Banking Crisis Aftermath: Considerations for Strengthening Banking sector

Banking Crisis Aftermath: Considerations for Strengthening Banking sector

Subject: Economy

Section: Monetary Policy

• Background:
  • A banking crisis involving Credit Suisse occurred a year ago.
  • Government-sponsored rescue of Credit Suisse and U.S. bank salvages in March 2023.
• Current Situation:
  • Regulators and lawmakers are beginning to address concerns.
  • Top global financial watchdog warned Switzerland to strengthen banking controls due to the risk posed by UBS.
• Key Weaknesses Identified:
  • Banks’ liquidity requirements found insufficient.
  • Liquidity Coverage Ratio (LCR) is crucial for banks’ ability to meet cash demands.
• Proposed Changes and Debates:
  • European regulators discussing shortening the period of acute stress for measuring banks’ buffers.
  • Potential for banks needing to hold higher levels of liquid assets, potentially increasing funding costs.
  • Industry-wide changes expected in Europe next year, including final implementation of post-financial crisis rules (Basel III).
• ECB Scrutiny and Central Bank Role:
  • ECB intensifies scrutiny of liquidity buffers of individual banks to prevent rapid runs.
  • Focus on making emergency loans widely available and examining collateral requirements.

The ongoing discussions and proposed changes aim to enhance banks’ resilience against rapid deposit outflows and liquidity stress, ensuring financial stability and preventing crises like those involving Credit Suisse.

Liquidity Coverage Ratio (LCR):

• The liquidity coverage ratio (LCR) is the ratio of highly liquid assets held by financial institutions. It ensures their ability to meet short-term obligations, acting as a stress test for market-wide shocks.

Basel III Reforms and LCR Implementation:

• Introduced as part of the Basel III reforms post-2008 financial crisis.
• Finalized by the Basel Committee on Banking Supervision in January 2013.
• LCR formula: LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow Amount.

Indian Framework for LCR:

• India’s framework for LCR requirements issued on June 9, 2014.
• Phased implementation from January 1, 2015, with minimum mandatory requirements starting at 60%.
• Gradually increasing to 100% by January 1, 2019.

High-Quality Liquid Assets (HQLA):

• HQLAs are assets quickly convertible to cash with no significant loss of value. Three categories:
• Level 1: Includes coins, banknotes, central bank reserves, and marketable securities.
• Level 2A: Securities issued/guaranteed by specific sovereign entities or multilateral development banks.
• Level 2B: Investment-grade corporate debt and publicly-traded common stock.

Importance of LCR for Banks:

• Promotes short-term resilience against liquidity disruptions.
• Ensures banks have sufficient HQLAs to survive acute stress scenarios lasting 30 days.
• Banks must hold HQLAs equal to expected total net cash outflows over the stress period.

Limitations of LCR:

• Requires banks to hold more cash, potentially leading to fewer loans issued.
• Increased cost of maintaining fund ratio could impact lending and economic growth.
• Banks’ cost of lending increases due to the need to cover fund ratio costs.

The Liquidity Coverage Ratio is a critical measure ensuring banks’ ability to weather short-term liquidity disruptions while balancing the need for lending and financial stability.