Addition of equities and mortgage bonds to LCR sparks criticism

Liquidity rules 'ruined' as regulators perform U-turn on equities, and also allow banks to include mortgage securities

Banks will be allowed to count equities and residential mortgage-backed securities (RMBSs) towards the new liquidity buffers required by Basel III's liquidity coverage ratio (LCR) after significant changes to the measure by the Basel Committee on Banking Supervision.

The new standard received the blessing of the committee's oversight body, and was announced at a press conference yesterday – along with a delay to the implementation schedule originally laid out when the LCR was first published in December 2010. But while the changes will make life easier for banks, not everyone in the industry is celebrating.

"The Basel Committee has caved in to the lobbying and made a stupid decision here," says a divisional treasurer at a large UK bank. "They've taken one of the soundest parts of Basel III and ruined it. Take the inclusion of RMBSs – it doesn't matter how highly rated the individual RMBS asset is, I know from personal experience that people won't buy them in a crisis, so they have zero liquidity value. It doesn't matter if the committee gives RMBSs a 25% haircut, because 75% of nothing is nothing."

The LCR requires banks to hold enough high-quality liquid assets to match expected outflows during a 30-day period of stress. In the first iteration of the rules, this buffer was dominated by government bonds and cash – with a second level of assets, including corporate bonds, added later. That second level now has two tiers – 2A and 2B – with RMBSs and equities added to the lower tier. In total, these assets can make up 15% of the whole buffer, but the RMBS must be rated AA or higher, and the equities must be unencumbered. The assets will also be subject to a 25% and 50% haircut, respectively.

The inclusion of equities is a U-turn for the regulators – Stefan Walter, the former secretary-general of the committee, was a strong opponent, and according to one senior European bank supervisor, the issue has been the subject of heated debate over the past few months. Again, the UK bank's treasurer is critical of the decision, but French banks had pushed hard for the change, with the backing of their regulators, and a senior equity derivatives trader at one French institution calls it a positive step.

It doesn't matter if the committee gives RMBS a 25% haircut, because 75% of nothing is nothing

Another change sees lower-rated corporate bonds also allowed into level 2B of the buffer – one of many changes reported in advance by Risk last month. Previously, only bonds rated AA– or higher could be included, but level 2B will now allow the inclusion of bonds rated A+ to BBB, subject to a haircut of 50%, rather than the 15% applied to higher-rated corporate debt.

The committee also made an array of changes to the LCR's outflow assumptions, which determine how big a bank's liquidity buffer needs to be. The outflow rate assigned to committed liquidity facilities offered to non-financial corporates has been reduced from 100% to 30%, the outflow for non-operational deposits provided by non-financial corporates, sovereigns and central banks has been cut from 75% to 40%, and the outflow for deposits protected by national insurance schemes has gone from 5% to 3%.

Speaking to Risk last month, sources close to the work said an internal Basel Committee report produced in the third quarter last year indicated these measures alone would improve the average level of bank compliance with the LCR by 14 percentage points.

The LCR was originally set for full implementation by 2015, but the Basel Committee has now granted the industry a bit more time. Compliance has been set at 60% for that year, with 10% added every following year until the full 100% is met in 2019. This may be hard to swallow for banks, such as those in Switzerland, that have already been pushed into early implementation of the measure by their domestic supervisors. One source on the committee suggests that, theoretically, these banks may be allowed to relax their LCR compliance back down below 60% until 2015, but adds that, in practice, their regulators will probably forbid it.