Annex 3: Guidance on Standards Governing Banks’ Usage of the Options for Alternative Liquidity Approaches (ALA) Under LCR
1. The following general and specific rules governing banks’ usage of the options are for the guidance of supervisors in developing relevant standards for their banks:
1. General Rules
(i) A bank that needs to use an alternative treatment to meet its LCR must report its level of usage to the bank supervisor on a regular basis.
2. A bank is required to keep its supervisor informed of its usage of the options so as to enable the supervisor to manage the aggregate usage of the options in the jurisdiction and to monitor, where necessary, that banks using such options observe the relevant supervisory requirements.
3. While bank-by-bank approval by the supervisor is not required for use of the ALA options, this will not preclude individual supervisors from considering specific approval for banks to use the options should this be warranted based on their jurisdiction-specific circumstances. For example, use of Option 1 will typically require central bank approval of the committed facility.
(ii) A bank should not use an alternative treatment to meet its LCR more than its actual need as reflected by the shortfall of eligible HQLA to cover its HQLA requirements in the relevant currency.
4. A bank that needs to use the options should not be allowed to use such options above the level required to meet its LCR (including any reasonable buffer above the 100% standard that may be imposed by the supervisor). Banks may wish to do so for a number of reasons. For example, they may want to have an additional liquidity facility in anticipation of tight market conditions. However, supervisors may consider whether this should be accommodated. Supervisors should also have a process (eg through periodic reviews) for ensuring that the alternative HQLA held by banks are not excessive compared with their actual need. In addition, banks should not intentionally replace its stock of Level 1 or Level 2 assets with ineligible HQLA to create a larger liquidity shortfall for economic reasons or otherwise.
(iii) A bank must demonstrate that it has taken reasonable steps to use Level 1 and Level 2 assets and reduce the amount of liquidity risk (as measured by reducing net cash outflows in the LCR) to improve its LCR, before applying an alternative treatment.
5. Holding a HQLA portfolio is not the only way to mitigate a bank’s liquidity risk. A bank must show that it has taken concrete steps to improve its LCR before it applies an alternative treatment. For example, a bank could improve the matching of its assets and liabilities, attract stable funding sources, or reduce its longer term assets. Banks should not treat the use of the options simply as an economic choice.
(iv) A bank must use Level 1 assets to a level that is consistent with the availability of the assets in the market. The minimum level will be set by the bank supervisor for compliance.
6. In order to ensure that banks’ usage of the options is not out of line with the availability of Level 1 assets within the jurisdiction, the bank supervisor may set a minimum level of Level 1 assets to be held by each bank that is consistent with the availability of Level 1 assets in the market. A bank must then ensure that it is able to hold and maintain Level 1 assets not less than the minimum level when applying the options.
II. Specific Standards for Option 2
(v) A bank using Option 2 must demonstrate that its foreign exchange risk management system is able to measure, monitor and control the foreign exchange risk resulting from the currency-mismatched HQLA positions. In addition, the bank must show that it can reasonably convert the currency-mismatched HQLA to liquidity in the domestic currency when required, particularly in a stress scenario.
7. To mitigate the risk that excessive currency mismatch may interfere with the objectives of the framework, the bank supervisor should only allow banks that are able to measure, monitor and control the foreign exchange risk arising from the currency mismatched HQLA positions to use this option. As the HQLA that are eligible under Option 2 can be denominated in different foreign currencies, banks must assess the convertibility of those foreign currencies in a stress scenario. As participants in the foreign exchange market, they are in the best position to assess the depth of the foreign exchange swap or spot market for converting those assets to the required liquidity in the domestic currency in times of stress. The supervisor is also expected to restrict the currencies of the assets that are eligible under Option 2 to those that have been historically proven to be convertible into the domestic currency in times of stress.
III. Specific Standards for Option 3
(vi) A bank using Option 3 must be able to manage the price risk associated with the additional Level 2A assets. At a minimum, they must be able to conduct stress tests to ascertain that the value of its stock of HQLA remains sufficient to support its LCR during a market-wide stress event. The bank should take a higher haircut (ie higher than the supervisor-imposed Option 3 haircut) on the value of the Level 2A assets if the stress test results suggest that they should do so.
8. As the quality of Level 2A assets is lower than that for Level 1 assets, increasing its composition would increase the price risk and hence the volatility of the bank’s stock of HQLA. To mitigate the uncertainty of performance of this option, banks are required to show that the values of the assets under stress are sufficient. They must, therefore, be able to conduct stress tests to this effect. If there is evidence to suggest that the stress parameters are more severe than the haircuts set by bank supervisors, the bank should adopt the more prudent parameters and consequently increase HQLA as necessary.
(vii) A bank using Option 3 must show that it can reasonably liquidate the additional Level 2A assets in a stress scenario.
9. With additional reliance on Level 2A assets, it is essential to ensure that the market for these assets has sufficient depth. This standard can be implemented in several ways. The supervisor can:
• require Level 2A assets that can be allowed to exceed the 40% cap to meet higher qualifying criteria (eg minimum credit rating of AA+ or AA instead of AA-, central bank eligible, etc.);
• set a limit on the minimum issue size of the Level 2A assets which qualifies for use under this option;
• set a limit on the bank’s maximum holding as a percentage of the issue size of the qualifying Level 2A asset;
• set a limit on the maximum bid-ask spread, minimum volume, or minimum turnover of the qualifying Level 2A asset; and
• any other criteria appropriate for the jurisdiction.
These requirements should be more severe than the requirements associated with Level 2 assets within the 40% cap. This is because the increased reliance on Level 2A assets would increase its concentration risk on an aggregate level, thus affecting its market liquidity.