One of many lessons learned from the global financial crisis of 2007-2008 was the relationship between systemic risk and liquidity. The crisis saw financial institutions on both sides of the Atlantic urgently seeking liquidity support from central lenders, without ever having breached their respective capital adequacy requirements. Aside from central lending and emergency support, practical liquidity assurance mechanisms for banks, pre-crisis, appeared to rely to some extent on the sale of assets. The crisis revealed the danger of this strategy. Given the widespread cross-exposure to the credit and liquidity risks of financial institutions in every capital market, globally, would-be purchasers for assets were absent at a time when the availability of leveraged finance was minimal and most major market participants needed to sell.
In its response to the crisis, an early priority for the Basel Committee on Banking Supervision (the BCBS) was to strengthen the role of liquidity risk management in the overall capital maintenance framework. The result of this effort was the publication, in 2008, of the Principles for Sound Liquidity Risk Management and Supervision ("Sound Principles"), a paper covering existing guidance and wisdom on liquidity control and risk mitigation. To complement the principles expressed in Sound Principles, The BCBS developed two minimum standards for funding liquidity – the Net Stable Funding Radio (NSFR) and the Liquidity Coverage Ratio (LCR). The LCR is envisaged as encouraging short-term resilience of a bank's liquidity position, such that the bank can survive a stress scenario for a period of one month. The NSFR contemplates a year of liquidity pressure, and provides a maturity structure for assets and liabilities. Adherence with the two standards, and with the principles of sound liquidity risk management, is set out as the minimum standard of liquidity for internationally active financial institutions.
The advent of a liquidity-based outlook on capital adequacy is a genuinely new feature of banking regulation. Each bank will experience the effects of this shift in focus differently, depending on its market position, management, and growth plan. Canadian banks, having avoided the worst of the financial crisis, will likely experience this change to a lesser degree than their counterparts in Europe and the United States. Nevertheless, specifically with regard to the imposition of the LCR, we can prognosticate as to certain likely impacts on the Canadian banking sector, including a necessity for re-emphasizing term deposits and liquidity in the bank's retail and commercial banking business lines, pressure on ETFs, and a streamlining of operations to account for increased regulatory cost and a decreased willingness to commit to capital-intensive assets and business strategies.
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