INTRODUCTION
Banking has undergone rapid transformation in the recent years. With the increased usage of technology, the ability to make instantaneous bank transfers and withdrawals have increased which led to increase in associated risks, requiring proactive management.
One of the crucial tools for monitoring and safeguarding the liquidity risk of banks is the LCR which requires banks to hold certain high quality liquid assets with the aim to ensure that there is no liquidity crisis. Banks that meet LCR requirements are better positioned to weather any liquidity or financial challenges, which if not managed effectively could put a significant stress on the wider financial ecosystem.
The RBI in its Bi-Monthly Monetary Policy Statement for 2024-25 dated 05 April 2024, announced that a draft circular on modifications to LCR framework shall be issued for comments. On 25th July 2024, the RBI issued a draft circular which is applicable to all Commercial Banks (excluding Payments Banks, Regional Rural Banks and Local Area Banks) and the proposed revisions would be applicable from 01 April 2025.
The draft guidelines seek to better manage risks associated with digital banking activities as the banking landscape continues to evolve with rapid technological advancements. The guidelines suggest a comprehensive adjustment in how banks handle liquidity with a focus on increasing liquidity buffers, and valuation of HQLAs. The RBI has sought feedback from all stakeholders on the draft guidelines as part of its review of the extant LCR framework for banks in India.
Salient features of the RBI circular
RBI’s draft guidelines on ‘Review of Haircuts on High Quality Liquid Assets (‘HQLA’) and Run-off Rates on certain categories of Deposits’ includes the following:
- Banks shall now account for deposits enabled with Internet and Mobile Banking (IMB) with a higher run-off factor.
- Level 1 assets shall be valued at an amount not greater than the current market value.
- Level 1 HQLA denominated in Government Securities shall now attract haircuts in line with the margin requirements as per the Liquidity Adjustment Facility (‘LAF’) and Marginal Standing Facility (‘MSF’) prescribed by RBI.
- Deposits which were excluded from LCR computation and pledged as a collateral to secure a loan shall now be treated as callable deposits for LCR purposes.
Understanding the LCR
A significant vulnerability exposed by the financial crisis of 2008 in banking sectors worldwide was the inadequate monitoring of liquidity risk. The sharp decline in the U.S housing market triggered severe financial distress in the US from mid-2007 to early 2009. This period saw numerous banks across the globe incurring massive losses and depending heavily on central banks to stave off bankruptcy.
In response to this crisis, the LCR was introduced in 2009 to enhance the control and monitoring of financial firms’ liquidity. This initiative was part of the broader “Basel III post- crisis reforms,” a comprehensive set of measures aimed at strengthening the regulation, supervision, and risk management within the banking sector. In India, the Reserve Bank of India (RBI) implemented LCR on 1st January 2015, after the Indian framework for LCR requirements was issued on 9th June 2014.
The Liquidity Coverage Ratio is a regulatory standard designed to ensure that financial institutions maintain an adequate level of HQLA that can be easily converted into cash. The primary goal is to meet short-term liquidity needs during periods of financial stress, specifically over a 30-day period. Presently, banks are required to maintain LCR of 100%
The LCR is calculated using the following formula: LCR = HQLA / Total Net Cash Outflows over 30 days
HQLA are assets that can be readily sold in the market without significantly affecting their price and are categorized as Level 1 and Level 2 assets. Level 2 assets are further classified as Level 2A and Level 2B assets.
Level 1 assets include cash, excess cash reserve ratio balance, central bank reserves and high-quality sovereign bonds. Level 2 assets include marketable securities representing claims on or claims guaranteed by sovereigns, public sector entities or multilateral development banks that are not issued by a bank/financial institution/non-banking finance company or any of its affiliated entities. Level 2 assets also include corporate bonds and commercial papers not issued by a bank /financial institution/non-banking finance company or any of its affiliated entities.
Level 1 assets have nil haircut. Level 2 A and 2 B have haircut of 15% and 50% respectively.
Total net cash flows are expected cash outflows net off expected cash inflows over next 30 days.
Proposed Changes
Some of the changes proposed in the revised guidelines for computation of LCR are explained in the pdf.
How Uniqus sees the proposed changes
The RBI’s draft guidelines aim to ensure banks are prepared for sudden withdrawals via digital channels so that banks in India are geared up to deal with such instances which have happened globally. These guidelines once implemented could impact banks by requiring them to set aside more liquid assets to handle potential withdrawals.
The guidelines may lead banks to operate in a more balanced manner – trying to focus on traditional branch banking with new age digital banking considering higher liquidity requirements in the latter. Banks will need to increase the proportion of stable deposits, non- callable deposits and hold more HQLA to meet these new requirements.
The guidelines require banks to comply with haircuts on Level 1 HQLA government securities which in turn will require banks to increase their investments in government securities, potentially diverting funds which could have otherwise been available to the Bank for its primary lending business. This may slowdown credit expansion. Given the sluggish growth in deposits, banks will be compelled to maintain high deposit rates to attract funds while simultaneously moderating their lending growth to align with the available funding sources.
This balancing act may have repercussions on their profitability and ability to lend in the market. Maintaining higher liquidity might lead to increased lending rates to compensate for the added costs and to protect profit margins.
