Financial & Monetary Theory: Liquidity Rules Impact on Bank Funding

This report delves into the impact of liquidity rules, particularly those introduced under Basel III, on the composition of bank funding. It discusses how the new liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) affect banks' short-term funding and the stability of company deposits. The report also highlights the potential increase in the cost of derivative business and the overall limitations on bank growth due to leverage ratios. While acknowledging the challenges and costs associated with implementing these rules, the report emphasizes the merits of liquidity rules, such as reducing the probability of failures among systematically important banks, improving competition, and lowering financial risks. Ultimately, the report concludes that Basel III aims to create a safer and more robust banking system, protecting customer interests and fostering a competitive environment.

Running head: FINANCIAL AND MONETYARY THEORY
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Table of Contents
Introduction:..........................................................................................................................................2
Literature review:..................................................................................................................................2
What has been the impact of liquidity rules on the composition of overall bank funding?....................2
Merits of the liquidity rules for the banking sector:...............................................................................4
Conclusion:............................................................................................................................................5
References:............................................................................................................................................7

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Introduction:
The financial crisis of the year 2007 top 2009, also known as the Global financial crisis, is
one of the largest and worst economic and financial crises, which the world had witnessed, since the
Great Depression. It had its inception in the Mortgage market of the United States, which had led to a
robust and huge banking crisis with the collapse of the legendary investment banking company
Lehman Brothers, back in 2008. In these uncertain times, financial crisis is one of the last things,
desired by humans. In order to prevent depressions of such drastic nature, various steps had been
taken to consolidate the financial market. Basel III has also been initiated and brought into existence
for the purpose of consolidating the banking industry, across the world. It was specifically designed to
change the way, banks conduct their business. It helped in introducing new set of liquidity rules for
the banks, the impact of which upon the banking sector has been discussed in this report.
Literature review:
What has been the impact of liquidity rules on the composition of overall
bank funding?
The Basel Committee’s new liquidity rules are of paramount importance to the overall
banking and financial sector of the economies across the world. Accordingly the procedure has
attracted a great deal attention on the new rules. According to the reports of McKinsey (2016), the full
implementation of the new rules would take place by 2019. It would lead to significant amount of
deduction in the pre-tax Return on Investment of the European banks. It would result from the impact
of the new rules on the capital and funding of the banking companies. The funding impact has been
described below:
 A total shortfall in the short term funding of the banks would take place, as a result of the
introduction of the new liquidity coverage ratio (LCR), with the amount leading to a

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staggering t €1.3 trillion. This accounts for roughly 40% of the average liquid stocks held by
the banks as of today.
 Due to introduction of the NSFR, which is the amount of stable funds in relation with the
amount of required stable fund, the liquidity value of company deposits either as transactional
bank accounts or non operating term deposits is gravely influenced because only 50% i
considered stable funding by the bank for its lending related activities. This would compel the
banks to charge heavily for the early financial speed breakers.
In accordance with the new rules of liquidity, specifically with the advent of the NSFR derivative
assets must compulsorily backed with stable funding at a 100%. This exercise would consequently
increase the cost of the derivative business of the banks (Demirguc-Kunt and Huizinga., 1999).
Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence.
World Bank Economic Review 13 (2), 379- 408.
 . And in all probability, the increased cost would be passed on to the clients of the banks. This
in turn would consequently lead decrease in the banking business with the lack of clients as
they would have to bear the burden of extra costs.
When the overall funding structure of the banks are considered, the following important impacts have
been pointed out by Dagmar Recklies’s report on the side effects of Basel III on banks. They have
been discussed below:
 The leverage ratio of the banking companies would limit the growth of the business, based on
their external debt. This refers to that amount of funds, through which the banks can grow
their banking business on the basis of external debts borrowed by the banks. It goes on to
state that the total exposure of the bank should not be any more than 33 % of the Tier one
capital of the company. This includes the shareholder’s funds and the retained earnings of the
company.
 The new liquidity requirements of the banks would cover both short term as well as long term
liquidity. This would compel the banks to hold a certain amount of liquid assets. This would

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severely restrict the profit making capabilities of the banks as liquid funds do not generally
yield very many profits.
 In an overall overview of the new rules in the new Basel III system, the prime objective is to
create a sound and secure financial structure of the company. This has been done in order to
decrease the incentives of the banks to tighten their efforts to undertake more risks and earn
more profits.
 The banks would have to offshore a lot of their funds in order to implement as well as to
adjust to the new regulations advocated by Basel III. It will absorb a significant amount of
funds of these banking companies, in terms of both financial as well as non-financial
operations (Choi , Park & Ho ., 2009). It would take up huge amount of banking company’s
funds in terms of increased manpower and man management.
Merits of the liquidity rules for the banking sector:
The dreadful financial crisis of 2008 has highlighted the shortcomings in the area of funding
and liquidity management in financial institutions which has motivated the formation of new liquidity
regulations under the Basel III regulatory framework for banks BCBS (Basel Committee on Banking
Supervision, 2010). The main meritorious impact of the new rules has been mentioned below:
 One of the most significant breakthroughs offered by the implementation of the new rules and
regulations of Basel III is the reduction of the probability as well as the impact of the failure
the Systematically Important Banks or the (SISs).
 Another significant advantage proposed by the introduction of Basel III is that it would lead
to an improvement in the competitive nature of the banking industry (Athanasoglou,
Brissimis, Delis., 2008). It would help in levelling the playing field of the banks, so that the
advantages received by the ‘too big to fail’ companies would be distributed and reduced.
 The introduction of the new rules of Basel III would lead to ease and lowering of unwanted
financial risks. The new liquidity rules would help in trading of the less risky assets, and

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another advantage it would provide, is the high liquidity attached to it. This would be possible
in case of the implementation of the provisions of HQLA or the High Quality Liquid Assets.
 The implementation of the new provisions of Basel III, certain important improvements
would be made in the working of the banking companies. Some of which are balance sheet
restructuring, improvement of loan loss provisions, optimisation of market risk models,
initiating improvement of capital efficiency ( Arellano and Bover, 1995). This would lead to
better management of the balance sheet and other important financial statements of the
banking companies. The long term fund costing would also improve and decrease as a result
of the application of the new rules.
 The implementation of the various aspects of the Basel III would lead to the creation of a
safe, secure and robust banking system free from the complexities and risks of the modern
day banking system. It would help in protecting the interests of the customers, and safeguard
their hard earned money (Dietrich and Wanzenried, 2013). Moreover, the application of the
new liquidity rules of Basel III would help in creating a highly competitive environment. This
would help in breaking the monopolies and duopolies in the banking industry of various
economies. This would help the customers to receive top notch banking services at various
competitive prices.
Conclusion:
Under Basel III, all individual banks across the world would have to maintain higher and
better-quality liquid assets and the need to ensure better management of the liquidity risks would
consequently increase. The policy work for the creation of Basel III framework for the most part has
been completed. These reforms, advocated by Basel III are significant and all of them bring together
various important macro as well as micro lessons of the financial crisis. The Committee entrusted
with the creation of Basel III, has now successfully, moved to the next phase of the financial security,
which is the implementation. It will be hard to predict the cause of the next crisis. Many risks are still

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looming on the horizon, and all countries need to continue the process of building their capacity to
absorb shocks – whatever the source.

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References:
Allen, W. A., Chan, K. K, Milne, A. K. L. and Thomas, S. H., 2010. Basel III: Is the Cure Worse than
the Disease? Available at SSRN: http://ssrn.com/abstract=1688594 or
http://dx.doi.org/10.2139/ssrn.1688594.
Arellano, M., Bover, O., 1995. Another look at the instrumental-variable estimation of
errorcomponents models. Journal of Econometrics 68 (1), 29-52.
Athanasoglou, P., Brissimis, S., Delis, M., 2008. Bank-specific, industry-specific and macroeconomic
determinants of bank profitability. Journal of International Financial Markets, Institutions and Money
18 (2), 121-136.
Baltagi, B.H., 2001. Econometric Analysis of Panel Data, 2nd ed. John Wiley & Sons, Chichester.
BCBS (Basel Committee on Banking Supervision). 2010a. Basel III: International framework for
liquidity risk measurement, standards and monitoring. Basel: Basel Committee on Banking
Supervision.
BCBS (Basel Committee on Banking Supervision). 2010b. (LEI Report), “An Assessment of the
Long-Term Impact of Stronger Capital and Liquidity Requirements”,
Basel. Berger, A. N., Bouwman, C., 2009. Bank Liquidity Creation, The Review of Financial Studies,
22(9), 3779-3837.
Choi P. P., Park J., Ho C., 2009, “Insurer liquidity creation: The evidence from U.S. property and
liability insurance industry”, Working Paper.
Demirguc-Kunt, A., Huizinga, H., 1999. Determinants of Commercial Bank Interest Margins and
Profitability: Some International Evidence. World Bank Economic Review 13 (2), 379- 408.

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Dietrich, A., Wanzenried, G., 2013. Determinants of bank profitability before and during the crisis:
Evidence from Switzerland. Journal of International Financial Markets, Institutions and Money 21 (3),
307-327.