Liquidity Risk Disclosure Could be a Game-Changer
On paper, President Obama’s plan to levy a 0.15 percent financial crisis responsibility fee on the largest and most levered Wall Street firms may seem straightforward, but determining how leveraged they are may be a problem.
If you recollect, one of the reasons the financial crisis reached the heights it did was because many banks and companies did not have an accurate way of measuring how much or the value of the illiquid mortgage backed securities they had on their books. On top of that, the international Basel Committee on Banking Supervision has released what is being termed Basel III to possibly be implemented in 2012.
This framework actually offers prescriptive guidance for such important measurements as liquidity coverage ratio and net stable funding ratio. It sets minimum standards for these two important bank capital ratios.
Technically, the changes proposed by the Basel committee in its two consultative papers in December 2009 (Strengthening the resilience of the banking sector and International framework for liquidity risk measurement, standards and monitoring) wouldn’t affect U.S. financial institutions until at least 2011 depending on when the country adopts Basel II, which was proposed in 2007. However, the U.S. Treasury issued interagency guidance last June that would set new standards for funding and liquidity risk management. The final guidance is due out in the next couple of weeks.
So what does that all mean for non-banks? Well, it could have an impact on company treasury activity. An unintended consequence of narrower ratios and stricter capital requirements could affect the markets of short-term securities that companies depend on for liquidity.
“Banks need to look at capital on a long-term basis,” Peter Davis, a principal in Ernst & Young’s Financial Services Office, said at a recent press briefing. “Some banks may find the costs of doing certain businesses may change, particularly for low risk, capital intensive businesses.”
When asked to specify which markets would be affected, he cited securities lending, repurchase agreements (usually involving government securities), or repos, and reverse repos. “They [the banks] have to assess what is profitable and not profitable,” he said. [Read Ernst & Young's A Rise in Liquidity Risk: Questions and Answers.]
So if banks start doing fewer transactions in such short-term capital markets, non-banks could be forced to look more closely at what short-term securities they use.
A big concern for bank boards is the governance questions raised by the proposed Basel and Treasury interagency guidance.
For example, the recent Basel guidance for a global capital framework would:
- Introduce a liquidity standard
- Strengthen the quality, consistency and transparency of the capital base
- Strengthen risk coverage of capital via capital requirements surrounding counterparty credit risk exposures (particularly derivatives, repos and securities lending)
- Introduce a formal leverage ratio
- Promote a countercyclical approach to building capital buffers.
Under the interagency (Federal Reserve, FDIC, Office of the Comptroller of the Currency and Office of Thrift Supervision, National Credit Union Administration) guidance, bank boards must:
- Be responsible for liquidity risk assumed by the financial institution and establish liquidity management strategies, policies and procedures
- Understand the nature of the liquidity risks
- Establish executive level lines of authority for managing liquidity risk
- Enforce management’s duties to identify, measure, monitor and control liquidity risk
- Understand and periodically review the institution’s procedures for handling potentially adverse liquidity events
- Comprehend the liquidity risk profiles of important subsidiaries.
In order to carry out such actions, banks would have to have a better handle on specific information that they may not have captured in the past, Davis said.
“They may have significant data components that weren’t disclosed before,” he said. “All of those processes and data will be subject to a higher level of scrutiny and governance. For example, on liquidity there is some data that is not being [captured] like it needs to be.”
And, similar to the assessment of internal controls of financial reporting under the Sarbanes-Oxley Act, there would need to be attestation of the Basel-like disclosures. “The CFO and CRO [Chief Risk Officer] may want to know who the key stakeholders are and sign off on the [credit model] processes,” Davis said.
My point for leading into this post with the President’s financial crisis responsibility fee is that, while it is designed to pay back taxpayers for the TARP (Troubled Asset Relief Program) assistance to some of the largest financial institutions, the lack of knowledge around how much some banks are leveraged is more important than whether or not such a fee should be levied. In this climate, survival is all about how leveraged a company is. And the first step to deleveraging is ascertaining how much your company is leveraged and how much liquidity it has.
Worth Reading …
The Conference Board’s recent Executive Action Report series on The Role of the Board in Turbulent Times included an article written by Mark Bergman of Paul, Weiss, Rifkind, Wharton & Garrison LLP titled Assessing Corporate Strategy: Liquidity Needs, Financial Transactions, Internal Controls and Disclosure. In it, the author stresses that the board should regularly have management report to it on access to commercial paper or short-term funding resources, maturity dates of term loans and termination dates of revolving credit as well current exposure to the securitization markets. To order the full report, click here.
- Gary Larkin
Excellent post.
Bill Adams says: Enjoyed your post on liquidity risk disclosure. It’s a pet issue of mine. (I wrote an article on Chinese bank counter-party risks in 2008. But I think the quote you cite about the tax on non-deposit liabilities driving up the cost of short-term financing by commercial paper, etc., may be a little one-sided. Financing costs for non-financial corporations in 2006 might have been higher if the tax had been in place then. But financing costs in 2008 might have been lower, since the tax would have encouraged banks to be less leveraged and so better insulated against a financial crisis. Long-term, it’s very hard to say if the gains from the financial crisis averted would be larger than the losses from higher financing costs between crises. Economists have a hard time measuring gains from stability vs. losses from efficiency. But the possibility seems worth mentioning to me.
Bill Adams
Resident Economist
The Conference Board
China Center for Economics and Business
OK, let’s not fool ourselves – the “financial crisis responsibility fee” has nothing to do with making sure the government is repaid TARP lending to the “largest financial institutions”. Last I checked just about all of lartest financials have paid back everything already and with each pay-back and subsequent warrant sale the Treasury touts the positive rate of return it has made on each of those loans. Where the government is not going to get paid back is from the lending to AIG, GM and Chrysler. Last time I checked they are not banks and the last two are not financial institutions at all (lending arms notwithstanding). The financial crisis responsibility fee is a politically motivated, punitive tax, whose biggest impact is likely to be to reduce market transparency and liquidity.