Liquidity: A bigger challenge than capital in Basel-III

As part of Basel compliance, banks must maintain two new liquidity ratios in addition to adequate capital. By introducing these ratios, namely Liquidity Coverage Ratio (LCR) and Net Stable Funding ratio (NSFR), the Basel committee aims to strengthen banks against adverse shocks, eliminate structural mismatches between assets and liabilities and encourage stable sources of funding both short and long-term. The liquidity requirements set in Basel-III guideline are likely to pose even bigger challenge than those of capital since liquidity and profitability are negatively correlated.
As per Risk Based Capital Adequacy guidelines published by Bangladesh Bank, banks have to maintain both LCR and NSFR of not less than 100 per cent and rationally they will be required to hold sufficient high quality liquid assets (HQLA). Banks that are heavily dependent on short-term wholesale funding, will struggle to meet the ratios. HQLA consists of low yield assets like cash, Govt. Bonds and other liquid securities.  Currently banks are maintaining Statutory Liquidity Ratio (SLR) at 19.5 per cent of their average deposits, out of which 6.5 per cent as Cash Reserve Ratio (CRR). But this 19.5 per cent will not be enough to maintain LCR of 100 per cent or more as it will require around 20-30 per cent of their deposits. For this banks will require more HQLA to hold. In Bangladesh, absence of efficient bond market will make this task very difficult and banks truly have little option to earn from HQLA and this will obviously drop down the average yield, which will ultimately push the interest rate on loans and advances to notch up.
NSFR is currently measured by Bangladesh Bank through hidden run-off factors. Banks are just submitting their asset liability position in central bank's prescribed format and hidden weight has been set by them on the basis of item-wise stability and requirement and NSFR is generated automatically by system. Hence, banks are in a murky situation to determine their asset liability mix properly.
There is a threat of "being squeezed from all sides". Banks are not the only ones who will feel the heat. Financial sector, infrastructure and private sector will feel the strain of reduced funding and overall lack of liquidity. Additional costs may arise for banks seeking to improve, or indeed simply to maintain, their liquidity positions because many banks will be attempting to take similar actions at the same time.

Advance Deposit Ratio (ADR) of banking industry has been prevailing between 69.8 per cent and 70.9 per cent in the last few quarters, for which they are not currently facing problems in maintaining liquidity though it has already affected their profitability. But central bank's monetary policy projected credit growths of 15 per cent in private sector while the government has a huge budget deficit that will be mostly met up by borrowing from banking sector. Loan growth is also expected to soar up if current political stability sustains and because of cheap availability of funds. If demand for credit and government borrowing goes up, existing liquidity will not be enough to meet the situation. Moreover 10 banks, those have around 35 per cent of total assets of the banking sector are not in a position to deploy loans due to capital shortfall which indicates that there will be a liquidity pressure for remaining banks. Though government borrowing will be a good source for banks in acquiring more HQLA, there will be no other way but to increase interest rates for private lending that will ultimately strike a new equilibrium between demand and supply of fund. However, computing NSFR gives more weight on Treasury Bills and Bonds having economic period (remaining maturity period) of one year or less. Considering this treasury people will face problem in maintaining their liquidity ratios.
Time has come to strengthen the Asset Liability Management, more specifically treasury division to cope up with the liquidity challenges of Basel-III. Efficiency of treasury will be an important determinant factor of profitability of the bank, that is, banks with more efficient treasury will be able to generate more profit. Obviously, treasury should have better insights into and projection over asset and liability growth and all types of financial markets like money market, capital market, bond market, foreign currency market of both local and global. They should also think about commodity market although it is absent in our country. But the scenario is expected to be changed in the coming days. Asset liability management should try for extending the maturity of liabilities where possible shifting the balance of deposits towards retail deposits, 'towards stable' rather than 'less stable' retail deposits, and towards medium-term funding through issuing bonds and other securities along with switching out of less liquid securities and other assets into government bonds and other instruments that count as HQLA reducing maturity of some lending so that it falls below one-year cut-off point which is so critical to NSFR.
Amidst the backdrop, banks should be urged to develop bond market and obviously have a mindset to sturdy their treasury including articulated job roles of its front, mid and back office to efficient and transparent activities to cope up with the liquidity challenge of Basel-III.
Writers are associated with Risk Management Division and Branch Banking of Mercantile Bank Ltd. Views are those of the authors and do not necessarily reflect the official position of the bank they are associated with.
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