P2.T7.

Operational & Integrated Risk Management

Bionic Turtle FRM Practice Questions

Basel III: The Liquidity Coverage Ratio and Liquidity

Risk Monitoring Tools
By David Harper, CFA FRM CIPM
www.bionicturtle.com
Please note: this set contains two rounds of question sets: questions T7.407 and T7.408
and questions T7.B14 to T7.B16. They review essentially the same learning outcomes
(AIMS). The difference is only that the first set (407 and 408) of questions was written
more recently, while the second set (B14 to B16) was written in a prior period.

BASEL III: THE LIQUIDITY COVERAGE RATIO AND LIQUIDITY RISK MONITORING
TOOLS ...................................................................................................................................... 3
P2.T7.407. BASEL III LIQUIDITY COVERAGE RATIO (LCR) ........................................................... 3
P2.T7.408. BASEL III LIQUIDITY COVERAGE RATIO (LCR), CONTINUED ........................................ 7
P2.T7.B14. MINIMUM LIQUIDITY COVERAGE RATIO (LCR) IN BASEL III ........................................10
P2.T7.B15. NET STABLE FUNDING RATIO (NSFR) IN BASEL III ...................................................16
P2.T7.B16. BASEL III LIQUIDITY MONITORING TOOLS .................................................................20

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Basel III: The Liquidity Coverage Ratio and Liquidity Risk
Monitoring Tools
P2.T7.407. Basel III liquidity coverage ratio (LCR)
P2.T7.408. Basel III liquidity coverage ratio (LCR), continued
P2.T7.B14. Minimum Liquidity Coverage Ratio (LCR) in Basel III
P2.T7.B15. Net Stable Funding Ratio (NSFR) In Basel III
P2.T7.B16. Basel III Liquidity Monitoring Tools

P2.T7.407. Basel III liquidity coverage ratio (LCR)

AIMs: Define and describe the minimum liquidity coverage ratio. Describe the
characteristics of high quality liquid assets (HQLA) and operational requirements for
assets to qualify as HQLA.
407.1. Which objective of Basel's liquidity framework is meant to be achieved with the minimum
liquidity coverage ratio (LCR)?

a) To promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has
sufficient funds to survive a significant stress scenario lasting for one month
b) To promote resilience over a longer time horizon, at least one year, by creating
additional incentives for banks to fund their activities with more stable sources of funding
on an ongoing basis
c) To strengthen capital adequacy by adding a capital buffer to effectively increase core
Tier 1 capital
d) To complement value at risk (VaR) and stress VaR metrics with a measures that
mitigate transactions liquidity risk

407.2. Which type of liquidity risk does the minimum liquidity coverage ratio most nearly
address?

a) Endogenous liquidity risk

b) Exogenous liquidity risk
c) Funding (aka, cash flow) liquidity risk
d) Asset (aka, market or product) liquidity risk

407.3. Which of the following assets, by virtue of characteristics displayed, is most likely to
qualify as a high-quality liquid asset (HQLA) according to the liquidity coverage ratio (LCR)?

a) An asset with low volatility but that is not easy to value; the pricing formula is not easy to
calculate and depends on strong assumptions
b) An unencumbered asset held at the bank and not rehypothecated, but that nevertheless
was received in a reverse repo transaction
c) An asset with low counterparty risk but without an active and stable market
d) An asset with low volatility but that is encumbered

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Answers:
407.1. A. To promote short-term resilience of a bank’s liquidity risk profile by ensuring
that it has sufficient funds to survive a significant stress scenario lasting for one month
BCBS 238: "To complement these principles [basic principles of liquidity risk management], the
Committee has further strengthened its liquidity framework by developing two minimum
standards for funding liquidity. These standards have been developed to achieve two separate
but complementary objectives. The first objective is to promote short-term resilience of a bank’s
liquidity risk profile by ensuring that it has sufficient HQLA to survive a significant stress
scenario lasting for one month. The Committee developed the LCR to achieve this objective.
The second objective is to promote resilience over a longer time horizon by creating additional
incentives for banks to fund their activities with more stable sources of funding on an ongoing
basis. The Net Stable Funding Ratio (NSFR), which is not covered by this document,
supplements the LCR and has a time horizon of one year. It has been developed to provide a
sustainable maturity structure of assets and liabilities."

407.2. C. Funding (aka, cash flow) liquidity risk

Recall that (at least in the FRM) we typically parse liquidity into market liquidity risk and funding
liquidity risk.
 Market liquidity risk (aka, asset liquidity risk or product liquidity risk) is the risk associated
with an inability to perform market transactions at the current mark-to-market value. Dowd
distinguishes between two types of market liquidity risk which are not mutually exclusive:
 Exogenous liquidity risk which assumes prices are exogenous is commonly
measured by the bid-ask spread
 Endogenous liquidity risk which assumes prices react to the trade itself but which is
assumed to be material only if the position is large relative to its market
 Funding (aka, cash flow) liquidity risk is the risk attached to prospective cash flows over
a defined horizon period; or as Jorion writes, it "refers to the inability to meet payment
obligations to creditors or investors."

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407.3. B. Unencumbered asset held at the bank and not rehypothecated but nevertheless
received in a reverse repo transaction. Excerpt from assigned Basel III: The Liquidity
Coverage Ratio and liquidity risk monitoring tools:

"1. Characteristics of HQLA (High-quality liquid assets)

(i) Fundamental characteristics

 Low risk: assets that are less risky tend to have higher liquidity. High credit standing of the
issuer and a low degree of subordination increase an asset’s liquidity. Low duration, low
legal risk, low inflation risk and denomination in a convertible currency with low foreign
exchange risk all enhance an asset’s liquidity.
 Ease and certainty of valuation: an asset’s liquidity increases if market participants are
more likely to agree on its valuation. Assets with more standardized, homogeneous and
simple structures tend to be more fungible, promoting liquidity. The pricing formula of a high-
quality liquid asset must be easy to calculate and not depend on strong assumptions. The
inputs into the pricing formula must also be publicly available. In practice, this should rule
out the inclusion of most structured or exotic products.
 Low correlation with risky assets: the stock of HQLA should not be subject to wrong-way
(highly correlated) risk. For example, assets issued by financial institutions are more likely to
be illiquid in times of liquidity stress in the banking sector.
 Listed on a developed and recognized exchange: being listed increases an asset’s
transparency.
(ii) Market-related characteristics
 Active and sizable market: the asset should have active outright sale or repo markets at all
times. This means that:
o There should be historical evidence of market breadth and market depth. This could be
demonstrated by low bid-ask spreads, high trading volumes, and a large and diverse
number of market participants. Diversity of market participants reduces market
concentration and increases the reliability of the liquidity in the market.
o There should be robust market infrastructure in place. The presence of multiple
committed market makers increases liquidity as quotes will most likely be available for
buying or selling HQLA.
 Low volatility: Assets whose prices remain relatively stable and are less prone to sharp
price declines over time will have a lower probability of triggering forced sales to meet
liquidity requirements. Volatility of traded prices and spreads are simple proxy measures of
market volatility. There should be historical evidence of relative stability of market terms (eg
prices and haircuts) and volumes during stressed periods.
 Flight to quality: historically, the market has shown tendencies to move into these types of
assets in a systemic crisis. The correlation between proxies of market liquidity and banking
system stress is one simple measure that could be used.

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2. Operational requirements
...
31. All assets in the stock should be unencumbered. “Unencumbered” means free of legal,
regulatory, contractual or other restrictions on the ability of the bank to liquidate, sell, transfer, or
assign the asset. An asset in the stock should not be pledged (either explicitly or implicitly) to
secure, collateralize or credit-enhance any transaction, nor be designated to cover operational
costs (such as rents and salaries). Assets received in reverse repo and securities financing
transactions that are held at the bank, have not been rehypothecated, and are legally and
contractually available for the bank's use can be considered as part of the stock of HQLA. In
addition, assets which qualify for the stock of HQLA that have been pre-positioned or deposited
with, or pledged to, the central bank or a public sector entity (PSE) but have not been used to
generate liquidity may be included in the stock."

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p2-t7-407-basel-iii-liquidity-

coverage-ratio-lcr.7956/

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P2.T7.408. Basel III liquidity coverage ratio (LCR), continued
AIMs: Differentiate between Level 1, Level 2A, and Level 2B assets, and define the
respective cap for each asset class as a percentage of total HQLA. Define how total net
cash outflows are calculated for the minimum liquidity coverage ratio. Describe
additional metrics to be used by supervisors as monitoring tools when assessing the
liquidity risk of a bank.

408.1. anzone International Bank carries $3.0 billion in Level 1 assets plus $2.0 billion in Level
2A assets. With respect to expected cash outflows over the next 30 days, the bank carries "less
stable" deposits (liabilities) of $80.0 billion with an average run-off rate (factor) of 10%; expected
cash inflows are $10.0 billion. Please note per Basel III:
 Level 1 assets can comprise an unlimited share of the pool and are not subject to a haircut
under the LCR
 A 15% haircut is applied to the current market value of each Level 2A asset held in the stock
of HQLA
 Level 2 assets (comprising Level 2A assets and any Level 2B assets permitted by the
supervisor) can be included in the stock of HQLA, subject to the requirement that they
comprise no more than 40% of the overall stock after haircuts have been applied
 Definition: Total net cash outflows over the next 30 calendar days = Total expected cash
outflow - Min{total expected cash inflows; 75% of total expected cash outflows}
Which is nearest to Canzone's liquidity coverage ratio (LCR)?
a) 87.5%
b) 136.5%
c) 235.0%
d) 360.0%

408.2. Which asset class is mostly likely to receive a run-off factor of 5.0%?
a) Stable deposits
b) Less stable deposits
c) Operational deposits generated by clearing, custody and cash management activities
d) Unsecured wholesale funding provided by other legal entity customers

408.3. Each of the following is a viable liquidity monitoring metric that can supplement the
liquidity coverage ratio (LCR) EXCEPT for which is the least likely to supplement the LCR?
a) Funding liabilities sourced from each significant counterparty as a percentage (%) of
total liabilities
b) Available unencumbered assets that are marketable as collateral in secondary markets
c) Contractual cash and security inflows and outflows from all on- and off-balance sheet
items, mapped to defined time bands based on their respective maturities.
d) Change in the periodic provision for loan losses as a percentage (%) of net interest
income

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Answers:
408.1. C. 235.0%
High quality liquid assets (HQLA) = L1 + L2 * (1-haircut) = 3.0 + 2.0 * (100% - 15%) = $4.7
billion. As 2/(3+2) = 40%, the 40% cap on L2 assets implies a post-haircut L2 max of $2.0
billion, but post-haircut L2 assets are only valued at $1.7 such that cap does not apply.

Total net cash outflows = ($80.0 * 10.0%) - Min{10, 75%*8.0} = 8 - 6 = $2.0 billion.
Therefore, LCR = $4.7/2.0 = 235.0%. Note this is greater than the LCR ratio requirement of
100%.

In summary, the liquidity coverage ratio (LCR) = (Stock of HQLA)/(Total net cash outflows
over the next 30 calendar day) and LCR must be equal to or greater than 100%.
 Stock of HQLA refers to unencumbered high-quality liquid assets (HQLA) that can be
converted easily and immediately in private markets into cash to meet their liquidity needs
for a 30 calendar day liquidity stress scenario.
 Total net cash outflows is defined as the total expected cash outflows minus total
expected cash inflows in the specified stress scenario for the subsequent 30 calendar
days.
o Total expected cash outflows are calculated by multiplying the outstanding balances
of various categories or types of liabilities and off-balance sheet commitments by the
rates at which they are expected to run off or be drawn down.
o Total expected cash inflows are calculated by multiplying the outstanding balances of
various categories of contractual receivables by the rates at which they are expected to
flow in under the scenario up to an aggregate cap of 75% of total expected cash
outflows.
408.2. A. Stable deposits
"75. Stable deposits, which usually receive a run-off factor of 5%, are the amount of the deposits
that are fully insured by an effective deposit insurance scheme or by a public guarantee that
provides equivalent protection and where:
 the depositors have other established relationships with the bank that make deposit
withdrawal highly unlikely; or
 the deposits are in transactional accounts (eg accounts where salaries are automatically
deposited)"

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408.3. D. Provision and net interest income are accrual (not cash) based concepts
 In regard to (A), (B) and (C), each is TRUE as a viable liquidity monitoring metric. The
following metrics, as complements to LCR which can be monitored, are discussed in the
reading:
I. Contractual maturity mismatch;
II. Concentration of funding;
III. Available unencumbered assets;
IV. LCR by significant currency; and
V. Market-related monitoring tools

 In regard to (A), this is a funding concentration metric. The three listed funding concentration
metrics are:

A. Funding liabilities sourced from each significant counterparty as a % of total liabilities

B. Funding liabilities sourced from each significant product/instrument as a % of total
liabilities and
C. List of asset and liability amounts by significant currency

Discuss in forum here: https://www.bionicturtle.com/forum/threads/p2-t7-408-basel-iii-liquidity-

coverage-ratio-lcr-continued.7962/

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P2.T7.B14. Minimum liquidity coverage ratio (LCR) in Basel III
AIM: Define and discuss the minimum liquidity coverage ratio (LCR)
B14.1. Which of the following is TRUE with respect to the framework for liquidity risk in Basel
III?

a) Similar to standardized/internal approach to credit risk, a bank must select and meet at
least one of the two standards, LCR and NSFR, but a bank does not need to meet both
standards
b) Common Equity Tier 1 capital, by definition, automatically satisfies (i.e., qualifies into)
the numerator requirements of both ratios in both liquidity standards
c) In order to “harmonize” with consistency across international jurisdictions, none of the
numerical values and parameters in the liquidity framework can be altered by national
authorities
d) There are two liquidity standards because the Committee has both short-term and long-
term liquidity objectives

B14.2. Which of the following (ceteris paribus) will DECREASE the liquidity coverage ratio?

a) Increase marketable securities

b) Increase in Level 1 assets
c) An increase in the haircut applied to a Level 2 asset from the minimum 15% to 25%
d) Lower run-off rate for retail deposits

B14.3. Which of the following liabilities has the lowest run-off factor?

a) Less stable retail deposits

b) Unsecured wholesale funding from non-financial corporations
c) Asset-backed securities
d) Positive current exposure on OTC interest rate swap (i.e., net derivative payable)

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B14.4. EACH of the following is a characteristic of a high-quality asset EXCEPT for:

a) Active and sizeable market with evidence of market breadth (price impact per unit of
liquidity) and market depth (units of the asset that can be traded for a given price impact)
b) High market concentration among a limited set group of buyers and sellers
c) Low correlation with risky assets; i.e., not subject to wrong-way risk
d) Asset class has shown historical tendency to be a "flight to quality" destination

B14.5. With respect to high-quality assets, assume a bank carries $10 million in Level 1 assets
plus $10 million in Level 2 assets. With respect to expected cash outflows over the next 30
days, the bank carries a liabilities of $40 million with an average run-off rate (factor) of 25%;
expected cash inflows are $15 million. What is the liquidity coverage ratio (LCR)?

a) -370%
b) 667%
c) 800%
d) 1,600%

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Answers:
Please note: Liquidity Coverage Ratio (LCR): Stock of high-quality liquid assets / Total
net cash outflows over the next 30 calendar days >= 100%, where:

1. High quality assets (e.g., cash, marketable securities) can be Level 1 Assets
(carried at 100%) or Level 2 Assets (carried at 85%; i.e., minimum 15% haircut);

2. Total net cash outflows over the next 30 calendar days = outflows – Min {inflows;
75% of outflows} and outflows are determined by multiplying the balance by a run-
off factor

B14.1. D. There are two liquidity standards because the Committee has both short-term
and long-term liquidity objectives

“4. To complement these principles, the Committee has further strengthened its liquidity
framework by developing two minimum standards for funding liquidity. These standards have
been developed to achieve two separate but complementary objectives. The first objective is to
promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient
high-quality liquid assets to survive a significant stress scenario lasting for one month. The
Committee developed the Liquidity Coverage Ratio (LCR) to achieve this objective. The second
objective is to promote resilience over a longer time horizon by creating additional incentives for
banks to fund their activities with more stable sources of funding on an ongoing basis. The Net
Stable Funding Ratio (NSFR) has a time horizon of one year and has been developed to
provide a sustainable maturity structure of assets and liabilities.”

 In regard to (A), this is false: as the LCR is designed to meet the short-term and the
NSFR is designed to meet the long-term, the two standards are complementary
 In regard to (B), this is false: the LCR is a short-term liquidity test where the numerator is
“high-quality liquid assets.” This is assets not equity, with respect to the balance sheet;
e.g., a bank can have high common equity due to a preponderance of illiquid assets
(equity = assets - liabilities).
 In regard to (C), this harmony is true only at a shallow, limited level and ultimately false
as supervisors are encouraged to increase values, at their preference:
“5. These two standards are comprised mainly of specific parameters which are
internationally “harmonized” with prescribed values. Certain parameters, however,
contain elements of national discretion to reflect jurisdiction-specific conditions. In these
cases, the parameters should be transparent and clearly outlined in the regulations of
each jurisdiction to provide clarity both within the jurisdiction and internationally.“

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B14.2. C. An increase in the haircut applied to a Level 2 asset from the
minimum 15% to 25%

LCR: Stock of high-quality liquid assets / Total net cash outflows over the next 30
calendar days >= 100%

 In regard to (A) and (B), both increase the numerator

 In regard to (C), a reduction to the Level 2 asset haircut increases the numerator of the
LCR (15% is the Level 2 minimum. Level 1 assets are carried at 100%).
 In regard to (D), net cash flows = total expected cash outflows - total expected cash
inflows; where run-rates are multiplied by liabilities to represent a percentage that “flow
out.” Higher run rates therefore increase the denominator.

“50. The term total net cash outflows is defined as the total expected cash outflows minus total
expected cash inflows in the specified stress scenario for the subsequent calendar days. Total
expected cash outflows are calculated by multiplying the outstanding balances of various
categories or types of liabilities and off-balance sheet commitments by the rates at which they
are expected to run off or be drawn down. Total expected cash inflows are calculated by
multiplying the outstanding balances of various categories of contractual receivables by the
rates at which they are expected to flow in under the scenario up to an aggregate cap of 75% of
total expected cash outflows.”

B14.3 A. Less stable retail deposits have a minimum 10% run-off factor. While 5% of
stable deposits are assumed to run-off, 10% of less stable are assumed to run-off.

 In regard to (B), Unsecured wholesale funding to non-financial corporates, sovereigns,

central banks and PSEs: 75% run-off
 In regard to (C) and (D), they each have 100% run-off factors; their entire balance is
included in the numerator; e.g., intuitively, an OTC swap is not really a source of funding!

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B14. 4. B. NOT HIGH, but rather: Low market concentration among a limited set group of
buyers and sellers

"Characteristics of high-quality liquid assets

(a) Fundamental characteristics

 Low credit and market risk: assets that are less risky tend to have higher liquidity. High
credit standing of the issuer and a low degree of subordination increases an asset’s
liquidity. Low duration, low volatility, low inflation risk and denomination in a convertible
currency with low foreign exchange risk all enhance an asset’s liquidity.
 Ease and certainty of valuation: an asset’s liquidity increases if market participants are
more likely to agree on its valuation. The pricing formula of a high-quality liquid asset
must be easy to calculate and not depend on strong assumptions. The inputs into the
pricing formula must also be publicly available. In practice, this should rule out the
inclusion of most structured or exotic products.
 Low correlation with risky assets: the stock of high-quality liquid assets should not be
subject to wrong-way (highly correlated) risk. For example, assets issued by financial
institutions are more likely to be illiquid in times of liquidity stress in the banking sector.
 Listed on a developed and recognized exchange market: being listed increases an
asset’s transparency.

(b) Market-related characteristics

 Active and sizable market: the asset should have active outright sale or repurchase
agreement (repo) markets at all times (which means having a large number of market
participants and a high trading volume). There should be historical evidence of market
breadth (price impact per unit of liquidity) and market depth (units of the asset that can
be traded for a given price impact).
 Presence of committed market makers: quotes will most likely be available for buying
and/or selling a high-quality liquid asset.
 Low market concentration: a diverse group of buyers and sellers in an asset’s market
increases the reliability of its liquidity.
 Flight to quality: historically, the market has shown tendencies to move into these types
of assets in a systemic crisis."

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B14.5. B. 667%
As Level II Assets can only comprise 40% after haircut,
 Level II Assets = $6.67, and
 High quality assets = $10 + $6.667 = $16.667
Net cash outflows = Total net cash outflows over the next 30 calendar days
= outflows – Min {inflows; 75% of outflows}. In this case,
= $40*25% run-off - MIN{15, 75%*40*25%}
= $10 - 7.5 = $2.5
LCR = 16.667 / 2.5 = 667%

From Basel III: International framework for liquidity risk … Dec 2010" (emphasis mine)
"(ii) Level 2 assets:
41. Level 2 assets can be included in the stock of liquid assets, subject to the requirement
that they comprise no more than 40% of the overall stock after haircuts have been
applied. As mentioned above, the Level 2 cap also effectively includes cash or other Level 1
assets generated by secured funding transactions (or collateral swaps) maturing within 30 days.
The method for calculating the cap on Level 2 assets is set out in paragraph 36. The portfolio of
Level 2 assets held by any institution should be well diversified in terms of type of assets, type
of issuer (economic sector in which it participates, etc) and specific counterparty or issuer.
42. A minimum 15% haircut is applied to the current market value of each Level 2 asset
held in the stock. Level 2 assets are limited to the following:
(a) Marketable securities representing claims on or claims guaranteed by sovereigns, central
banks, non-central government PSEs or multilateral development banks that satisfy all of the
following conditions: assigned a 20% risk weight under the Basel II Standardized Approach for
credit risk; traded in large, deep and active repo or cash markets characterized by a low level of
concentration; proven record as a reliable source of liquidity in the markets (repo or sale) even
during stressed market conditions …
(b) Corporate bonds and covered bonds that satisfy all of the following conditions: not issued by
a financial institution or any of its affiliated entities (in the case of corporate bonds); not issued
by the bank itself or any of its affiliated entities (in the case of covered bonds); assets have a
credit rating from a recognized external credit assessment institution (ECAI) of at least AA-12 or
do not have a credit assessment by a recognized ECAI and are internally rated as having a
probability of default (PD) corresponding to a credit rating of at least AA-; traded in large, deep
and active repo or cash markets characterized by a low level of concentration; and proven
record as a reliable source of liquidity in the markets (repo or sale) even during stressed market
conditions: ie, maximum decline of price or increase in haircut over a 30-day period during a
relevant period of significant liquidity stress not exceeding 10%."

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coverage-ratio-lcr-in-basel-iii.4521/

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P2.T7.B15. Net stable funding ratio (NSFR) in Basel III
AIM: Define and discuss the net stable funding ratio.
B15.1. Which of the following potential causes (or risk sources) of the Global Financial Crisis
(GFC) is the net stable funding ratio (NSFR) in Basel III most nearly designed to address?

a) Securitization of asset backed securities (e.g. MBS)

b) Mark-to-market accounting
c) Gary Gorton’s “run on” (panic in) the shadow banking system
d) The inability of the risk-weighting (risk weighted assets) to capture certain granular risks

B15.2. EACH of the following is TRUE about the net stable funding ratio (NSFR) in Basel III
EXCEPT:

a) NSFR includes off-balance sheet (OBS) exposures

b) Unsecured liabilities with maturities of more than one year are excluded from available
stable funding (ASF; i.e., ASF factor = 0%)
c) While the liquidity coverage ratio (LCR) aims to mitigate short-term liquidity risk, the
NSFR aims to mitigate medium- and long-term funding liquidity risk
d) Cash is an asset that requires no (zero) stable funding

B15.3. Which is the net stable funding ratio (NSFR)?

a) NSFR = Required amount of stable funding minus (-) Available amount of stable funding
and must exceed Tier 1 capital
b) NSFR = Available amount of stable funding minum (-) Required amount of stable funding
and must exceed Tier 1 capital
c) NSFR = Required amount of stable funding / Available amount of stable funding and
must exceed 100% (1.0)
d) NSFR = Available amount of stable funding / Required amount of stable funding and
must exceed 100% (1.0)

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B15.4. Which of the following is a correctly ordered sequence with respect to the stability of
available stable funding (ASF) sources, from MOST stable to LEAST stable?

a) Tier 2 Capital > Insured demand deposits (e.g. FDIC) > Uninsured demand deposits >
Unsecured wholesale funds
b) Unsecured wholesale funds > Tier 2 Capital > Insured demand deposits (e.g. FDIC) >
Uninsured demand deposits
c) Uninsured demand deposits > Unsecured wholesale funds > Tier 2 Capital > Insured
demand deposits (e.g. FDIC)
d) Insured demand deposits (e.g. FDIC) > Uninsured demand deposits > Unsecured
wholesale funds > Tier 2 Capital

B15.5. Which of the following is a correctly ordered sequence with respect to the required
source funding (RSF) factors, from highest RSF factor (exposure that requires much stable
funding) to lowest RSF factor (exposure that requires no stable funding)?

a) Marketable securities issued by 0% risk-weighted central bank > Short-term small

business loan > Stock in S&P 500 index constituent > Long-term “A” rated corporate
bond
b) Long-term “A” rated corporate bond > Marketable securities issued by 0% risk-weighted
central bank > Short-term small business loan > Stock in S&P 500 index constituent
c) Short-term small business loan > Stock in S&P 500 index constituent > Long-term “A”
rated corporate bond > Marketable securities issued by 0% risk-weighted central bank
d) Short-term small business loan > Marketable securities issued by 0% risk-weighted
central bank > Long-term "A" rated corporate bond > Stock in S&P 500 index constituent

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Answers:
B15.1. C. Gary Gorton’s “run on” (panic in) the shadow banking system
Emphasis is mine: “120. In particular, the NSFR standard is structured to ensure that long term
assets are funded with at least a minimum amount of stable liabilities in relation to their liquidity
risk profiles. The NSFR aims to limit over-reliance on short-term wholesale funding during
times of buoyant market liquidity and encourage better assessment of liquidity risk across all
on-and off-balance sheet items. In addition, the NSFR approach offsets incentives for
institutions to fund their stock of liquid assets with short-term funds that mature just outside the
30-day horizon for that standard.”

B15.2. B. Unsecured, long-term liabilities are stable funding sources; they have an ASF
factor of 100%. Far less stable are short-term, secured liabilities.

In regard to (A), (C), and (D), each are TRUE about the NSFR.

 In regard to (A), “135. Off-balance sheet exposures: Many potential OBS liquidity
exposures require little direct or immediate funding but can lead to significant liquidity
drains in times of market or idiosyncratic stress. As a result, the application of an RSF
factor to various OBS activities results in a requirement for the institution to establish a
“reserve” of stable funding that would be expected to fund existing assets that might not
otherwise be funded with stable funds as defined in other parts of this standard. While
funds are indeed fungible within a financial institution, this requirement could be viewed
as promoting the stable funding of the stock of liquid assets that could be used to meet
liquidity requirements arising from OBS contingencies in times of stress.“
 In regard to (C), “119. To promote more medium and long-term funding of the assets
and activities of banking organisations, the Committee has developed the Net Stable
Funding Ratio (NSFR). This metric establishes a minimum acceptable amount of stable
funding based on the liquidity characteristics of an institution’s assets and activities over
a one year horizon. This standard is designed to act as a minimum enforcement
mechanism to complement the LCR and reinforce other supervisory efforts by promoting
structural changes in the liquidity risk profiles of institutions away from short-term funding
mismatches and toward more stable, longer-term funding of assets and business
activities.”
 In regard to (D), this is true: the RSF factor of cash is 0%.

B15.3. D. NSFR = Available amount of stable funding / Required amount of stable funding
and must exceed 100% (1.0)

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B15.4. A. Tier 2 Capital > Insured demand deposits (e.g. FDIC) > Uninsured demand
deposits > Unsecured wholesale funds

Some ASF Factors:

 Unsecured wholesale funding = 50%;
 Less stable (uninsured) demand deposits = 80%
 Stable (insured) demand deposits = 90%
 Tier 1/Tier 2/LT preferred = 100%

B15.5. C. Short-term small business loan > Stock in S&P 500 index constituent > Long-
term “A” rated corporate bond > Marketable securities issued by 0% risk-weighted
central bank

Some RSF Factors:

 Cash = 0%
 Unencumbered marketable securities issued by sovereigns, central banks = 0% (if RW =
0%) to 20%
 Unencumbered corporate bonds or covered bonds rated AA- or higher with residual
maturities of one year = 20%
 Unencumbered gold = 50%
 Unencumbered equity securities, not issued by financial institutions or their affiliates,
listed on a recognized exchange and included in a large cap market index = 50%
 Unencumbered loans to retail customers (ie natural persons) and small business
customers (as defined in the LCR) having a remaining maturity of less than one
year = 85%

Discuss in forum here: http://www.bionicturtle.com/forum/threads/l2-t7-b15-net-stable-funding-

ratio-nsfr-in-basel-iii.4524/

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P2.T7.B16. Basel III liquidity monitoring tools
AIM: Define and discuss practical applications of prescribed liquidity monitoring tools,
including: Contractual maturity mismatch; Concentration of funding; Available
unencumbered assets; Liquidity coverage ratio by significant currency; Market related
monitoring tools
B16.1. With respect to the monitoring tools (that complement the liquidity coverage ratio, LCR,
and the net stable funding ratio, NSFR) in the Basel III liquidity framework, which tool (metric)
looks at the size of significant counterparty liabilities as percentage of the bank’s balance sheet?

a) Contractual maturity mismatch

b) Concentration of funding
c) Available unencumbered assets
d) Liquidity coverage ratio by significant currency

B16.2. If a bank funds US dollar (USD) high-quality, long-duration, unencumbered credit-

sensitive assets by rolling over a diversified set of short-term USD (liability) funding sources,
which of the liquidity framework tools is most likely to raise a red flag?

a) Contractual maturity mismatch

b) Concentration of funding
c) Available unencumbered assets
d) Liquidity coverage ratio by significant currency

B16.3. Which of the liquidity framework tools is focused on the positions, exposures or
instruments that can be used as collateral to tap additional liquidity sources?

a) Contractual maturity mismatch

b) Concentration of funding
c) Available unencumbered assets
d) Liquidity coverage ratio by significant currency

B16.4. Which of the liquidity framework metrics is a ratio that directly mixes both both (on- and
off-) balance sheet accounts and cash flows? (for example, the current ratio = current
assets/current liabilities and therefore directly is a ratio of balance sheet accounts. Compare to
cash flow return on investment, CFROI, which divides a cash flow numerator in a balance sheet
denominator)

a) Contractual maturity mismatch

b) Concentration of funding
c) Available unencumbered assets
d) Liquidity coverage ratio by significant currency

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Answers:
B16.1. B. Concentration of funding
Concentration of funding:
“151. This metric is meant to identify those sources of wholesale funding that are of such
significance that withdrawal of this funding could trigger liquidity problems. The metric thus
encourages the diversification of funding sources recommended in the Committee’s Sound
Principles.
2. Definition and practical application of the metric
A. Funding liabilities sourced from each significant counterparty / The bank’s balance sheet total
B. Funding liabilities sourced from each significant product or instrument / The bank’s balance
sheet total
C. List of asset and liability amounts by significant currency “

B16.2 A. Contractual maturity mismatch

“140. The contractual maturity mismatch profile identifies the gaps between the contractual
inflows and outflows of liquidity for defined time bands. These maturity gaps indicate how much
liquidity a bank would potentially need to raise in each of these time bands if all outflows
occurred at the earliest possible date. This metric provides insight into the extent to which the
bank relies on maturity transformation under its current contracts.”
 In regard to (B), the funding sources are diversified not concentrated.
 In regard to (C), this metric might raise a red flag but not necessarily if the assets can be
used as collateral. This answer might be acceptable but (A) is arguably more to the
point.
 In regard to (D), there is not a currency mismatch as both assets and liabilities are in
USD.

B16.3. C. Available unencumbered assets

“Objective: 164. This metric provides supervisors with data on the quantity and key
characteristics, including currency denomination and location, of banks’ available
unencumbered assets. These assets have the potential to be used as collateral to raise
additional secured funding in secondary markets and/or are eligible at central banks and as
such may potentially be additional sources of liquidity for the bank.”

B16.4. D. Liquidity coverage ratio by significant currency

Foreign Currency LCR = Stock of high-quality liquid assets in each significant currency / Total
net cash outflows over a 30-day time period in each significant currency
i.e., LCR = asset / cash outflow
 In regard to (A), contractual maturity mismatch is primarily a CASH FLOW perspective;
 In regard to (B), concentration of funding focuses on balance sheet (funding)
LIABILITIES
 In regard to (C), available unencumbered assets focuses on balance sheet ASSETS

Discuss in forum here: http://www.bionicturtle.com/forum/threads/l2-t7-b16-basel-iii-liquidity-

monitoring-tools.4527/

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