Liquidity management practices of banks in emerging market economies under Basel III liquidity regulations.

Abstract

During the 2007 to 2009 global financial crisis, several banks experienced liquidity problems, largely as a result of liquidity management practices they pursued prior to the crisis. In an effort to strengthen banks’ liquidity management practices, the Basel Committee on Banking Supervision announced harmonized and binding liquidity requirements for banks in December 2010 under the Basel III framework in the form of the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The LCR aims to enhance banks’ short term resilience to liquidity stress lasting 30 calendar days by requiring them to maintain sufficient stock of high quality liquid assets. The NSFR seeks to limit banks’ asset and liability mismatch by demanding them to maintain a balanced funding mix that is commensurate with their asset base and off-balance sheet activities. Thus, liquidity standards are deliberately aimed at affecting banks’ liquidity management practices. However, the new liquidity regulations introduced by the Basel Committee on Banking Supervision may bring a new source of intertemporal assets and liabilities choices that are currently absent in banks’ decision making processes. Moreover, as with all regulations, liquidity standards may or may not produce their expected goals. Accordingly, this study sought to examine the impact of the Basel III liquidity standards, in particular, the LCR which is now binding on liquidity management practices of banks operating in emerging market economies. Employing the two-step system Generalised Method of Moments estimation technique on a panel dataset of forty commercial banks operating in eleven emerging market economies over the period 1 January 2011 to 31 December 2016, the results obtained revealed that banks in emerging market economies have target liquidity ratios they pursue and partially adjust their liquidity due to financial frictions. Furthermore, the study established that the Basel III LCR liquidity regulation complemented liquidity management practices of banks in emerging markets. In terms of the behavioral response of banks in emerging markets to liquidity standards, the study found that, on the asset side, banks in emerging markets appear to have elevated their stock of high quality liquid assets and on the liability side, it seems banks in emerging markets increased retail deposits, equity and long term funding. Moreover, empirical results demonstrated that the LCR charge did not adversely affect the profitability of banks in emerging markets. Among other things, these findings suggest that the LCR liquidity regulation is less effective in jurisdictions with high liquidity reserves. In addition, changes in banks’ funding mix caused by regulatory pressure stemming from the LCR rule may lead to stiff competition for retail deposits among banks. The study therefore recommends that regulators and policy makers should monitor competition for retail deposits to prevent reversal of financial sector stability gains achieved by the liquidity regulations. The study also advocates for the adoption of the Basel III liquidity standards in jurisdictions with commercial banks that depend more on capital markets for funding.