Committed liquidity facility

What Is Committed Liquidity Facility?

A committed liquidity facility (CLF) is a contractual arrangement under which a central bank or other financial authority agrees to provide a pre-determined amount of liquidity to a qualifying financial institution upon demand, typically against eligible collateral. This facility falls under the broader category of Financial Regulation and Liquidity Management, serving as a crucial backstop for banks to manage their liquidity risk. It aims to ensure that banks have access to a reliable source of funding, especially during periods of market stress, thereby contributing to overall financial stability. The committed liquidity facility is designed to complement a bank's holdings of High-Quality Liquid Assets (HQLA) in meeting regulatory requirements.

History and Origin

The concept of a committed liquidity facility gained significant prominence following the 2008 global financial crisis. The crisis exposed severe vulnerabilities in banks' liquidity management, as many institutions faced difficulties in accessing funding when interbank lending markets froze. In response, the Basel Committee on Banking Supervision (BCBS) introduced a comprehensive set of reforms known as Basel III, which included the implementation of the Liquidity Coverage Ratio (LCR). The LCR requires banks to hold sufficient HQLA to cover their net cash outflows over a 30-day stress scenario.

However, some jurisdictions, particularly those with smaller government bond markets, found it challenging for banks to hold enough HQLA in the form of sovereign bonds without disrupting market functioning. To address this, Basel III allowed for the inclusion of certain central bank committed liquidity facilities as an alternative or supplementary source of liquidity to meet LCR requirements. The Bank for International Settlements (BIS) outlines the conditions for these "Restricted-use committed liquidity facilities" within the Basel III framework.⁹ Countries like Australia, through its Reserve Bank of Australia (RBA), adopted CLFs to ensure their banking systems could comply with the LCR while considering the local market's characteristics.⁸

Key Takeaways

• A committed liquidity facility provides a guaranteed source of liquidity from a central bank to eligible financial institutions.
• It serves as a critical backstop, enhancing a bank's ability to withstand liquidity shocks, especially during times of market stress.
• CLFs are a component of international banking regulations, particularly the Basel III Liquidity Coverage Ratio (LCR), allowing banks to count the committed amount towards their liquidity buffers.
• Banks typically pay a commitment fee for a committed liquidity facility, irrespective of whether the funds are drawn upon.
• The facility generally requires the pledging of eligible collateral, which the central bank can value and accept.

Formula and Calculation

While there isn't a universal formula for the committed liquidity facility itself, its primary application is within the calculation of the Liquidity Coverage Ratio (LCR). The LCR is expressed as:

In jurisdictions where a committed liquidity facility is permitted to count towards LCR requirements, the undrawn value of the CLF can be included in the "Stock of HQLA" component, subject to specific conditions and haircuts determined by the local regulator and central bank. The Basel III framework specifies that the undrawn value of a contractual CLF provided by a central bank can be included in Level 2B assets under certain conditions.⁷ This inclusion effectively increases the numerator of the LCR, improving a bank's compliance.

Interpreting the Committed Liquidity Facility

The presence and size of a committed liquidity facility indicate a bank's robust approach to liquidity risk management and its ability to meet regulatory capital requirements. For regulators, it signifies that financial institutions have a pre-arranged, reliable mechanism to access liquidity, reducing the likelihood of a liquidity crisis escalating into a broader systemic risk. The commitment fee paid by banks for a CLF reflects the cost of this liquidity insurance. From a supervisory perspective, understanding how banks integrate their committed liquidity facility into their overall funding strategy is crucial for assessing their resilience.

Hypothetical Example

Imagine "MegaBank," a large commercial bank operating in a country where the central bank offers a committed liquidity facility. MegaBank has assessed its potential liquidity needs under a severe 30-day stress scenario and determines it requires an additional $50 billion in liquid resources beyond its existing HQLA. To meet its LCR requirements and enhance its resilience, MegaBank enters into a CLF agreement with the central bank for $50 billion.

Under this agreement:

1. MegaBank pledges a portfolio of eligible, unencumbered assets, such as mortgage-backed securities, as collateral for the facility.
2. It pays an annual commitment fee on the $50 billion undrawn amount, for instance, 0.75% as per Basel III guidelines for restricted-use CLFs.⁶
3. Should a liquidity stress event occur, MegaBank can draw on the $50 billion committed liquidity facility by formally requesting funds from the central bank against the pre-positioned collateral, without needing a new credit assessment at the time of draw-down, provided the bank remains solvent.

This committed liquidity facility provides MegaBank with immediate access to crucial funds, preventing a potential liquidity shortfall and allowing it to continue meeting its short-term obligations during the stress period.

Practical Applications

Committed liquidity facilities are primarily observed in the realm of banking regulation and central bank operations, particularly in relation to the Liquidity Coverage Ratio (LCR). Key applications include:

• LCR Compliance: Banks utilize CLFs to supplement their holdings of High-Quality Liquid Assets to meet the quantitative requirements of the LCR, ensuring they have sufficient liquidity to cover outflows in a stress scenario.
• Contingency Funding Plans: A committed liquidity facility is a core component of a bank's contingency funding plan, providing a pre-arranged and reliable source of emergency funding.
• Market Stability: By ensuring individual banks can access liquidity, CLFs contribute to broader financial stability, reducing the likelihood of a localized liquidity crunch spreading through the interbank market.
• Central Bank Toolkit: Central banks like the Federal Reserve in the U.S. and the European Central Bank (ECB) have various facilities that serve similar backstop functions, reinforcing their role as liquidity providers of last resort.⁵,⁴ The Federal Reserve also addresses the treatment of liquidity commitments like those provided to municipalities and public sector entities within the LCR framework.³

Limitations and Criticisms

While beneficial for liquidity management and regulatory compliance, committed liquidity facilities have certain limitations and have faced criticism:

• Moral Hazard: Critics argue that providing guaranteed liquidity facilities might create a moral hazard, potentially reducing banks' incentives to manage their own liquidity prudently in normal times.
• Cost and Usage: The commitment fees associated with CLFs can be substantial, and if the facility is never drawn upon, it represents a direct cost to the bank without direct liquidity benefits. Historically, some proposed CLFs, such as those discussed for the U.S., have been criticized for having fees considered uneconomic.²
• Reliance on Central Bank: An over-reliance on a committed liquidity facility could imply a lack of sufficient market-based HQLA, making the banking system more dependent on the central bank during stress periods, potentially blurring the lines between liquidity provision and government support.
• Collateral Haircuts: The value of the collateral pledged for a CLF is typically subject to "haircuts" by the central bank, meaning the facility's effective borrowing capacity is less than the nominal value of the collateral, which can reduce its actual utility.¹

Committed Liquidity Facility vs. Discount Window

The committed liquidity facility (CLF) and the discount window are both mechanisms through which a central bank provides liquidity to commercial banks, but they differ significantly in their nature and typical use.

While the discount window serves as a lender of last resort, often used during acute, unexpected liquidity shortages, a committed liquidity facility is a planned part of a bank's liquidity management and regulatory compliance strategy. The CLF aims to prevent the need for an emergency draw from the discount window by providing a predictable liquidity backstop.

FAQs

What is the primary purpose of a committed liquidity facility?

The primary purpose of a committed liquidity facility is to provide banks with a reliable, pre-arranged source of liquidity from a central bank, enabling them to meet regulatory requirements like the Liquidity Coverage Ratio (LCR) and manage potential liquidity shortfalls during periods of market stress.

How does a committed liquidity facility relate to Basel III?

Under Basel III regulations, specifically the Liquidity Coverage Ratio (LCR), some jurisdictions allow banks to include a portion of their undrawn committed liquidity facility from a central bank as a component of their High-Quality Liquid Assets (HQLA), subject to specific conditions and haircuts. This helps banks comply with the LCR without solely relying on holdings of liquid securities.

Do banks pay for a committed liquidity facility if they don't use it?

Yes, banks typically pay a commitment fee on the total committed amount of a committed liquidity facility, whether or not they actually draw upon the funds. This fee is the cost of having the guaranteed access to liquidity. This is similar to paying a premium for an insurance policy.

What kind of collateral is typically required for a committed liquidity facility?

For a committed liquidity facility, banks are generally required to pledge high-quality, unencumbered collateral as specified by the central bank. This can include government securities, highly-rated corporate bonds, or other eligible assets that the central bank deems sufficiently secure. The collateral helps protect the central bank in case the facility is drawn.