Estimating the LCR Haircut to the GSIB Surcharge

An important question to answer in determining whether or not to impose substantially heightened capital requirements on global systemically important banks (GSIBs) is the extent to which these new requirements already overlap with other existing regulatory requirements leading to “double counting.”  Any overcapitalization of the banking system increases borrowing costs, reduces lending and is detrimental for economic activity.  In a recent op-ed in the American Banker, our colleague Jeremy Newell explains why now is the perfect time to revisit and recalibrate the current U.S. GSIB surcharge.

This blogpost summarizes the results of a just published research note that proposes a recalibration of the GSIB surcharge to take into account the impact of the liquidity coverage ratio (LCR) on a GSIB’s probability of failure.  As a result of the introduction of Basel III liquidity requirements, large banks hold a sizable stock of high quality liquid assets that can be easily liquidated if a financial crisis (and resulting run of liabilities) were to occur.  These large stockpiles of highly liquid assets make fire sales of illiquid assets much less likely to occur, thereby decreasing the potential magnitude of a large bank’s losses during a crisis and the probability of the bank’s failure.  Our findings indicate that compliance with the Basel III liquidity requirements has reduced GSIBs’ probability of failure and should translate into capital surcharges that are approximately 25 percent lower than the calibration done before compliance with the liquidity coverage ratio (LCR) was required.  Furthermore, our results show that a 25 percent LCR “haircut” yields a reduction in the GSIB surcharge between 50 to 100 basis points.  Our results are similar to those found in the foundational BCBS 2010 study on the costs and benefits of Basel III.  That paper reports that an increase in the ratio of liquid assets to total assets consistent with compliance with the Basel III liquidity requirements is equivalent to a 1 percentage point reduction in the level of capital requirements for internationally active banks.

Background on liquidity requirements and the GSIB surcharge

The Basel III LCR focuses on hypothetical short-term liquidity needs over a 30-day period of both idiosyncratic and market stress.  Large and internationally active U.S. banks began compliance with the LCR in January 2015.  The U.S. final rule also included a less strict version of the LCR, the so called modified LCR, which applies to banks with consolidated assets between $50 billion and $250 billion.[1]

The GSIB surcharge is an additional capital buffer that each U.S. GSIB is required to hold, over and above its risk-based capital requirements and other capital buffers.  The calibration of the GSIB surcharge uses an expected impact framework, whereby each GSIB surcharge is chosen such that it equalizes the expected loss from a GSIB’s failure to the expected loss from the failure of a non-GSIB reference BHC.  To estimate the GSIB capital surcharge, the U.S. methodology requires three inputs (i) the relationship between capital and the probability of failure; (ii) the GSIB’s systemic score; and (iii) the reference non-GSIB’s systemic score.

This blogpost and the accompanying research note study the impact of the U.S. implementation of the Basel III liquidity coverage ratio on the relationship between capital and the probability of failure.  Of course, compliance with the LCR also reduces the cost of failure as it allows for greater time to bring about an orderly failure.  The impact of the LCR on the cost of failure is an important item for further research that we do not pursue here.

The white paper published in 2015 by the Federal Reserve on “Calibrating the GSIB Surcharge,” acknowledges the importance of liquidity requirements on the calibration of the GSIB surcharge (page 8)

“…post-crisis liquidity initiatives (the liquidity coverage ratio and the net stable funding ratio) should reduce the default probabilities of large banking firms and the associated risk of fire sales. Together, these reforms may lessen a GSIB’s probability of default and potentially imply a lower GSIB surcharge.”

However, the paper stated that this adjustment could not be rigorously quantified (nor could the impact of government intervention on the past crisis).  In the accompanying research note, we follow the procedure subsequently suggested in a paper by Federal Reserve staff (Firestone et al, 2017) to quantify the impact of liquidity requirements on a bank’s probability of default and find the impact to be statistically significant and economically important.  Moreover, as noted earlier the magnitude of our results are similar to the ones suggested by the analysis done in 2010 by the Basel Committee on Banking Supervision (BCBS), the international body that requires that GSIBs maintain higher capital ratios.

LCR haircut to the GSIB surcharge

The chart below shows the impact of the LCR haircut on the GSIB surcharge for each of the eight U.S. GSIBs.  For details on the estimation of the LCR haircut please see the accompanying research note.  The yellow line represents the current mapping between the GSIB score (represented in the x-axis) and the capital surcharge (shown in the y-axis).  The mapping is done in increments of 50 basis points of capital surcharge for each 100-point fixed-width band of G-SIB systemic indicator score starting at 130.  The red dots represent the current method 2 scores and the corresponding GSIB surcharge for each of the eight U.S. GSIBs.  The impact of the LCR haircut on the GSIB surcharge is represented by the orange line.  Under our approach, the LCR requirement only impacts the mapping between the scores and the surcharge (that is, the relationship between capital and bank failure), thus the systemic score of each GSIB remains unchanged.  As shown by the difference between the yellow and orange lines, the LCR haircut yields a reduction in the GSIB surcharge between 50 to 100 basis points, depending on each bank’s method 2 surcharge.

image of graph

Concluding thoughts

The research note summarized in this blog post, the 2017 working paper published by the Federal Reserve, and the research produced by the Basel Committee appear to make untenable the claim that liquidity benefits cannot be rigorously quantified and therefore included in the GSIB methodology. Indeed, the existing U.S. GSIB methodology currently includes numerous components – for example, the translation of systemic indicators to the systemic score and the doubling of bank scores under Method 2 in the United States – that lack any rigor whatsoever.

There are several other post-crisis reforms that should also imply a lower GSIB surcharge and need to be rigorously quantified.  Specifically, the introduction of the total loss absorbing capacity standard has reduced moral hazard and, therefore, it is expected to also have lessened a GSIB’s probability of failure.  Indeed, the Financial Stability Board (FSB) 2015 report of the costs and benefits of TLAC finds that compliance is equivalent to an additional 1 percentage point reduction in capital requirements of GSIBs. (See page 25 of the report).  Lastly, there are several other post-crisis reforms that should also suggest a lower GSIB surcharge.  Specifically, other regulatory changes designed specifically to reduce failure costs, such as living wills, greater reliance on longer-term debt, the elimination of cross-default clauses (as well as the LCR, as mentioned above) and more stringent credit limits for inter-GSIB exposures.  These are all areas for future research.

[1] In addition, the Basel III liquidity requirements also include a longer-term requirement, the so called net stable funding ratio (NSFR).  The NSFR was finalized as an international standard by the BCBS in 2014 and the U.S. agencies issued the NSFR for public comment in mid-2016; however the final rule has not yet been published by the agencies.  This note does not consider potential effects of the NSFR.