Thursday, 25 October 2012

TP issues in Liquidity Management in the light of Basel III

Liquidity management is always an important topic within any organization, and becoming even more so at financial institutions as they consider the implications of the emerging “Basel III”1 global standards on capital and liquidity adequacy. In general, the Basel III framework raises the minimum level of capital that must be held against risk-weighted assets (as compared to the requirements under the Basel II guidance), including through a new “capital conservation buffer”; adds a supplemental leverage ratio backstop; and provides incentives and guidelines for institutions to raise their risk management and disclosure standards.
Another new pillar of Basel III is the requirement that financial companies hold a “liquidity buffer” to guard against unforeseen events (stress). The buffer is essentially made up of two components, represented by a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR):
  • The LCR mandates that a financial institution hold enough high-quality/low-risk assets (e.g., cash, government bonds) to cover projected net cash outflows under conditions of acute stress over a 30-day period. Acute stress conditions can be defined by significant losses of deposits, loss of access to secured and unsecured funding sources, calls on credit and liquidity facilities, etc.
  • The NSFR requirement aims at a similar goal but over a one-year period, mandating that at least 100 percent of assets be funded through stable sources, with both assets and funding sources weighted according to stability, tenor, and overall risk profiles.
These new liquidity requirements are likely to result in additional costs for most financial institutions, due to an increase in holdings of low-yielding assets as well as the need for costlier longer-term funding. A key transfer pricing issue will be how these additional costs should be allocated, if at all, among group members. Are these a “head office” cost, since they involve compliance with regulatory standards, or should they be shared with affiliates who might benefit from an institution’s global liquidity management, or treasury, function? The right answer will likely depend on the facts and circumstances of each case; relevant factors will include:
  • Would an individual affiliate need to hold a liquidity buffer if it were independent? (Regulators in many countries are expected to apply the Basel III standards to local affiliates.)
  • If a separate buffer is needed, how do associated costs compare with what might be allocated from a central treasury?
  • Are loans to affiliates priced on an arm’s length basis, i.e., treating them as stand-alone entities?
  • Is the treasury operation treated as a profit or cost center?
  • Are there (or will there be) any inbound charges for liquidity buffers held by an overseas affiliate?
  • What is the institution’s schedule for adopting the new standards, and what methods/systems will be available to gauge their impact?
The last point highlights an important measurement issue. No matter how liquidity buffer costs are treated for transfer pricing purposes, such costs will have to be determined. One approach would be through a financial institution’s existing Funds Transfer Pricing (FTP) methodology, which disaggregates the total spread between borrowing/deposit and lending/investment rates in order to measure the net interest component of profitability by business unit, product, customer, etc. FTP is a useful management reporting and business strategy tool, but it may also provide some data applicable to intercompany charges. A robust FTP system should allow for the isolation of liquidity buffer costs and the identification of incremental costs associated with any new investment or asset. As discussed above, however, such costs should not necessarily be allocated from one legal entity to another. (In the absence of a comprehensive FTP process, a taxpayer may be able to estimate buffer costs by manually applying fundamental FTP principles.)
Precise translation of the Basel III guidelines on liquidity (and for that matter capital ratios) to specific rules will be the responsibility of national banking regulators in each country over the coming months and years. Some variation in country approaches is to be expected, though the 2008 financial crisis will likely force a greater degree of uniformity than was the case for the Basel II standards. National banking authorities are already signaling possible flexibility in the definition of high-quality assets for the LCR, for example. Financial institution tax departments would be well-advised to follow these regulatory developments closely in all countries in which they operate, as well as to familiarize themselves with liquidity management tools which might be useful in implementing any needed changes to transfer pricing policies.
Source: Ceteris' Transfer Pricing Times, Volume IX, Issue 10