The document discusses Basel III, a global regulatory framework for banking designed to mitigate risks and enhance the resilience of financial institutions post the 2007-08 financial crisis. It focuses on liquidity risk management, outlining key components like the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), which aim to ensure banks can meet their financial obligations. The challenges posed by these regulations, particularly for Islamic banks due to the lack of developed markets and liquid investment instruments, are also highlighted.

1. Ayesha Majid
5-25-2018
Lahore School of economics
Liquidity Risk
As under Basel III

2. Introduction
Basel accord are a global, voluntary regulatory framework on bank capital adequacy, stress
testing, and market liquidity risk. Basel III is the latest set of regulations developed by the Basel
Committee to regulate the banking industry. The Basel III regulations are devised to mitigate damage
to the economy caused by banks that take on excess risk. This third instalment of the Basel Accords
was developed in response to the deficiencies in financial regulation revealed by the financial crisis of
2007–08. It is aimed at improving the banking sector's ability to deal with financial stress, improve
risk management, and strengthen the banks' transparency. It is part of the continuous effort to enhance
the banking regulatory framework and builds on the Basel I and Basel II documents.
Basel I (1988) produced a harmonized set of capital adequacy requirements, Basel II (2004)
produced a revised set of harmonized capital adequacy and supervisory requirements, Basel III (2010
onwards) resulted in new guidelines on capital, leverage, and liquidity requirements aimed at reducing
the incentives for building up high-risk, highly-leveraged, bank balance sheets. Basel III is based on 3
primary pillars which are pillars are Minimum Capital Requirement, Supervisory review Process and
Market Discipline.
Liquidity Risk
In Basel III, in accordance to G20 recommendations the Basel committee has decided to setup
minimal Regulatory standards for liquidity risk. Basel III defines liquidity risk as “Liquidity risk is the
risk that the Bank will be unable to meet its payment obligations associated with its financial liabilities
when they fall due and to replace funds when they are withdrawn.”
As per the Basel accords liquidity risk can be calculated using two ratios, Liquidity Coverage
Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The Basel Committee is still working to
calibrate these two ratios to make it more acceptable for the banks especially Islamic Banks as it is
currently focused on interest baring instruments.
LCR measures the extent to which a bank’s short-obligations are covered (hedged) by its liquid
assets. The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of
banks. The LCR is calculated by dividing a bank's stock of high-quality liquid assets by its total net
cash outflows over a 30-day stress period. The high-quality liquid assets include only those with a high
potential to be converted easily and quickly into cash. There are three categories of high-quality
liquidity assets with decreasing levels of quality: level 1, level 2A and level 2B assets. It aims to
quantify a bank’s financial position and ability to recover from a major cash outflows within a time
period of a month. As per Basel III for LCR banks have to keep a liquidity buffer if their net cash flow
for a month is outflow. That is there are more cash outflows than cash inflows. The liquidity buffer
can only constitute of sovereign debt and corporate debt. In light of it the U.S Banks also calculate
Supplementary Leverage Ratio (SLR). SLR is the US implementation of the Basel III Tier 1 leverage
ratio, with which banks calculate the amount of common equity capital they must hold relative to their
total leverage exposure. Large US banks must hold 3%.

3. NSFR measures the proportion by which a bank has stable funding by comparing the amount
the bank can acquire and that it needs. NSFR is calculated as the amount of available stable funding
relative to the amount of required stable funding. It caters long term liquidity constraint. It defines the
minimum amount of stable funding that a bank needs to keep for a 1-year stress period.
Table 1: International liquidity framework according to Basel III Source: Deloitte
Table 2 SLR Calculation Source: Harvard Law School Forum
Basel III liquidity risk requirements will affect Islamic banks for two reasons. The first one is
that the lack of a developed Islamic money market and the second one the lack liquid Islamic
investment instruments with short term maturities.