# LO 59.6: Describe and calculate ratios intended to improve the management of

LO 59.6: Describe and calculate ratios intended to improve the management of liquidity risk, including the required leverage ratio, the liquidity coverage ratio, and the net stable funding ratio.
In the wake of the 20072009 financial crisis, one of the primary goals of Basel III is to improve liquidity risk management in financial institutions. Basel III specifies a minimum leverage ratio (capital / total exposure) of 3%. As of the 2010 Basel III publication date, the type of capital required to calculate the ratio was not decided. Total exposure includes all items on the balance sheet, in their entirety (i.e., not risk-weighted). It also includes some off-balance sheet items such as loan commitments.
Banks often finance long-term obligations with short-term funds such as commercial paper or repurchase agreements. This is fine during normal economic periods. However,
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2018 Kaplan, Inc.
Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
in times of financial stress, this mismatched financing gives rise to liquidity risk. Banks find it difficult to roll over the short-term financing when they have, or are perceived to have, financial problems. During the 2007-2009 financial crisis, liquidity risk, not a lack of capital, was the real problem for many banks (e.g., Lehman Brothers). Basel III requires banks to meet the following two liquidity ratios: (1) liquidity coverage ratio and (2) net stable funding ratio.
Liquidity Coverage Ratio (LCR): The LCR focuses on the banks ability to weather a 30- day period of reduced/disrupted liquidity. The severe stress considered could be a three- notch downgrade (e.g., AA to A), a loss of deposits, a complete loss of wholesale funding, a devaluation of the value of collateral for funding agreements like repurchase agreements (i.e., increased haircuts), and potential drawdowns on lines of credit. The ratio is computed as:
high quality liquid assets / net cash outflows in a 30-day period > 100%
Liquid assets need to be at least as great as potential net cash outflows such that the bank can withstand one or more of the pressures described earlier.
Net Stable Funding Ratio (NSFR): The NSFR focuses on the banks ability to manage liquidity over a period of one year. The ratio is computed as:
amount of available stable binding / amount of required stable funding > 100%
To calculate the numerator, each source of funding (such as retail deposits, repurchase agreements, capital, and so on) is multiplied by a factor that reflects the relative stability of the funding source. See Figure 5 for the available stable funding (ASF) factors and types of funding available.
Figure 5: ASF Factors in NSFR
ASF Factor
100%
90%
80%
50%
0%
Category
Tier 1 and Tier 2 capital, preferred stock, debt with remaining maturity greater than one year. Stable demand and term deposits from individuals and small businesses with maturities less than one year. Less stable demand and term deposits from individuals and small businesses with maturities less than one year. Wholesale funding (demand and term deposits) from nonfinancial corporations, sovereigns, central banks, multi-lateral development banks, and public sector entities with maturities less than one year. All other liability and equity categories.
2018 Kaplan, Inc.
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Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
To calculate the denominator, each required amount of stable funding is multiplied by a factor that reflects the relative permanence of the funding required. See Figure 6 for the required stable funding (RSF) factors and the types of assets requiring the funding.
Figure 6: RSF Factors in NSFR
RSF Factor
Category
0%
5%
20%
50% 65% 85%
100%
Cash and short-term instruments, securities, and loans to financial entities with residual maturities of less than one year. Marketable securities with maturities of greater than one year, if claim is on a sovereign with 0% risk weight (e.g., U.S. Treasury securities). Corporate bonds with rating of AA- or higher and residual maturity greater than one year. Claims on sovereigns or similar bodies with risk-weight of 20%. Gold, equities, bonds rated A+ Residential mortgages. Loans to small businesses or retail customers with remaining maturities less than one year. All other assets.
to A-.
Example: Calculating the NSFR
Bank of the Bluegrass has the following balance sheet:
Retail deposits (less stable) Wholesale deposits Tier 2 capital Tier 1 capital Cash (coins and banknotes) Central bank reserves Treasury bonds (> 1 yr) Mortgages Retail loans (< 1 yr) Small business loans (< 1 yr) Fixed assets Total assets Using the information in Figures 5 and 6 to find the corresponding ASF and RSF factors, calculate the banks net stable funding ratio. 10 10 10 30 30 90 15 195 100 75 2 18 Total liabilities and equity 195 Page 298 2018 Kaplan, Inc. Topic 59 Cross Reference to GARP Assigned Reading - Hull, Chapter 16 Answer: ASF = (100 x 0.8) + (75 x 0.5) + (2 x 1.0) + (18 x 1.0) = $137.50 RSF = (10 x 0) + (10 x 0) + (10 x 0.05) + (30 x 0.65) + (30 x 0.85) + (90 x 0.85) + (15 x 1.0) =$137.00 NSFR= 137.50 / 137.00 = 1.0036 = 100.36% With an NSFR greater than 100%, Bank of the Bluegrass satisfies the new liquidity requirement. These new rules represent a significant change for banks and will impact bank balance sheets. The LCR is scheduled to be implemented January 1, 2015, and the NSFR is scheduled to be implemented January 1, 2018. C o n t i n g e n t C o n v e r t i b l e B o n d s