How Useful Is Basel III's Liquidity Coverage Ratio? Evidence From US Bank Holding Companies

• Date: 01 October 2017
• DOI: http://doi.org/10.1111/eufm.12116
• Published date: 01 October 2017
• Author: Brian Du

How Useful Is Basel III’s Liquidity

Coverage Ratio? Evidence From US

Bank Holding Companies

Brian Du

College of Business and Economics, California State University, East Bay, 25800 Carlos Bee Blvd.,

Hayward, California 94588, USA

E-mail: brian.du@csueastbay.edu

Abstract

This paper approximates a construction of Basel III’s Liquidity Coverage Ratio

(LCR) for US bank holding companies. This study examines (i) the LCR’s marginal

contribution to a firm’s systemic risk and (ii) whether the LCR can predict ex ante

which banks are most exposed to systemic losses in a true systemic event. Panel

regressions from 2002 to 2015 show that the LCR is associated with lower relative

systemic risk, measured by DCoVaR. The LCR may be used conjunctively with

marginal expected shortfall to predict a firm’s systemic losses during the crisis of

2007–2008.

Keywords: financial crisis, banking, systemic risk, liquidity coverage ratio

JEL classification: G01, G10, G18, G21

‘Adoption by the bank regulatory agencies of the Liquidity Coverage Ratio (LCR) will

establish, for the first time, a liquidity rule applicable to the entire balance sheet of large

banking organisations. This rule implements the international LCR standard developed by

the Basel Committee on Banking Supervision, which was a response to the fact that liquidity

squeezes were the agents of contagion in the financial crisis. The LCR makes such squeezes

less likely by limiting large banks from taking on excessive liquidity risk in advance of a

period of financial stress, during which the distinction between illiquidity and insolvency can

be increasingly blurred, as asset values tumble and uncertainty heightens’.

-Board of Governors, US Federal Reserve, Daniel K. Tarullo

The author is grateful to an anonymous referee for helpful suggestions and comments and is

grateful to the Editor, John Doukas, for his time and effort in reviewing the paper. The

author also thanks fellow colleagues: Jagdish Agrawal, Nancy Mangold, Scott Fung,

Tammie Mosley, Fung-Shine Pan, Eric Fricke, Sinan Goktan, and Robert Loveland for

their valuable research support and feedback. All remaining errors are those of the author.

European Financial Management, Vol. 23, No. 5, 2017, 902–919

doi: 10.1111/eufm.12116

© 2017 John Wiley & Sons, Ltd.

1. Introduction

The foundation of all financial crises can be characterised as some form of liquidity

inadequacy. Bank runs, in the traditional form, involve depositors withdrawing cash due

to fears of bank failure (Bryant, 1980; Diamond and Dybvig, 1983). It can be argued that

the financial crisis of 2007–2008 is a bank run in a more modern sense because the

establishment of deposit insurance rendered traditional bank runs obsolete. Modern

financial institutions rely heavily on alternative funding sources, such as repurchase

agreements (repos) and commercial paper. He and Xiong (2012a, 2012b) show that these

extreme short-term debt instruments can incentivise creditors to run when the underlying

fundamentals deteriorate. Excessive off-balance sheet arrangements, such as loan

commitments and letters of credit, obligate financial institutions to extend credit which

borrowers can draw down on demand. During economic downturns, the aggregate

supply of liquidity diminishes, spurring businesses to exercise these contingent

obligations (Ivashina and Scharfstein, 2010). Financial institutions’cash holdings have

steadily declined –Acharya et al. (2011) show that in the early 1980s, cash holdings

were 10% of total assets, but that proportion dipped to below 3% prior to the crisis.

Excessive risk exposures from these collective factors play a critical role in the recent

financial crisis.

In the aftermath of the financial crisis of 2007–2008, the Basel Committee on Banking

Supervision (BCBS) unanimously endorsed the Liquidity Coverage Ratio (LCR) as a

minimum for enhanced prudential liquidity standards on 6 January 2013. In September

of 2014, the US Department of Treasury and the Federal Reserve finalised a standardised

minimum liquidity requirement of 100%, based on the LCR, and approved its adoption

by 1 January 2017. The purpose is to promote the short-term resilience of liquidity risk

exposure and absorb shocks from economic stress. The final rule applies to large and

internationally active US bank holding companies with US$250 billion or more in assets

or US$10 billion or more in on-balance sheet foreign exposure due to their complexity,

funding profiles, and potential risk to the financial system. The implementation of the

rule for these firms is commensurate with their contribution to overall systemic risk in the

US. In general, the purpose of prudential liquidity standards is to ensure the stability of

the banking system, although Hartlage (2012) argues that the LCR may undermine the

goals of effective liquidity regulation and contribute to liquidity risk.

This paper provides a conservative construction of the LCR for a widely used dataset

(FR Y-9C) for US bank holding companies (BHCs). This construction is based on

BCBS-recommended guidelines (BCBS, 2013) and further detailed in section 2.3.

1

To

provide motivation for this study, Figure 1 shows the mean LCR, estimated each quarter,

for BHCs from 2002 through 2015. Due to data limitations, the LCR can be only

approximated and may not reflect the actual LCR; however, it is measured consistently

across time. It is clear that the LCR fell below 100% long before the onset of the financial

crisis of 2007–2008. The dotted line shows the average LCR for all BHCs, whereas the

solid line shows the average LCR for those banks with over US$250 billion in assets. For

all BHCs, the LCR dropped below 100% during 2004Q3. For systemically large banks,

1

While the LCR calculation is straightforward, proper identification of various components

of the LCR and calibration of time horizon requires some subjective judgements due to the

availability of data.

© 2017 John Wiley & Sons, Ltd.

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