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

Date01 October 2017
Published date01 October 2017
How Useful Is Basel IIIs 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
This paper approximates a construction of Basel IIIs Liquidity Coverage Ratio
(LCR) for US bank holding companies. This study examines (i) the LCRs marginal
contribution to a rms 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 rms systemic losses during the crisis of
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 rst 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 nancial crisis. The LCR makes such squeezes
less likely by limiting large banks from taking on excessive liquidity risk in advance of a
period of nancial 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, 902919
doi: 10.1111/eufm.12116
© 2017 John Wiley & Sons, Ltd.
1. Introduction
The foundation of all nancial 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 nancial crisis of 20072008 is a bank run in a more modern sense because the
establishment of deposit insurance rendered traditional bank runs obsolete. Modern
nancial 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 nancial 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 institutionscash 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
nancial crisis.
In the aftermath of the nancial crisis of 20072008, 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 nalised 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 nal 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 proles, and potential risk to the nancial system. The implementation of the
rule for these rms 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.
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 reect 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 nancial
crisis of 20072008. 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,
While the LCR calculation is straightforward, proper identication 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.
How Useful Is Basel IIIs Liquidity Coverage Ratio? 903

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