(iv) Treatment for Jurisdictions with Insufficient HQLA
(a) Assessment of Eligibility for Alternative Liquidity Approaches (ALA)
55. Some jurisdictions may have an insufficient supply of Level 1 assets (or both Level 1 and Level 2 assets24) in their domestic currency to meet the aggregate demand of banks with significant exposures in this currency. To address this situation, the Committee has developed alternative treatments for holdings in the stock of HQLA, which are expected to apply to a limited number of currencies and jurisdictions. Eligibility for such alternative treatment will be judged on the basis of the qualifying criteria set out in Annex 2 and will be determined through an independent peer review process overseen by the Committee. The purpose of this process is to ensure that the alternative treatments are only used when there is a true shortfall in HQLA in the domestic currency relative to the needs in that currency.25
56. To qualify for the alternative treatment, a jurisdiction should be able to demonstrate that:
• there is an insufficient supply of HQLA in its domestic currency, taking into account all relevant factors affecting the supply of, and demand for, such HQLA;26
• the insufficiency is caused by long-term structural constraints that cannot be resolved within the medium term;
• it has the capacity, through any mechanism or control in place, to limit or mitigate the risk that the alternative treatment cannot work as expected; and
• it is committed to observing the obligations relating to supervisory monitoring, disclosure, and periodic self-assessment and independent peer review of its eligibility for alternative treatment.
All of the above criteria have to be met to qualify for the alternative treatment.
57. Irrespective of whether a jurisdiction seeking ALA treatment will adopt the phase-in arrangement set out in paragraph 10 for implementing the LCR, the eligibility for that jurisdiction to adopt ALA treatment will be based on a fully implemented LCR standard (ie 100% requirement).
24 Insufficiency in Level 2 assets alone does not qualify for the alternative treatment.
25 For member states of a monetary union with a common currency, that common currency is considered the “domestic currency”.
26 The assessment of insufficiency is only required to take into account the Level 2B assets if the national authority chooses to include them within HQLA. In particular, if certain Level 2B assets are not included in the stock of HQLA in a given jurisdiction, then the assessment of insufficiency in that jurisdiction does not need to include the stock of Level 2B assets that are available in that jurisdiction.(b) Potential Options for Alternative Treatment
58. Option 1 – Contractual committed liquidity facilities from the relevant central bank, with a fee: For currencies that do not have sufficient HQLA, as determined by reference to the qualifying principles and criteria, Option 1 would allow banks to access contractual committed liquidity facilities provided by the relevant central bank (ie relevant given the currency in question) for a fee. These facilities should not be confused with regular central bank standing arrangements. In particular, these facilities are contractual arrangements between the central bank and the commercial bank with a maturity date which, at a minimum, falls outside the 30-day LCR window. Further, the contract must be irrevocable prior to maturity and involve no ex-post credit decision by the central bank. Such facilities are only permissible if there is also a fee for the facility which is charged regardless of the amount, if any, drawn down against that facility and the fee is set so that banks which claim the facility line to meet the LCR, and banks which do not, have similar financial incentives to reduce their exposure to liquidity risk. That is, the fee should be set so that the net yield on the assets used to secure the facility should not be higher than the net yield on a representative portfolio of Level 1 and Level 2 assets, after adjusting for any material differences in credit risk. A jurisdiction seeking to adopt Option 1 should justify in the independent peer review that the fee is suitably set in a manner as prescribed in this paragraph.
59. Option 2 – Foreign currency HQLA to cover domestic currency liquidity needs: For currencies that do not have sufficient HQLA, as determined by reference to the qualifying principles and criteria, Option 2 would allow supervisors to permit banks that evidence a shortfall of HQLA in the domestic currency (which would match the currency of the underlying risks) to hold HQLA in a currency that does not match the currency of the associated liquidity risk, provided that the resulting currency mismatch positions are justifiable and controlled within limits agreed by their supervisors. Supervisors should restrict such positions within levels consistent with the bank’s foreign exchange risk management capacity and needs, and ensure that such positions relate to currencies that are freely and reliably convertible, are effectively managed by the bank, and would not pose undue risk to its financial strength. In managing those positions, the bank should take into account the risks that its ability to swap currencies, and its access to the relevant foreign exchange markets, may erode rapidly under stressed conditions. It should also take into account that sudden, adverse exchange rate movements could sharply widen existing mismatch positions and alter the effectiveness of any foreign exchange hedges in place.
60. To account for foreign exchange risk associated with foreign currency HQLA used to cover liquidity needs in the domestic currency, such liquid assets should be subject to a minimum haircut of 8% for major currencies that are active in global foreign exchange markets.27 For other currencies, jurisdictions should increase the haircut to an appropriate level on the basis of historical (monthly) exchange rate volatilities between the currency pair over an extended period of time.28 If the domestic currency is formally pegged to another currency under an effective mechanism, the haircut for the pegged currency can be lowered to a level that reflects the limited exchange rate risk under the peg arrangement. To qualify for this treatment, the jurisdiction concerned should demonstrate in the independent peer review the effectiveness of its currency peg mechanism and assess the long-term prospect of keeping the peg.
61. Haircuts for foreign currency HQLA used under Option 2 would apply only to HQLA in excess of a threshold specified by supervisors which is not greater than 25%.29 This is to accommodate a certain level of currency mismatch that may commonly exist among banks in their ordinary course of business.
62. Option 3 – Additional use of Level 2 assets with a higher haircut: This option addresses currencies for which there are insufficient Level 1 assets, as determined by reference to the qualifying principles and criteria, but where there are sufficient Level 2A assets. In this case, supervisors may choose to allow banks that evidence a shortfall of HQLA in the domestic currency (to match the currency of the liquidity risk incurred) to hold additional Level 2A assets in the stock. These additional Level 2A assets would be subject to a minimum haircut of 20%, ie 5% higher than the 15% haircut applicable to Level 2A assets that are included in the 40% cap. The higher haircut is used to cover any additional price and market liquidity risks arising from increased holdings of Level 2A assets beyond the 40% cap, and to provide a disincentive for banks to use this option based on yield considerations.30 Supervisors have the obligation to conduct an analysis to assess whether the additional haircut is sufficient for Level 2A assets in their markets, and should increase the haircut if this is warranted to achieve the purpose for which it is intended. Supervisors should explain and justify the outcome of the analysis (including the level of increase in the haircut, if applicable) during the independent peer review assessment process. Any Level 2B assets held by the bank would remain subject to the cap of 15%, regardless of the amount of other Level 2 assets held.
27 These refer to currencies that exhibit significant and active market turnover in the global foreign currency market (eg the average market turnover of the currency as a percentage of the global foreign currency market turnover over a ten-year period is not lower than 10%).
28 As an illustration, the exchange rate volatility data used for deriving the FX haircut may be based on the 30- day moving FX price volatility data (mean + 3 standard deviations) of the currency pair over a ten-year period, adjusted to align with the 30-day time horizon of the LCR.
29 The threshold for applying the haircut under Option 2 refers to the amount of foreign currency HQLA used to cover liquidity needs in the domestic currency as a percentage of total net cash outflows in the domestic currency. Hence under a threshold of 25%, a bank using Option 2 will only need to apply the haircut to that portion of foreign currency HQLA in excess of 25% that are used to cover liquidity needs in the domestic currency.
30 For example, a situation to avoid is that the opportunity cost of holding a portfolio that benefits from this option would be lower than the opportunity cost of holding a theoretical compliant portfolio of Level 1 and Level 2 assets, after adjusting for any material differences in credit risk.(c) Maximum Level of Usage of Options for Alternative Treatment
63. The usage of any of the above options would be constrained by a limit specified by supervisors in jurisdictions whose currency is eligible for the alternative treatment. The limit should be expressed in terms of the maximum amount of HQLA associated with the use of the options (whether individually or in combination) that a bank is allowed to include in its LCR, as a percentage of the total amount of HQLA the bank is required to hold in the currency concerned.31 HQLA associated with the options refer to: (i) in the case of Option 1, the amount of committed liquidity facilities granted by the relevant central bank; (ii) in the case of Option 2, the amount of foreign currency HQLA used to cover the shortfall of HQLA in the domestic currency; and (iii) in the case of Option 3, the amount of Level 2 assets held (including those within the 40% cap).
64. If, for example, the maximum level of usage of the options is set at 80%, it means that a bank adopting the options, either individually or in combination, would only be allowed to include HQLA associated with the options (after applying any relevant haircut) up to 80% of the required amount of HQLA in the relevant currency.32 Thus, at least 20% of the HQLA requirement will have to be met by Level 1 assets in the relevant currency. The maximum usage of the options is of course further constrained by the bank’s actual shortfall of HQLA in the currency concerned.
65. The appropriateness of the maximum level of usage of the options allowed by a supervisor will be evaluated in the independent peer review process. The level set should be consistent with the projected size of the HQLA gap faced by banks subject to the LCR in the currency concerned, taking into account all relevant factors that may affect the size of the gap over time. The supervisor should explain how this level is derived, and justify why this is supported by the insufficiency of HQLA in the banking system. Where a relatively high level of usage of the options is allowed by the supervisor (eg over 80%), the suitability of this level will come under closer scrutiny in the independent peer review.
31 The required amount of HQLA in the domestic currency includes any regulatory buffer (ie above the 100% LCR standard) that the supervisor may reasonably impose on the bank concerned based on its liquidity risk profile.
32 As an example, if a bank has used Option 1 and Option 3 to the extent that it has been granted an Option 1 facility of 10%, and held Level 2 assets of 55% after haircut (both in terms of the required amount of HQLA in the domestic currency), the HQLA associated with the use of these two options amount to 65% (ie 10%+55%), which is still within the 80% level. The total amount of alternative HQLA used is 25% (ie 10% + 15% (additional Level 2A assets used)).(d) Supervisory Obligations and Requirements
66. A jurisdiction with insufficient HQLA must, among other things, fulfil the following obligations (the detailed requirements are set out in Annex 2):
• Supervisory monitoring: There should be a clearly documented supervisory framework for overseeing and controlling the usage of the options by its banks, and for monitoring their compliance with the relevant requirements applicable to their use of the options;
• Disclosure framework: The jurisdiction should disclose its framework for applying the options to its banks (whether on its website or through other means). The disclosure should enable other national supervisors and stakeholders to gain a sufficient understanding of its compliance with the qualifying principles and criteria and the manner in which it supervises the use of the options by its banks;
• Periodic self-assessment of eligibility for alternative treatment: The jurisdiction should perform a self-assessment of its eligibility for alternative treatment every five years after it has adopted the options, and disclose the results to other national supervisors and stakeholders.
67. Supervisors in jurisdictions with insufficient HQLA should devise rules and requirements governing the use of the options by their banks, having regard to the guiding principles set out below. (Annex 3 includes additional guidance on banks’ usage of ALA.)
• Principle 1: Supervisors should ensure that banks’ use of the options is not simply an economic choice that maximises the profits of the bank through the selection of alternative HQLA based primarily on yield considerations. The liquidity characteristics of an alternative HQLA portfolio must be considered to be more important than its net yield.
• Principle 2: Supervisors should ensure that the use of the options is constrained, both for all banks with exposures in the relevant currency and on a bank-by-bank basis.
• Principle 3: Supervisors should ensure that banks have, to the extent practicable, taken reasonable steps to use Level 1 and Level 2 assets and reduce their overall level of liquidity risk to improve the LCR, before the alternative treatment can be applied.
• Principle 4: Supervisors should have a mechanism for restraining the usage of the options to mitigate risks of non-performance of the alternative HQLA.