FINANCIAL INSTITUTIONS a Research Publication by DZ BANK AG

1/27 FINANCIAL INSTITUTIONS A Research Publication by DZ BANK AG EU Commission’s finalised LCR rules BONDS spring no surprises Flash » The EU Commission has published a delegated act setting out the details of 21 Oct 2014 how the liquidity coverage requirement (LCR) ratio is to be calculated. Alt- hough the detailed LCR ratio is based on the liquidity ratio defined in the Basel 3 framework, the EU Commission took the view that the Basel standard could not be implemented in Europe without being adapted to the specificities of the EU. Greater recognition is to be given to certain covered bonds which emerged » from the technical analysis carried out by the European Banking Authority (EBA) as excellent performers in terms of liquidity and credit rating. This greater recognition will be subject to a number of conditions. Thus covered bonds with ECAI 1 ratings may account for up to 70% of the liquidity buffer and have a 7% haircut applied to their value, while ECAI 2-rated covered bonds may make up a maximum 40% of the liquidity buffer and take a 15% haircut. Now on Bloomberg: DZBR <GO> » With regard to ABS the EU Commission is proposing to permit a broader range of securitised assets rather than just residential mortgage-backed securities (RMBS). The limit of 15% of banks' liquidity buffer for Level 2B assets may also include a number of other types of ABS, such as auto ABS, which the Commission believes have demonstrated adequate liquidity. A couple of smaller ABS classes with a solid liquidity and credit quality history, which play an important role in financing loans to SMEs and consumers – i.e. securitisations backed by consumer credit assets and loans to SMEs – will also be per- mitted. » The introduction of the binding minimum LCR ratio of 60% from 1 October 2015 is unlikely to have a huge impact on demand for the different asset categories, as the banks have already significantly boosted their LCR ratios in re- cent years. However, there could be switches within the current liquidity portfo- lio that could lead to shifts in demand for individual asset classes. In addition, Authors: the rating sensitivity of covered bonds could increase around the rating thresh- Dr. Abdoulaye Aboubakar, ANALYST old of AA- / A+ in future. Thorsten Euler, ANALYST Ann-Kristin Möglich, ANALYST Oliver Piquardt, ANALYST 1) – 9) Important: Please read the references to possible conflicts of interest and disclaimers/disclosures at the end of this report. DZ BANK RESEARCH 2/27 FINANCIAL INSTITUTIONS – EU COMMISSION'S FINALISED LCR RULES SPRING NO SURPRISES FLASH 21 OCT 2014 FINALISED LIQUIDITY COVERAGE REQUIREMENT (LCR) RULES The EU Commission has published a delegated act setting out the details of how the Detailed LCR ratio liquidity coverage requirement (LCR) ratio is to be calculated. The detailed LCR ratio is based on the liquidity ratio defined in the Basel 3 framework, according to which banks must have sufficient high-quality liquid assets (HQLA) in their liquidity buffer to cover the difference between the expected cash outflows and the expected capped cash inflows over a 30-day stressed period. However, the EU Commission took the view that the Basel standard could not be implemented in Europe without being adapted to the specificities of the EU. One reason for this is the fact that the Basel agreement was designed for implemen- Deviation from Basel standard to tation by a small number of internationally active financial institutions, whereas the take account of EU specificities EU will apply the LCR to all 8,000 EU banks. A second is that the Basel 3 liquidity coverage standard applies only at the consolidated level, while the EU will apply the LCR ratio at both individual institutional and consolidated levels. Thirdly, the Basel 3 definition of eligible assets is confined to a group of assets (notably government bonds, cash positions and risk exposures to central banks) deemed to be highly liquid in all BCBS jurisdictions and hence eligible for inclusion in the liquidity buffer without upper limit or haircut. However, this fails to give adequate recognition to certain specific assets which might demonstrate higher liquidity in some of those jurisdictions than is assumed in the Basel agreement. These assets need to be accorded greater eligibility as HQLA than is currently envisaged in the Basel agreement. In the European Union the liquidity and/or rating performance of certain asset classes (notably top-quality covered bonds and asset-backed securitisations backed by auto loans) has been equal or even superior to that of the asset classes defined as eligible under Basel 3. Against this backdrop the EU Commission has proposed the following changes with Adjustments for covered bonds and regard to covered bonds and ABS: ABS » Greater recognition is to be given to certain covered bonds which emerged from Eligibility criteria for covered bonds the technical analysis carried out by the European Banking Authority (EBA) as to be loosened excellent performers in terms of liquidity and credit rating. This greater recognition will be subject to a number of conditions (aggregated upper limit, haircuts, diversification requirements). Thus covered bonds with ECAI 1 ratings may account for up to 70% of the liquidity buffer and have a 7% haircut applied to their value, while ECAI 2-rated covered bonds may make up a maximum 40% of the liquidity buffer and take a 15% haircut (for details, see the “LCR criteria for covered bonds” section below). » With regard to asset-backed securities the EU Commission proposes the inclu- Broader pool of eligible ABS sion of a broader range of securitisations rather than just residential mortgage- backed securities (RMBS). Under the 15% liquidity buffer cap applicable to Lev- el 2B assets the plan is to allow certain other ABS types, such as auto ABS, which have demonstrated high levels of liquidity. In addition, recognition should also be given to a number of smaller ABS categories that likewise display strong liquidity and rating performance and play an important role in financing lending to SMEs and consumers, namely securitisations backed by consumer credit assets and by loans to SMEs. The EU Commission takes the view that these in- 1) – 9) Important: Please read the references to possible conflicts of interest and disclaimers/disclosures at the end of this report. DZ BANK RESEARCH 3/27 FINANCIAL INSTITUTIONS – EU COMMISSION'S FINALISED LCR RULES SPRING NO SURPRISES FLASH 21 OCT 2014 struments are compatible with the overarching supervisory objective of ensuring adequate liquidity coverage, while their recognition would avoid the unintended effect of not including them, i.e. a decrease in present and future demand for these instruments with adverse consequences for the financing of the underly- ing activities of SMEs and consumers (see the “LCR criteria for securitisations” section below). » Finally, the EU Commission’s LCR rules introduce a number of other important Centrally managed liquidity in net- specifications. For example, the delegated act clarifies the treatment of the cen- works of cooperatives trally managed liquidity of networks of cooperatives and banks participating in institutional protection schemes not covered by the international standard. Ac- cording to the EU Commission, these types of credit institutions would otherwise face considerable uncertainty or substantial difficulties. The proposed rules likewise clarify the treatment of specialist intermediaries in areas such as leas- ing and factoring which play an important role in the financing of companies, and especially SMEs, in the real economy. Accordingly, the LCR is as follows: High-quality liquid assets (HQLA) LCR= > 100% Net cash outflows – Capped net cash inflows The delegated act lays down the requirements that determine which assets are eligible as HQLA and how the expected cash outflows and inflows are to be calculated in stressed conditions. Liquid assets The LCR rules define liquid assets as various categories of assets that must gener- Valuation of liquid assets ally have high or extremely high liquidity and credit quality. Depending on their quality and liquidity, these assets are factored into the calculation of the numerator of the LCR formula at their market value minus a possible discount (haircut). To be eligible as liquid, assets must » be unencumbered or readily retrievable from a collateral pool, » originate from an issuer outside the banking group, » have a market price or a price that can be calculated using a simple formula on the basis of publicly available information rather than strong assump- tions, » be recognised as eligible collateral for the normal monetary policy opera- tions of a central bank in a member state or a third country (where cash outflows in that country are to be covered), » be listed on a recognised exchange or realisable by outright sale or a straightforward repurchase (repo) contract on recognised repo markets. 1) – 9) Important: Please read the references to possible conflicts of interest and disclaimers/disclosures at the end of this report. DZ BANK RESEARCH 4/27 FINANCIAL INSTITUTIONS – EU COMMISSION'S FINALISED LCR RULES SPRING NO SURPRISES FLASH 21 OCT 2014 ASSETS ELIGIBLE AS HQLA Haircut on Assets Cap market value Level 1 assets minimum 60% Cash deposits no cap 0% Central bank deposits no cap 0% Bonds issued by public sector entities no cap 0% Securities issued by state-guaranteed banks or development 0% no cap banks Bonds issued by multilateral development

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