012).13 The main drivers of adjustment with highly significant coefficients across all specifications in both approaches are:

  • Increasing shares of Level 1 HQLA (i.e. drawable central bank reserves, zero risk weight and non-zero risk weight domestic sovereign bonds, covered bonds), and
  • Decreasing shares of non-operational deposits from non-financial corporates maturing within the next 30 days.

The EBA is explicitly mandated to report on the impact of the LCR on lending to the real economy (especially SMEs) and trade finance.14 The analysis in both approaches across all specifications shows that neither changes of the share of loans to non-financial corporates, to retail/SME customers, nor to trade finance (or their respective starting levels in Q2 2011) have a significant impact on changes of the LCR in the sample. To the contrary, in the logit approach an increasing share of loans to non-financial corporates even increases the probability of a transition from non-compliance to compliance.

The overall finding that the LCR does not reduce lending to the real economy, SMEs, or trade finance is corroborated by a recent survey of Zeb (2013) which finds that banks in their sample (23 Austrian and German banks) mainly plan to adjust by reducing unsecured/secured outflows, increasing HQLA, and committed lines, but not by cutting loans to the real economy. A comprehensive study on a natural experiment in the UK (Banerjee and Mio 2013) arrives at similar conclusions: the strengthening of quantitative liquidity regulation in the UK in 2010 did not reduce lending to the real economy. The EBA report also contains case studies from two countries that have already introduced liquidity regulation very similar to the LCR (Sweden and Switzerland). Both conclude that the new standards did not reduce lending to the real economy or negatively affect economic growth. The finding is also in line with our own findings concerning the pecking order of deleveraging in the euro area banking system (Puhr et al. 2012).

The impact on financial markets of an increased demand for HQLA is likely to be small

How does an extra demand for HQLA in the EU of about EUR 70 to 264 billion (assuming no adjustments of net cash outflow, but allowing for redistribution of liquidity/ruling out such distribution, respectively) impact EU financial markets? Ideally, we would like to analyse this question in a comprehensive model of EU financial markets and the real economy. An increasing demand for HQLA (e.g. government bonds, high quality covered and corporate bonds) would lead to increased issuance and/or reduced interest rates, ceteris paribus, which, in turn, would have a positive impact on growth and reduce the costs of funding for the real economy. However, the EBA report takes a more simplified route. Based on market data, the EBA (2013b) report tries to gauge the total size of EU HQLA markets. Taking into account the Basel III definition of HQLA and the associated eligibility criteria, operational criteria, and hair-cuts, the EBA (2013b) exercise results in a total market size of EUR 11,000 billion. The extra demand of EUR 70 to 264 billion amounts to only 0.6 to 2.4% of total market size. Phased-in until 2019, we expect this extra demand, even under the restrictive simplifications, not to have any detrimental impact on EU financial markets.15

The EBA report on HQLA finds that the Basel III definition of HQLA is too broad for the EU; some asset classes (i.e. equity) are too volatile, both in terms of price and in terms of liquidity value. Nevertheless, the EBA proposed not to deviate from the Basel III HQLA definition. However, the Basel III definition also implies that only assets that are actually (extremely) liquid and of (extremely) high credit quality are considered HQLA within the asset classes that are eligible.

The macroeconomic costs of the LCR are likely to be minimal

The EBA report also provides a comprehensive and transparent impact assessment of the LCR on the EU macroeconomy. The assessment proceeds along three steps:

  • Firstly, the expected opportunity costs of banks’ behavioural adjustment are estimated.16
  • Secondly, under the assumption that banks cannot pass the additional costs on to customers, their Return on Assets (RoA) decreases by an average of 0.02% (though, initially the LCR impact on profitability will be larger for individual banks that rely heavily on profits from uncovered maturity transformation; the lengthy transition period addresses this concern). If banks can shift the incremental costs to (some of) their customers,17 this results in a very conservative estimate of repriceable assets of 20 and 31% of banks’ total assets during the phase-in period and in the long-run, respectively. Across the EU, loan spreads would increase by a mere of 7 basis points (based on the central estimate of expected opportunity costs of 2.7%).
  • Thirdly, this translates into a macro-economic impact of -5 and -3 basis points (deviation from GDP levels without the LCR after three periods) during the phase-in period and in the long-run, respectively. The results are robust with respect to a number of sensitivity analyses for reduced pass-through rates of incremental costs to customers and the other two behavioural adjustment strategies.

Based on the data presented in the EBA report, the case for an effective quantitative liquidity regulation in the EU is overwhelming. A comprehensive literature survey of empirical literature corroborates this conclusion.

What are the social costs of strengthening the liquidity risk management of EU banks? Neither the analysis presented in the EBA report, nor the experience of countries that recently introduced LCR-like regulation, nor the evidence of the literature contain evidence that the LCR is likely to reduce lending to the real economy in the EU. Furthermore, high credit growth at interest rates that do not cover credit and liquidity risk costs should not be a policy objective (Kopp et al. 2010). The mispricing of credit leads to the misallocation of capital and risk. BCBS (2013b) argues that unpriced liquidity insurance provided by central banks (the lender of last resort) lead to the mispricing and the potential socialisation of liquidity risk. Banks’ costs of the LCR partly consist of the decreasing value of this subsidy. Thus, they are not social but private costs, as the costs for banks are benefits to the public (plus the distortions associated with the unpriced subsidy are partly removed).

The macro-economic costs of the LCR are minimal. Across the EU this results in an average increase in loan spreads of 7 basis points (based on the central estimate of expected opportunity costs of 2.7%). This translates into a macro-economic impact of -5 and -3 basis points (deviation from GDP levels without the LCR after three periods) during the phase-in period and in the long-run, respectively. Finally, the EBA report shows that the LCR and other regulatory ratios are complementary rather than conflicting measures.

Disclaimer: The views expressed in this column are those of the authors and do not necessarily represent those of the OeNB/IMF/EBA or OeNB/IMF/EBA policy. Stefan W Schmitz chaired the EBA Project Team on the LCR Impact Assessment.


Banerjee, R., H. Mio (2013), “Measuring the Impact of the UK Liquidity Regulation on Bank Behaviour,” paper presented at the Bank of England, 20th June 2013.

BCBS (2013a), “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools”.

———, (2013b), “Liquidity stress-testing: a survey of theory, empirics and current industry and supervisory practices,” Basel Committee of Banking Supervision WP 24, Basel.

Bologna, P, (2011), “Is There a Role for Funding in Explaining Recent US Banks’ Failures?” IMF Working Paper No. 11/180 (Washington: International Monetary Fund).

Committee of European Banking Supervisors (2009), “Guidelines on liquidity buffers and survival periods,” London.

Demirgüç-Kunt, A, and H Huizinga, 2010, “Bank Activity and Funding Strategies: The Impact on Risk and Returns,” Journal of Financial Economics, Vol. 98, No. 3, pp. 626–50.

EBA (2013a), “Report on Impact Assessment for Liquidity Measures under Article 509 (1) of the CRR,” December 20, 2013.

———(2013b), “Report on appropriate uniform definitions of extremely high quality liquid assets (extremely HQLA) and high quality liquid assets (HQLA) and on operational requirements for liquid assets under Article 509(3) and (5) CRR,” December 20, 2013.

Huang, R, and L Ratnovski, (2011), “The Dark Side of Bank Wholesale Funding,” Journal of Financial Intermediation, Vol. 20, No. 2, pp. 248–63.

International Monetary Fund (IMF), (2013), “Changes in bank funding pattern and financial stability risks”, in: “Global Financial Stability Report”, October 2013, Washington, DC, pp. 105–48.

Kopp, E., C. Ragacs, S. W. Schmitz (2010), “The Economic Impact of Proposals to Strengthen Bank Resilience – Estimates for Austria,” Financial Stability Report No. 20, 2010, 90-119

Puhr, C, S. Schmitz, R. Spitzer and H. Hesse (2012), “Room for manoeuvre: The deleveraging story of Eurozone banks since 2008,” June 14, VoxEU Blog

Schmieder C, H Hesse, B Neudorfer, C Puhr, and S W Schmitz (2012), “Next Generation System-Wide Liquidity Stress Testing,” IMF Working Paper 3.

Schmitz, S W and A Ittner (2007), “Why central banks should look at banks’ liquidity risk management,” Central Banking Vol. XVII No. 4, 32-40.

Schmitz, S W (2012), “The LCR under Siege”, VoxEU.org, 28 July.

Schmitz, S W (2013), “The Impact of the LCR on the Implementation of Monetary Policy,” Economic Notes Vol. 42 No. 2, 135-170.

Shin, H S, (2009), “Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis,” Journal of Economic Perspectives, Vol. 23, No. 1, pp. 101–20.

Vazquez, F, and P Federico, (2012), “Bank Funding Structures and Risk: Evidence from the Global Financial Crisis,” IMF Working Paper No. 12/29 (Washington: International Monetary Fund).

Zeb (2013), „Aktuelle Herausforderungen im Liquiditätsrisikomanagement – Fokus LCR und Liquiditätskostenverrechnung,“ Wien/Münster.

1 Article 460 of the CRR requires the EU Commission to adopt the delegated act by June 30th, 2014; it shall enter into force by December 31st, 2014, though it shall not apply before January 1st, 2015. For the definition of the LCR see BCBS (2010, 2013a).

2 The CRR implements reporting requirements as of 2014. It does not define an LCR, let alone enforce compliance with the LCR.

3 See EBA (2013a) and EBA (2013b)

4 The NSFR is currently under review by the BCBS.

5 Many empirical studies provided evidence that the reliance on wholesale funding was a major source of bank vul-nerability during the crisis (Shin 2009, Demirgüç-Kunt and Huizinga 2010, Bologna 2011, Huang and Ratnovski 2011, Vazquez and Federico 2012).

6 The EBA report also discusses the interaction between the LCR and monetary policy implementation; but a discussion is beyond the scope of this blog (see also Schmitz 2013).

7 More recent data could not be analysed due to the comprehensive data quality checks and the decision making structure of the EBA.

8 The reduction of the run-off rates of non-operational deposits of non-financial companies and committed liquidity facilities to non-financial corporates as well as the broadening of HQLA.

9 The EBA study is based on single bank data and mostly consolidated data.

10 In the EBA report on the LCR impact assessment countries are indexed as C1 to C21.

11 The recalibration was driven by lower run-offs for non-financial corporate deposits and committed lines. It was motivated by the desire to agree on an internationally harmonised liquidity standard despite fierce opposition from a few countries in the BCBS and from banks.

12 Furthermore, both approaches find that neither changes to other regulatory ratios (CET1, LR, and NSFR) nor their starting levels in Q2 1011 contribute significantly to the explanation of variations of the changes of the LCR across banks.

13 Banks in the sample that had been non-compliant in Q2 2011 but became compliant in Q4 2012 are assigned the value 1, all others the value 0.

14 As leverage ratio and NSFR data are not available for all banks in the sample back to Q2 2011, the sample consists of 97 EU banks. About 10 model specifications are tested in each approach taking into account different control variables (by OLS and Logit regressions, respectively). In all specifications the variables are jointly highly significant; the explanatory power is satisfactory (R² 50 and 40%, respectively).

15 The relevant data is available, as both have to be reported in the leverage ratio template.

16 From a dynamic perspective, the interplay between the supply and demand of HQLA and the price mechanism is a key objective of the LCR. In the past crisis banks increased liquidity risk exposure during a credit boom and relied on central banks as lender of last resort. The LCR aims at preventing this. In financial markets supply/demand of HQLA is endogenized by the price mechanism; with the LCR, credit booms feed into HQLA demand and prices, and liquidity is priced more accurately and allocated more efficiently.

17The estimates take into account differences in the credit risk exposure associated

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