Prepared by Nadya Wildmann, Beatrice Scheubel, Luisa Fascione, Georg Leitner
Efforts made by the Basel Committee on Banking Supervision (BCBS) to reform financial regulation in response to the global financial crisis (GFC) included introducing regulatory standards for liquidity risk. During the GFC, several banks failed because they had significant maturity mismatches on their balance sheets. These banks did not have sufficient liquid assets to match liability outflows. The ensuing confidence crisis caused a widespread liquidity crunch in the interbank market. In response, the BCBS reformed its regulatory standards, introducing a new measure aimed at ensuring the short-term resilience of the liquidity risk profile of banks.
The BCBS established the LCR standard in 2013. The LCR aims to ensure that banks maintain a liquidity buffer on their balance sheets which can be liquidated quickly during a period of liquidity stress. In particular, the LCR is a forward-looking measure which requires banks to hold a sufficient stock of high-quality liquid assets (HQLA) that can be converted into cash easily and immediately to survive a period of significant liquidity stress lasting 30 calendar days:
The EU implemented the LCR in line with the Basel Framework requirements and applies it to all banking institutions in the EU, by default at both consolidated and individual level. Following a three-year phase-in period, the minimum LCR requirement of 100% came into effect on 1 January 2018.
The March 2023 banking turmoil raised the question of whether the LCR works as intended. The stress scenario in the LCR entails a liquidity shock which is calibrated based on the experience of the global financial crisis. The liquidity shock constitutes a significant – but not worst-case – stress scenario. For example, for stable retail deposits, which on average constitute the largest share of deposits for significant euro area banks, the LCR assumes an outflow rate of 5% for its 30-day liquidity stress scenario. During the March 2023 banking turmoil, actual deposit outflows for the affected banks in the United States (mostly uninsured deposits) and Switzerland (mostly non-financial corporate deposits) were significantly higher than the LCR run-off assumptions for those deposits. As highlighted in Table A, Silicon Valley Bank lost 85% of its total deposits over a two-day period. For First Republic Bank and Credit Suisse, total deposit outflows stood at 57% and 21% respectively over a 90-day period. It should be noted that total deposit outflows as reported by the US and Swiss authorities may not be perfectly comparable with the net deposit outflows available in European banking supervision reporting. Correspondingly, the BCBS is currently examining whether specific features of the Basel Framework, including liquidity risk, performed as intended during the turmoil. This is especially warranted in an environment in which higher and more rapid outflow rates may also be expected in the future due to the digitalisation of banking and the potential sentiment-amplifying impact of social media.
Cash outflows and selected categories of retail and wholesale deposits, March 2023
Observed outflow rate
Silicon Valley Bank
First Republic Bank
Average (net) outflows for the euro area SIs
Retail less stable
The LCR is not designed to cover all tail events involving deposit outflows, such as bank runs: instead, it should ensure that banks can withstand a certain liquidity stress scenario. The LCR is designed to be a minimum standard for liquidity risk and has, as such, only limited early warning properties to identify extreme peaks in liquidity stress. Banks are expected to conduct their own internal stress tests to ascertain their required level of liquidity beyond this minimum.
Moreover, some liquidity risks, such as funding concentration or intraday liquidity risk, are not explicitly captured in the LCR, which is why the BCBS has introduced specific liquidity monitoring tools for supervisors. These tools can help supervisors to better assess a bank’s liquidity risk profile, although their availability may vary across BCBS jurisdictions. Supervisors can apply more stringent liquidity requirements under Pillar 2, depending on the bank’s liquidity risk profile.
The March turmoil has not resulted in significantly higher outflow rates for institutions covered by ECB banking supervision. Since January 2018, when the LCR came into force in the EU, significant banks’ LCRs stood comfortably above the minimum of 100%. Chart 1, panel a) shows that the average LCR for significant institutions in the euro area has remained above 150% since the coronavirus (COVID-19) period, helping to contain the fallout from recent banking stress in the United States and Switzerland. Following the events of March, contagion fears remained short lived amid solid euro area bank fundamentals. Significant institutions in the euro area did not experience considerably higher net outflow rates since March 2023.
For significant banks supervised by the ECB, the available evidence confirms that the LCR run-off rates covered most significant net deposit outflows during stress episodes between 2016 and 2023. Chart 1, panel b) shows all observed net outflows over the whole observation period for the stable retail deposit class, which is one of the most significant categories by share of total deposits. Since data on gross deposit outflows are not reported in the supervisory statistics, net outflows constitute a useful proxy for gross outflows when net flows are significantly negative, as it can then be assumed that the relative importance of gross deposit inflows is more limited. Around 92% of all observed net outflow rates were covered by the LCR for that category between 2016 and 2023. Further analysis of net retail outflows during stress periods highlights that few net outflows were higher than the corresponding LCR run-off factor, particularly during the COVID-19 period. Some outliers were also recorded for other selected stress periods. Chart A, panel c) shows that the median and the interquartile range (where 50% of net outflows are located) are larger during the COVID-19 period for euro area significant institutions, with more observations above the median. Taken together, these observations call for further analysis of deposit outflows to gain a better understanding of the underlying drivers.
LCR and net deposit outflows for euro area banks have both been in line with their respective regulatory thresholds
a) LCR over time, 2016-2023
b) Observed net outflows – stable retail deposits, 2016-23
c) Observed net outflows – total deposits, COVID-19 period and banking turmoil
(y-axis: number of observations, x-axis: net outflows, percentages)
The March turmoil highlighted the impact of tail events for which the LCR has not been designed. The early identification of outliers reflecting tail risks is therefore essential and may require more granular and higher-frequency reporting during normal times. Comparing the net outflow rates during the March turmoil for significant institutions and affected banks suggests that for affected banks the March events may have constituted one of the tail events for which the LCR has not been designed. Consequently, the ongoing discussion should shift towards the need for better supervisory metrics to detect such tail risks. This may require more granular and higher-frequency supervisory reporting and monitoring.
In the EU, ECB Banking Supervision and the national supervisors already have the authority to request additional and higher-frequency reporting from banks for supervisory purposes. Banks located in the EU are required to report the LCR to supervisors on a monthly basis, so data typically refer to the situation at the end of the respective month. However, the supervisor has the option of increasing reporting frequency to weekly, or even daily. As an example of this, ECB Banking Supervision has recently initiated weekly liquidity reporting following the March turmoil. To enhance the pre-emptive and early identification of tail risks, additional supervisory scrutiny could include the more frequent reporting of liquidity and funding data, even in a business-as-usual environment, as well as additional standardised stress indicators to complement the analytical toolbox available to supervisors under Pillar 2.
This box has shed light on the design, purpose and limitations of the LCR and has highlighted the need to gain a better understanding of the behaviour of deposit outflows. The LCR was designed as a minimum requirement to protect banks against potential failure caused by liquidity mismatches in their balance sheets. The LCR should not, therefore, be expected to serve as an early warning tool or a remedy for the type of rapid, extreme deposit outflows observed during the March banking turmoil in the United States and Switzerland. The March events, however, have served as an indication that there could be merit in reviewing and better understanding depositor behaviour. In particular, the use in banking of digitalisation and social media could affect depositor behaviour and might have a longer-lasting effect on run-off rates.
Looking ahead, buffer usability concerns warrant further monitoring to ensure the effective functioning of the LCR framework. While the LCR was not designed to cover tail events, its use as a buffer can provide banks and authorities time to take appropriate actions. However, the BCBS’s report on the lessons learned from the COVID-19 experience provides an indication that banks might, in practice, be reluctant to use their liquidity buffers in times of liquidity stress (i.e. to allow their LCR to fall below 100%). Reasons for such behaviour include potential market stigma, uncertainty about supervisory response or a desire to maintain a certain level of reserves to withstand potential further stress. However, if banks are unwilling to use liquidity buffers this might lead them to engage in exaggerated defensive measures, which could negatively affect the vital services banks provide to the economy.
I'm an expert in financial regulation and banking supervision, with a comprehensive understanding of the Basel Committee on Banking Supervision (BCBS) framework and its initiatives. My expertise is grounded in a deep knowledge of liquidity risk management and the regulatory standards introduced post the global financial crisis (GFC). I have a robust understanding of the Basel III framework, specifically the Liquidity Coverage Ratio (LCR), and its implications for banking institutions globally.
The article you provided discusses the BCBS's efforts to reform financial regulation in response to the GFC, focusing on liquidity risk and the introduction of the LCR standard in 2013. The LCR is designed to ensure that banks maintain a sufficient liquidity buffer to survive a period of significant liquidity stress lasting 30 calendar days.
Key concepts discussed in the article:
Global Financial Crisis (GFC): The article highlights the background of the GFC, emphasizing that significant maturity mismatches on bank balance sheets led to failures during the crisis.
Liquidity Coverage Ratio (LCR): The LCR is a regulatory standard introduced by the BCBS in 2013. It mandates that banks hold a sufficient stock of high-quality liquid assets (HQLA) to cover net cash outflows over the next 30 calendar days, with a minimum requirement of 100%.
Implementation of LCR in the EU: The European Union (EU) implemented the LCR in line with Basel Framework requirements, applying it to all banking institutions in the EU. The minimum LCR requirement of 100% came into effect on January 1, 2018, following a three-year phase-in period.
March 2023 Banking Turmoil: The article discusses a banking turmoil in March 2023 and questions whether the LCR effectively worked as intended. Actual deposit outflows during this period were higher than the LCR run-off assumptions, leading to a reassessment of the Basel Framework's performance.
Stress Scenarios and Liquidity Shock: The LCR stress scenario includes a liquidity shock calibrated based on the GFC experience. The March 2023 events raised concerns about the adequacy of the stress scenarios, with deposit outflows exceeding LCR assumptions.
Supervisory Tools and Pillar 2: The article mentions that some liquidity risks, such as funding concentration or intraday liquidity risk, are not explicitly captured in the LCR. Supervisors can use specific liquidity monitoring tools and may apply more stringent liquidity requirements under Pillar 2, depending on a bank's liquidity risk profile.
Post-Implementation Performance: The article presents data on the post-implementation performance of LCR for significant banks supervised by the ECB. It suggests that, on average, LCRs remained above 150% since the COVID-19 period, indicating resilience in the face of banking stress.
Tail Events and Supervisory Reporting: The article emphasizes that the LCR is not designed for all tail events, and better supervisory metrics are needed to detect such risks. The discussion suggests the possibility of more granular and higher-frequency reporting to enhance the identification of outliers and tail risks.
Depositor Behavior and Digitalization: The article raises concerns about the impact of depositor behavior, especially in the context of digitalization and social media. It suggests that the use of digital channels might have a longer-lasting effect on deposit run-off rates.
Buffer Usability Concerns: The article concludes by discussing concerns about the usability of buffers, acknowledging that while the LCR was not designed for extreme events, its use as a buffer provides time for appropriate actions. However, banks may be reluctant to use their liquidity buffers due to various factors.
In summary, the article provides a comprehensive overview of the Basel III LCR framework, its implementation, and the challenges observed during a specific banking turmoil in March 2023, highlighting the need for ongoing scrutiny and potential enhancements to supervisory metrics.