Financial Services
The liquidity coverage
ratio proposal
key points for implementation
Authors
Michael Duane, Principal
Aaron Fine, Partner
Introduction
In 2010, Basel III first introduced the concept of a global liquidity
standard for banks. On October 24th, 2013 the Federal Reserve,
FDIC and OCC released their proposed Liquidity Coverage Ratio
(LCR) for the United States. On January 31st, 2014 the comment
period for the proposal will close. And on January 1st, 2015 US banks
with greater than $50 BN in assets will be expected to:
1. Be able to calculate their Liquidity Coverage Ratio on a
daily basis
2. Have their balance sheets positioned such that they will have
less expected liquidity outflow than inflow during a 30-day
stress period
After a relatively long incubation period, the concept of a liquidity
standard for US banks is now moving forward at a very rapid
pace. Given the very soon effective date of January 1st,2015
(which will also correspond with stress test submissions when it
arrives), complexity of the proposed rules, competing priorities
for resources, and required system changes it appears that all
banks will be challenged to meet the operational requirements of
the regulation. And unfortunately, while the initial proposal leaves
much to intellectual and legal debate, the reality is that banks
that have yet to accelerate their preparations must now create
and begin to execute on a tactical roadmap to implementation.
If they do not, they risk either failing to comply or needing to
make sub-optimal balance sheet decisions in order to achieve the
required positioning.
With the regulations at over 100 pages in length and encompassing
complexity across retail and wholesale business lines, treasury,
data and operations we are seeking in a pair of point of views to
provide an executive briefing on the most critical areas for nearterm focus. This first publication touches on implications of the
proposal, but is focused largely on establishing a framework by
which banks can begin to prioritize their operational challenge.
Exhibit 1: Key points of the liquidity coverage ratio calculation
Category
Balances
in question
LCR
outflow
range
Degree of challenge
Potential
impact
Data
Analysis
Business
implications
Small business (retail vs. wholesale)
~$1.0 TN
10% vs. 40%
~$300 BN
Medium
Medium
Medium
stable vs. other (Retail deposits)
~$9.0 TN
3% vs. 10%
~$600 BN
Medium
Medium
Medium
Financial vs. Non- financial clients
~$1.5 TN
40% vs. 100%
~$900 BN
Medium
Low
Low
Operational vs. Non-operational deposits
~$1.0 TN
25% vs. 40%
~$150 BN
High
High
High
Copyright © 2014 Oliver Wyman2
Introduction
The second publication, which will be released later in 1Q 2014
will focus in greater depth on the implications of the proposed
rule for the industry (and beyond).
While the proposal includes dozens of clauses and potential
calculations, we believe that the greatest points of leverage for
most banks are encompassed in the four lines of Exhibit 1. The
intent of the table is to indicate areas of the proposed rule that
are most significant in determining a bank’s ratio and that can be
most significantly impacted by the bank. As such, the table doesn’t
include the allowance for smaller (less than $250 BN in assets) and
less internationally diverse banks to apply a significantly lower
run-off rate to their outflows. While this clause has tremendous
impact (greatly favoring mid-size banks) and will be discussed in
our second POV, it isn’t something that can be easily impacted in
the short-term.
On the other extreme is the distinction drawn between financial
and non-financial clients. The proposal indicates that financial
clients would be likely to draw on any liquidity that they have
with a covered bank in a period of stress, and therefore these
clients would withdraw 100% of their deposit balances and draw
significantly on the undrawn portion of any credit and liquidity
facilities. While there is little a bank can do to change the nature
of its clients, there is a significant amount of effort that can and
must be spent to ensure that clients that should classify as nonfinancial receive that classification. So a great deal of value can
be impacted.
This assessment will vary significantly bank to bank, with the
criticality of each element of work dependent both on the
bank’s mix of business as well as its starting position. Going
through this exercise some institutions may find that they can
become compliant largely by undertaking relatively easier data
gathering and analytical tasks, and so would prioritize those.
Others however might find that they will need to pursue the most
difficult analytical proofs and enact changes to their client value
propositions in order to come closer to gaining compliance. For
some, even that won’t be enough and difficult changes to the
balance sheet may be necessary.
The remainder of this article is intended to discuss the most
important areas of action across each of the four key elements
outlined in the table. For each, we present an overview of the rule
followed by an assessment of the key data, analytical and business
change tasks that might be required in order to meet compliance.
Finally, we present an executive roadmap that sums up the
activities and their potential impact for an illustrative institution.
Our second point of view to be released later in1Q 2014 will
focus on the overall industry impact, and particularly on the
implications of marrying this new concept of regulatory liquidity
with historical ALM practices.
As a reminder, we have focused on what we believe to be the
most broadly critical and challenging to interpret rules across the
industry (which generally apply to deposits). We are happy to have
more in depth conversations on both these points and other areas
of the proposal.
Copyright © 2014 Oliver Wyman3
Overview
Liquidity Coverage Ratio
The LCR proposal applies to banks with greater than $50 BN in assets
•• The full rule applies to banks with greater than $250 BN in assets or that are heavily involved in international businesses
•• The modified rule applies to banks with greater than $50 BN in assets but less than $250 BN. Banks that are subject to the modified
rule must apply only 70% of the standard run-off factor (throughout this document we reference the full factor)
•• Banks with less than $50 BN in assets will not be subject to the rule, but it seems likely that investors and regulators might begin
expecting to see some similar view of liquidity from them at some point
Over time, banks will need to be able to demonstrate a minimum LCR of 100% on any given day. For practical purposes this likely means
that banks will need to maintain a buffer of HQLA above expected outflows and/or very actively manage their LCR position.
The 100% ratio however will be phased in over time. Banks will need to meet an 80% ratio on January 1st 2015, 90% on January 1st 2016,
and 100% on January 1st, 2017.
• Pool of liquid and readily marketable securities with potential to generate liquidity under stress
via sale or secured borrowing
• Eligible assets specified in rule based on liquidity profile, with haircuts applied to less liquid assets
• Eligible assets cannot be issued by financial sector entitles to avoid wrong-way risk
• In addition to eligibility, all assets must meet certain general and operational criteria
Stock of High-Quality
Liquid Assets (HQLA)
LCR =
Total net
cash outflows
• Cumulative net inflows and outflows over a 30-day stress period
– Inflow/outflow assumptions specified in proposal
– Inflows capped at 75% of outflows
• Denominator set to maximum cumulative net outflow over the 30day period to account for
differences in cashflow timing
• Assumed timing must be as conservative as possible
– Earliest possible outflow date, latest possible inflow date
– Includes timing to exercise any option (explicit or embedded)
Copyright © 2014 Oliver Wyman4
I . Retail vs. Wholesale
Small Business Clients
10% vs. 40%
30%
difference
Overview
Data: Medium
The proposed rule includes a very straightforward
quantitative classification metric – the client must provide
less than $1.5 MM in funding (generally deposits) to the
bank. This presents a quick metric for classification, but,
on its own will not be enough to meet the burden. Instead,
clients must be treated in the same manner as individual
clients and demonstrate liquidity behavior similar to those
clients. Achieving these two additional criteria may require
new forms of analysis, the formal re-classification of clients,
and in some cases, even the re-structuring of the small
business value proposition.
•• Small business client identifier
•• Total deposit relationship products of client
•• Monthly (or possibly weekly or daily) history of deposit balances
by account
•• Possibly, the transaction behavior of transaction accounts
Given the likely difference in run-off rate between the retail
and wholesale designation (30%) and the balances in
question, this is likely the most important area of significant
work that most banks should undertake.
Analysis: Medium
•• At a minimum: comparison of small business segment balance
volatility to that of individual segments
•• Other possibilities:
−− Daily or weekly analysis
−− Individual client level analysis
−− Stress period analysis
−− Average life analysis
Business changes: Medium
“
A small business would qualify as a retail customer or counterparty if
its transactions have liquidity risks similar to those of individuals and
are managed by a covered company in the same way as comparable
”
transactions with individuals.
•• At a minimum: Designation of the clients to the retail bank, and
service proposition that handles small business transactions in a
similar manner to individual clients
•• Potentially:
−− Product designs and incentives that limit deposits to
$1.5 MM
−− Re-structuring of the small business (or individual)
transaction service proposition to ensure parity
Copyright © 2014 Oliver Wyman5
II.Retail deposits
stable vs. other
3% vs. 10%
7%
difference
Overview
Data: Medium
The relatively small difference in the run-off rates between
stable and less stable deposits can cause the impact of
the distinction to go unappreciated. However the massive
volume of balances to which the clause applies, as well
as the moderate level of complexity to meeting the more
favorable classification makes it a key area of focus for most
banks. If one applies a liberal interpretation of the rule, and
assumes that all insured individual client deposits could
potentially be classified as stable if they were held within a
transaction account or in an account at the same institution
as the client’s transaction account, more than half a trillion
dollars in deposit run-off could be at stake for the industry.
Minimum:
•• Client identifier attached to each account
•• Current deposit balances by account
Given the very high value of this rule, and apparent
possibility of meeting it, it is critical that banks get a
definitive view of what will be required to meet the stable
definition as soon as possible – and then begin executing
on achieving it.
“
The proposed rule would define a stable retail deposit as a retail
deposit, the entire amount of which is covered by deposit insurance,
and either (1) held in a transactional account by the depositor or
(2) the depositor has another established relationship with a covered
”
company, such that withdrawal of the deposit would be unlikely.
Possibly,
•• Monthly, weekly or daily deposit history of accounts
•• Historical transaction behavior of transaction accounts
Analysis: Medium
•• At a minimum: comparison of deposit volatility by productholding based customer segment
•• Other possibilities:
−− Daily or weekly volatility analysis
−− Individual account level analysis
−− Stress period analysis
−− Average life analysis
Business changes: Medium
•• New value propositions (e.g., relationship pricing) that promote
the acquisition of transaction accounts from current nontransaction account savings customers
•• New product structures that promote balances in transaction
accounts and the stability of balances in all accounts (e.g., highinterest checking, sticky services, withdrawal penalties)
Copyright © 2014 Oliver Wyman6
III.Financial vs. non-financial clients
40% vs. 100%
60%
difference
Overview
Data: Medium
Throughout the proposed rule, relationships with financial
clients (outside of operational deposits) are heavily
penalized. Among other areas of the rule, they receive
elevated runoff rates for both wholesale funding (100% vs.
40%) and unfunded commitments, and securities issued by
financial institutions cannot be included in the HQLA buffer.
•• Total relationship products/services
For most banks, the critical implication of this rule will
not be what to do with financial clients, but rather how to
prove that non-financial clients are non-financial. Given the
relative ease of this task for most clients and the severity
of not being able to prove it, this should be a key area of
focus. In addition, banks that do have significant portions
of their business with financial clients will need to invest in
identifying exactly which clients qualify as financial under
the specific classifications of the proposal.
“
[The] higher outflow rate is associated with the elevated refinancing
•• Customer industry classification
(internal or third-party, e.g., NAICS)
Analysis: Low
•• There is not a significant analytical component to this rule.
However, for many banks identifying and classifying clients by
industry will not be entirely easy. So banks will need to devise
processes to gather and store the necessary evidence, and
likely to triage research on the most important and difficult to
classify clients.
Business changes: Low
•• There are limited potential business implications for this
component. The main question is whether banks will seek to
reduce deposit-taking from financial clients or increase pricing
to compensate for the punitive regulatory treatment
or roll-over risk in a stressed situation and the interconnectedness of
”
financial institutions.
Copyright © 2014 Oliver Wyman7
IV.Operational vs. non-operational deposits
25% vs. 40%
15%
difference
Overview
The proposed rule sets out extremely stringent and detailed
(relative to other sections) criteria for the qualification of
deposits as operational. To qualify, balances first must be
in accounts that include terms few banks currently utilize.
Even then, only the balances that can be proven to be
necessary for the actual operational needs of the client
will qualify. It seems clear that the intent of the rule is to
recognize the possibility that operational accounts will have
a lower run-off rate than other wholesale deposits, but to
set an extremely high burden of proof in order to gain this
recognition for any actual dollar of deposits.
We provide further detail on a theoretical construct for
determining operational balances that would qualify on
the following page. However for this to even be relevant,
the bank would first need to address the stringent account
criteria detailed below. In practice, given our current
interpretation of the rule we believe that very few banks will be able
to classify a material portion of balances as operational without a
dramatic effort across data collection, analysis and client-facing
business change. As an example the current version of the rule dictates
that accounts associated with operational services to investment
companies and investment advisors cannot qualify as operational
deposits, which will pose a significant challenge to custodian banks.
Key operational account requirements
1. The deposit must be held pursuant to a legally binding written
agreement, the termination of which is subject to a minimum
30 day notice period or significant termination costs are borne
by the customer providing the deposit if a majority of the deposit
balance is withdrawn from the operational deposit prior to the
end of a 30 day notice period;
2. The deposit must be held in an account designated as an
operational account;
“
Balances in these accounts should be recognized as operational
deposits only to the extent that they are critically important to
”
customers to utilize operational services offered by a covered company.
3. The customer must hold the deposit at the [BANK] for the
primary purpose of obtaining the operational services provided
by the [BANK];
4. The deposit account must not be designed to create an economic
incentive for the customer to maintain excess funds therein
through increased revenue, reduction in fees, or other offered
economic incentives.
Copyright © 2014 Oliver Wyman8
IV.Operational vs. non-operational deposits
Detailed discussion of operational balances
DAILY ACCOUNT BALANCE OF
ONE REPRESENTATIVE ACCOUNT
AVERAGE MONTHLY ACCOUNT BALANCE OF
ONE REPRESENTATIVE ACCOUNT
120
DAILY BALANCES OF THREE REPRESENTATIVE ACCOUNTS
OVER THE COURSE OF 150 DAYS
80
70
60
100
80
60
40
20
Operational
balance
60
Excess
balance
growth
40
Excess
balance
base
0
Month 1
Month 2
Month 3
Month 4
Month 5
“To qualify as operational, The [BANK] must demonstrate
that the deposit is empirically linked to the operational
services and that it has a methodology for identifying
any excess amount, which must be excluded from the
operational deposit amount. This seems to mean that
only the balances in an account that are volatile during the
course of a month (going in and out to meet operational
needs) will qualify. In the example above, growth in
deposit balances related to the economic crisis would not
qualify, nor would any other intra-month stable balances
that keeps but does not require for operational purposes.
20
0
1
2
3
4
Excess
balance
growth
50
Operational
balance
30
Excess
balance
base
10
5
“To qualify as operational, there must not be significant
volatility in the average balance of the deposit”. This
initially seems contradictory to the clause described to the
left but we currently interpret it to mean that the average
balance across months must be stable. The chart above
shows how the two clauses could be consistent – with
similar volatility within each month resulting in a stable
month to month average.
40
Account 3
20
Account 2
0
1
15
30
45
60
75
Account 1
90 105 120 135 150
The problem with this is that any balance that could be
classified as LCR operational wouldn’t actually be stable
funding (since it would go up and down on a daily basis).
As a result, the only way we believe a balance could be
both LCR operational and stable enough to be invested
long-term, is if the operational balances in different
accounts have daily in-flows and outflows that are
negatively correlated. In this case, the diversity benefit
would create a pool of intra-month stable funding from
a collection of accounts that were themselves volatile on
a daily basis.
If this interpretation is correct, even if a bank can classify its accounts as operational, and classify balances within those accounts as operational, it would still likely
struggle to deploy much of that balance as stable funding if it observed both regulatory and economic rules of liquidity. A deeper discussion of how regulatory and
economic liquidity would need to come together will be presented in our second paper to be released early next year.
Copyright © 2014 Oliver Wyman9
Implications for a hypothetical bank
In the table on the right-hand side, we
have outlined the full set of deposit
categories, and associated balances
for an illustrative bank. Where proof
is required to secure a more favorable
runof f treatment, we have also
included the higher runoff rate that a
deposit would receive if the institution
cannot supply proof to the satisfaction
of its regulator. Constructing a table
like this should be the first step in any
bank’s LCR readiness program – it will
allow the institution to size the runoff
balances at stake and prioritize its
resources based on opportunity
size and the degree of dif ficulty
in realizing the opportunity. For
example, the two most material
opportunities for the hypothetical
bank below are to ensure it can
adequately justify its classification
of non-financial customers and can
prove retail treatment for certain
small business deposits.
Category
Retail
Balance
Fully
insured
Not fully insured
Wholesale Operational
deposits
Non-operational
wholesale
Small
business
Retail
treatment
Wholesale
treatment
Brokered
deposits
Medium Low
Total
Degree of challenge
Run-off
at stake
Data
Analysis
Business
implications
25,000
3%
10%
1,750
Non-transaction,
“established relationship”
7,500
3%
10%
525
Non-transaction, no
“established relationship”
2,500
10%
10%
0
NA
NA
NA
All accounts
20,000
10%
10%
0
NA
NA
NA
Fully insured
100
5%
20%-100%
15-95
Not fully insured
800
25%
40%-100%
120-600
2,500
20%
100%
2,000
10,000
40%
100%
6,000
Financial sector clients
5,000
100%
100%
0
Fully insured with
“established relationship”
2,500
3%
20%-100%
425-2,425
Fully insured, no
“established relationship”
500
10%
40%-100%
150-450
Fully insured, not financial
sector client
Not fully insured, not financial
sector client
Not fully insured
5,000
10%
40%-100%
1,500-4,500
Fully insured, not financial
sector client
3,750
20%
100%
3,000
Not fully insured, not financial
sector client
6,250
40%
100%
3,750
Financial sector clients
1,300
100%
100%
0
Reciprocal
Fully insured
brokered deposits Not fully insured
1,000
10%
10%
0
NA
NA
NA
1,500
25%
25%
0
NA
NA
NA
Sweep
deposits
Fully insured, swept by bank itself
1,250
10%
10%
0
NA
NA
NA
Fully insured, swept by third party
1,250
25%
25%
0
NA
NA
NA
Not fully insured
1,500
40%
40%
0
NA
NA
NA
Mature in >30 days
550
10%
10%
0
NA
NA
NA
Mature in <30 days
250
100%
100%
0
NA
NA
NA
Other brokered
deposits
High Transaction account
Run-off
rate
Run-off
if can’t
prove
treatment
100,000
19,23525,095
Copyright © 2014 Oliver Wyman10
Conclusions
Implications for ongoing management
Regardless of the final assumptions or burden of proof demanded by regulators, the LCR will introduce
additional complexity to banks’ balance sheet management. Given the tight timeline, data and system
challenges, banks need to develop and quickly execute a roadmap to be able to report LCR daily
starting January 1st, 2015. The LCR introduces a binding “regulatory liquidity” constraint, which may
require some institutions to alter their balance sheet to achieve required positioning and materially
change ALM practices. Where deposit assumptions differ between the LCR and a bank’s own internal
economic liquidity characterization, institutions may need to reexamine the way they invest certain
types of funding, and make corresponding changes to pricing. Disfavored deposit classes (e.g.,
wholesale, financial customers) will need to be invested in high-quality liquid assets like US Treasuries,
which will significantly impact the economics of such deposits. The implications, which we will discuss
further in our next POV, may include changes to deposit pricing and/or deposit gathering behavior;
these implications will be most pronounced for institutions who find themselves in danger of violating
the minimum LCR levels given their current balance sheets.
Copyright © 2014 Oliver Wyman11
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