Basel liquidity ratios continue to worry South African banks

Despite amendments to the Basel Committee’s controversial liquidity ratios, South African banks still fall well short of the proposed standards. Consequently, regulators and banks are looking for ways to help meet the requirements. What options are on the table? Matt Cameron reports

Seven months after first revealing its controversial liquidity risk ratios, the Basel Committee on Banking Supervision issued a set of amendments on July 26, intended to make the liquidity rules more palatable to the international banking community. The impact on South African banks, however, has been marginal at best. Domestic financial institutions still have little hope of meeting the minimum ratios unless further major changes are made to the rules.

Although new modifications are being debated, no compromises have been made yet. As a result, local market participants have set up a structural funding and liquidity task force to consider the issue, but it seems only a wholesale rethink of bank funding practices and an overhaul of market structure will be enough to help local firms meet the standards. This is too much for some to stomach.

“We subscribe to the principles of the liquidity ratios and will do our best to comply, but we won’t turn the whole system upside down to conform. One can’t do the impossible. We don’t want a liquidity problem in the future, so we think it is important to address the issue, and we are doing that by adopting a best-efforts approach. But if a best-efforts approach falls short, that’s all we can do,” says a senior source close to the matter.

The problems centre on two liquidity ratios proposed by regulators in December last year – the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). The LCR is designed to ensure banks have enough unencumbered, high-quality liquid assets that can be converted into cash to meet liquidity needs over a 30-day period of acute stress. It is defined as a bank’s stock of high-quality liquid assets divided by its net cash outflows over the 30-day period. The NSFR, in contrast, is intended to deal with longer-term structural liquidity mismatches by establishing a minimum acceptable amount of stable funding based on the liquidity characteristics of a firm’s assets and activities over a one-year horizon. The ratio is calculated by dividing the available amount of stable funding by the required amount of stable funding. In both cases, banks must maintain a minimum ratio of 100%.

It quickly became clear South African banks would struggle to get anywhere near 100%. According to research published on July 12 by Rand Merchant Bank (RMB), none of four major banks – Absa, FirstRand, Nedbank and Standard Bank – would exceed a 50% ratio on the LCR and 60% on the NSFR under the original proposals. Absa was estimated to have a liquid asset shortfall of R102 billion ($14.3 billion), while FirstRand, Nedbank and Standard Bank had shortfalls of R67 billion, R92 billion and R91 billion, respectively.

The amendments announced by the Basel Committee on July 26 will help to some degree. In particular, a longer transition period for both liquidity ratios is welcomed by bankers. The NSFR will now not come into force until January 2018, while the LCR was delayed in September until January 2015. However, bankers say the fundamental problems that existed with the December proposals remain.

“The amendments were helpful in some respects, but they don’t go far enough,” says Arno Daehnke, head of treasury and capital management at Standard Bank in Johannesburg. “Not all the problems have been solved by the amendments and many challenges remain.”

One of the major difficulties was the definition of high-quality, liquid assets – also known as level 1 assets. Under the original proposal, this was mainly limited to cash, central bank reserves and government or central bank debt issued in domestic currencies by the country in which the liquidity risk is being taken or the bank’s home country. South African banks had complained there were not nearly enough securities of this type to go around.

In July, the Basel Committee extended this definition to include domestic sovereign debt issued in foreign currency, to the extent it matches the currency needs of the bank’s operations in that jurisdiction. A second level of assets was also incorporated, capped at 40% of the total liquid asset stock. These include government and public-sector entity assets that qualify for the 20% risk weighting under the standardised approach of Basel II, and high-quality (rated AA– and above) non-financial corporate and covered bonds not issued by the bank itself. All these level 2 assets are subject to a 15% haircut.

However, the same issue remains – the market lacks sufficient liquid assets to allow banks to meet the regulatory targets, say participants. “If you apply the definition of liquid assets in a South African context, it becomes incredibly narrow. There is far from enough South African sovereign paper to go round, while a large portion of the liquid assets banks hold at the moment comprise ineligible paper. What is more, because of our insolvency laws, no bank can issue covered bonds. Meanwhile, we have a very small corporate bond market and there is only one issuer that would qualify for the minimum rating,” says Cyril Daleski, head of balance-sheet risk at Investec in Johannesburg.

The shortage of qualifying assets could have a considerable impact on market liquidity, warn bankers – firms will have incentives to buy and hold high-quality assets. This in turn could increase prices. “We may have just enough assets for banks to meet the ratios, but if we mobilise all those assets, we will theoretically be killing the liquidity in the market,” says one senior banker.

The other major gripe stems from the NSFR. The Basel Committee wants to encourage more longer-term, stable funding by banks to eliminate structural liquidity mismatches. Banks are allowed to count retail deposits as part of their stock of available stable funding (ASF), along with unsecured wholesale funding. The problem is firms get more benefit from stable retail deposits, defined as those covered by an effective deposit insurance scheme. South Africa has no such system, meaning deposits are likely to be considered unstable and subject to a more draconian ASF factor for the purposes of the NSFR. Banks also have to assume worse run-off rates for unstable deposits in a period of stress for the calculation of the LCR.

The problem is compounded by the treatment of wholesale funding. Retail deposits account for just 20% of bank funding in South Africa, with wholesale funding making up a whopping 40% (see figure 1). Under the NSFR, banks are able to use a better ASF factor for liabilities with effective maturities of more than one year. Again, the structure of the South African market makes this difficult: local money market funds – big buyers of bank debt – are compelled to maintain an average maturity of no more than 90 days and cannot buy paper with a maturity longer than 12 months.

“We don’t believe there is sufficient stable funding within the South African economy to meet the requirements of the ratios, and because of our reliance on wholesale funding and because it tends to be of a short-term nature, we aren’t able to comply with the ratios,” says the senior banker.

The Basel Committee made some proposed changes to the NSFR in July, including modifications to the ASF factor for stable and less stable retail deposits. Run-off rates for stable and unstable deposits were also altered, from 7.5% to 5% and 15% to 10%, respectively. However, the changes are thought to improve liquidity ratios by no more than a few percentage points in total, meaning South African banks will still be some way from meeting Basel minimums. Regulators are keen to address the issue.

“We are clearly falling short of the ratios, but we all acknowledge we have to do something to bolster the system as a whole to take us to a better level,” says the senior source. “However, it is pretty early days to offer a fully formed opinion on it, only to say that internally we have been beavering away looking at how best to address the situation. We are also looking at the general structure within the South African financial environment on a liquidity basis, because we do have a unique funding structure. So once we have a better handle on it from that perspective, we will decide how best to approach this.”

One of the responses has been to create the industry task force on structural funding and liquidity. The group, set up at the behest of the South African finance ministry, comprises the seven largest banks, the Financial Services Board, the South African Reserve Bank, national treasury members and participants from the asset management industry.

As of September, the group had met just three times, but participants have discussed a number of possible proposals to alter the structure of the market. “There are a lot of suggestions on the table at the moment. They range from regulatory tweaks to examining how to stimulate different forms of funding, but we are at a very early stage and all options are still being considered,” says Paul Bowes, head of group funding and strategic liquidity management at Nedbank in Johannesburg.

One idea has been to modify the Collective Investment Scheme Act to enable funds to buy paper longer than 12 months in maturity and to stretch the 90-day average maturity limitation – an amendment that would help to eliminate the mismatch between the need for banks to issue longer-dated debt and the lack of investors for that paper. Others have suggested a look-through principle, which would recognise much of the cash underlying pension and money market funds comes from retail investors.

“Banks in South Africa do rely heavily on wholesale funding, and from an international perspective there is a general nervousness around the stickiness of wholesale, but the South African situation is very different,” says the senior banker. “The global view of wholesale is a bit misleading, because a large percentage of wholesale funding in South Africa originates from retail consumers, and there is a tendency for retail savers to save through pension funds and insurance companies. It is a highly intermediated market.”

Other proposals have focused on tweaking the tax regime to make it more favourable to invest in fixed-income securities and to consider ways of bolstering retail deposits in the country – although it is not clear how this would be achieved beyond hiking deposit rates (Risk September 2010, pages 19–22). Nonetheless, many bankers point out the South African market has many idiosyncrasies – not least its exchange controls – meaning wholesale funding is more stable than elsewhere, making it difficult to conform to global definitions.

“Because of the closed rand system, wholesale funding is essentially recycled contractual savings and money market funds. There are not many places the cash can go and it almost always ends up back with the banks. It is recycled contractual saving, which is wholesale funding, but stable,” says Andries Du Toit, group treasurer at FirstRand in Johannesburg.

As a result, bankers in South Africa have jumped on a passage in the July amendments that states the Basel Committee will review the requirements for countries that do not have sufficient level 1 assets. There are also hopes similar modifications may be made for the NSFR. A new set of proposals for this ratio will be released by the end of this year, and bankers hope there will be scope for national discretion. If not, local banks fear they won’t be able to comply.

“The Basel Committee opens the door for national discretion in the July amendments. We believe South Africa will be considered a jurisdiction that doesn’t have sufficient level 1 assets, and we anticipate that our regulator will be able to deem other assets to qualify as liquid assets or to deem some of our funding as stable. But as the current regulations stand, if you interpret the ratios without national discretion, it is certain we will not comply with the requirements,” says Du Toit.