Understanding BISS Background and Requirements

[John Creighto]

BISS Background

The BISS Rules help to regulate stability in the banking system by imposing rules for capital requirements. Bank leverage is based on risk weighted assets.

The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord.

http://en.wikipedia.org/wiki/Capital_requirement

The capital requirements for BIS are:

Tier 1 capital must be at least 4% of total risk-weighted assets. Total capital (Tier_1 plus Tier II capital)must be at least 8% of total risk-weighted assets.

Capital is simply the difference between assets and liabilities. Tier 1 capital is just a more conservative way of measuring this difference as it doesn't include as Assets:- undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

The key thing to remember here is that the ratio is based on risk weighted capital. Well a 4% capital requirement suggests that a bank could lever up to 25 times their assets this would be true if all their assets were BBB+ to BBB- bonds *** these assets are assigned a risk weight of 100%. AAA to AA-Corporate bonds are assigned a risk weight of 20% so in theory a bank could lever up to 100 times their tier 1 capital if all their assets were in AAA corporate bonds or equivalently 50 times their total capital.

Since short term government treasuries are assigned zero risk weight in theory a bank could lever up infinite times of their capital if all their assets were short term government treasuries but to do this the bank would some how need to be able to borrow the money at a cheap enough rate.

New Changes

What has been recognized is that the past BISS framework did little to protect against a liquidity crisis. This is because banks borrow in the short term but lend for the long term. To ensure banks are able to meet short term liquidity requirements in a crisis it is proposed that a certain percentage of their assets should be considered liquid.

Markets will be affected by the new regulation in several ways. One way is the categorisation of assets into liquid and illiquid assets for the numerator of the liquidity coverage ratio. The currently foreseen regulation includes cash, central bank deposits, and high-quality government securities in the "liquid assets" category. Corporate and covered bonds are included with a haircut. The choice of the assets to be considered as liquid is consistent with the evidence during the recent crisis, which has confirmed that the degree of liquidity can vary enormously across markets in periods of stress.

The implementation of the new liquidity standard is intended (and expected) to favour those assets that are counted as liquid, and at the same time reduce incentives to hold assets that are considered less liquid. This will affect the functioning of the underlying markets. In particular the yields of liquid securities are expected to decline relative to those of illiquid ones, so that yield spreads between liquid and illiquid assets would become wider.

At the moment, it is difficult to quantify the impact on the different market segments, or to judge whether the adjustment will take time or be abrupt. But it can be expected that the categorisation of assets into certain classes of liquidity will lead to a "cliff effect", by which the regulatory categorisation of assets as either liquid or illiquid plays a crucial role for the future of their market. Moreover, it implies that changes in market conditions, such as a downgrade, can move assets from one category into the other, leading to sudden changes in banks' fulfilment of the liquidity coverage ratio. This could make their fulfilment somewhat unpredictable. The cliff effect could also imply sudden changes in the market conditions for the asset in question, which could suffer from a sudden drying-up of market activity or liquidity. In the latest revision of the proposal of the liquidity coverage ratio, some attempts were made to introduce intermediate categories of liquidity. This somewhat reduces the cliff effect, but it still remains significant.3

Another way in which different segments of financial markets will be affected in an asymmetric manner by the regulation is the maturity profile, which is key for the denominator of the liquidity coverage ratio. Since the denominator consists of expected outflows in a stress situation over the following 30 days, shorter-term funding that needs to be repaid within that period will be penalised relative to long-term funding. This is an intended effect. The implication is that the relative size of wholesale funding markets for different maturities will change. Ultimately, the interaction of demand and supply effects will determine the overall impact on the volume and liquidity of the different segments of the money market. At this stage it is difficult to draw clear conclusions, but it may well be the case that activity at the short end of the money market will decline. As regards interest rates, the increased demand for and lower supply of longer-term financing (relative to short-term financing) stemming from the introduction of the liquidity coverage ratio is expected to lead to a relative Such effects are important for central banks - a point I will consider later on. First, less active money markets, and a corresponding higher volatility of short-term interest rates, could make the transmission of monetary policy signals more difficult and less precise. Second, an increase in the steepness of the money market yield curve would affect the transmission mechanism and the information extracted from the yield curve for monetary policy purposes. To the extent that this effect is well understood and anticipated, central banks will be able to adjust their policies to the changed market environment. Transitory changes during an adjustment period may pose however some challenges.

http://www.bis.org/review/r101001e.pdf

I presume government bonds would be considered liquid and some corporate bonds (not sure how they would determine which corporate bonds are liquid and which are illiquid). I presume real-estate, personal loans and derivatives would be consider illiquid (the latter being potential toxic depending on it's type).

 

[John Creighto]

here is some more on this:

In my post on Basel III's liquidity requirements, one thing I didn't cover was the controversy over "committed credit and liquidity facilities." And since I know how disappointed you all were about that, here's my take on the issue. (Sarcasm aside, it's actually a pretty big controversy.)

As a refresher, Basel III's Liquidity Coverage Ratio (LCR) requires banks to maintain a stock of "high-quality liquid assets" that is sufficient to cover net cash outflows for a 30-day period under a stress scenario. "Net cash outflows" is calculated by applying different run-off rates to each source of funding (e.g., repos, unsecured wholesale, etc.). A run-off rate reflects the amount of funding maturing in the 30-day window that won't roll over, and is designed to simulate a severe stress scenario.
...

http://economicsofcontempt.blogspot...:+economicsofcontempt+(Economics+of+Contempt)