Liquidity and stable funding
In accordance with the authorisation found in Article 12 of the Act on the Central Bank of Iceland, no. 36/2001, with subsequent amendments, the Central Bank has issued the Rules on Liquidity Ratio, etc., no. 1031/2014, and the Rules on Funding Ratios in Foreign Currencies, no. 1032/2014.
The Rules on Liquidity Ratio, etc., no. 1031/2014, took effect on 1 December 2013 and are issued in accordance with Article 12 of the Act on the Central Bank of Iceland, no. 36/2001, with subsequent amendments, which authorises the Central Bank to set rules on credit undertakings’ minimum or average liquidity. The rules replaced the previous Rules on Liquidity Ratio and are based on liquidity guidelines from the Basel Committee on Banking Supervision.
The objective of the new liquidity rules is to mitigate the adverse effects of financial market shocks that surface in liquidity shortages within one or more credit institutions. The rules are designed to reduce the liquidity risk of these institutions and of the financial system as a whole by ensuring that credit institutions always have sufficient liquidity to meet foreseeable and conceivable payment obligations during specified periods of time. With new liquidity rules for credit institutions, steps are taken towards reducing foreign currency liquidity risk (currency mismatches), which proved to be a major risk factor during the run-up to the banking collapse of 2008. Furthermore, criteria for liquid asset quality have been tightened, and deposits have been classified in greater detail and assigned weights based on risk. Moreover, greater consideration is now given to risk stemming from off-balance sheet items. Information disclosure requirements have been broadened, and requirements are now made at the group level instead of the parent company level.
These rules apply to credit undertakings – commercial banks, savings banks, other institutions and companies that are authorised by law to accept deposits from the general public for custody and investment – and other credit institutions that operate in accordance with the law and are obliged to comply with Central Bank Rules on Minimum Reserve Requirements, no. 373/2008. The rules apply to parent companies and to the group for which a credit institution acts as the parent company. Credit institutions are obliged to send the Central Bank monthly reports providing information underlying the calculation of their liquidity ratios. Parent company reports shall be submitted to the Central Bank by the tenth (10th) day of each month, and group-level reports shall be submitted by the twentieth (20th) day of each month. The Central Bank is authorised to levy per diem fines for negligence in reporting. The liquidity requirements according to the rules apply to 30-day liquidity ratios; however, the rules specify that, for assessment of liquidity risk, three-month ratios shall be calculated and tracked and developments in these ratios monitored. If a credit institution should fall below the minimum specified in the rules, or if it is foreseeable that it will fall below the minimum within the next six months, the institutions shall immediately send the Central Bank a written report outlining the reasons for the deviation. The institutions shall also present a dated schedule of who it intends to restore its liquidity ratio to the regulatory minimum. In addition to the liquidity reports, credit institutions shall submit deposit and funding summaries for informational purposes. Institutions shall also provide any and all information the Central Bank deems necessary to assess the liquidity position of the institution concerned more accurately or to conduct stress tests.
Rules, template, and guidelines
Rules on Liquidity Ratio, etc., no. 1031/2014. These rules and others can be found here: Laws and rules.
The Rules on Funding Ratios in Foreign Currencies, no. 1032/2014, took effect on 1 December 2014. The funding ratio is intended to ensure a minimum level of stable one-year funding in foreign currencies and therefore restrict the degree to which the commercial banks can rely on unstable short-term funding to finance long-term foreign-denominated lending. The rules on funding ratios limit maturity mismatches and the extent to which the banks can depend on unstable short-term funding to finance long-term assets that could prove difficult to sell.
Maturity transformation between assets and liabilities is an important contribution made by the banks to the economy, but it is also risky. By transmitting liquidity to the banking system and acting as a lender of last resort, central banks can mitigate the systemic risk that accompanies this maturity transformation. A central bank’s ability to grant foreign-denominated last-resort loans is limited, however. As a result, it is undesirable that the banks should take risks based on the assumption that the Central Bank will be able to extend foreign-denominated loans to them under duress. During the prelude to the 2008 financial crisis, the large commercial banks’ maturity mismatches escalated markedly. The banks relied increasingly on short-term foreign funding, including collateralised short-term loans and foreign deposit collection, which led to rising foreign refinancing risk. Rules on stable funding should impede adverse developments such as those taking place during the run-up to the financial crisis.
In view of experience, the Central Bank considers it important to reduce the risk that could result from excessive maturity mismatches between the commercial banks’ assets and liabilities by explicitly limiting maturity mismatches in foreign currency. This is particularly important during the prelude to capital account liberalisation. The funding ratio in foreign currencies that the Bank has adopted is based on the Basel Committee’s rules concerning net stable funding ratios (NSFR).
The Bank intends to implement the rules on funding ratios in foreign currencies, which are designed to cover periods ranging up to three years, in 2015. This is in accordance with the declared objectives set forth in the Bank’s publication entitled “Prudential Rules Following Capital Controls”, according to which domestic financial institutions should be able to withstand closure of foreign credit markets for up to three years.