www.davy.

ie/creditunions
Basel III Liquidity Standards:
The Implications for Credit Union
Investments
MAY 2013
CONTENTS
Section Title Page
1 Introduction & Background 1
2 Liquidity Ratios under Basel III 1
3 The Impact on Credit Unions 3
4 Can Credit Unions Apply for a Reclassication? 5
5 Suggested Next Steps 6
6 Conclusion 6
Appendix 1 7
This document is intended to provide a summary of the potential impact of
certain aspects of the Basel III liquidity standards on credit unions. It is provided
for information and discussion purposes only and is not intended to be
comprehensive. Readers may wish to supplement the content by reading the
source materials referred to throughout and form their own view. Statements
and other assumptions contained in this document are based on the current
expectations, opinions and/or beliefs of Davy at the time of publishing. These
assumptions and statements may or may not prove to be correct and actual
outcomes may differ.
Executive Summary
f Basel III is a comprehensive set of global banking measures which introduces
two new liquidity ratios that are intended to ensure that banks hold sufcient
liquidity aside for crisis situations. These ratios have important implications for
the credit union sector.
f For the purposes of liquidity, banks will be required to classify deposits
according to their perceived stability.
f Under Basel III, funds from credit unions are likely to be classied as Non-bank Financial Institutions (NBFIs). This classication
means that it is assumed that credit union deposits may be withdrawn from banks in a period of market stress, and therefore will
be viewed as a relatively unstable source of funding.
f As a result, deposits from credit unions may no longer be as attractive to banks, especially those deposits with maturities of less
than one year.
f The main implication of the lower deposit rates resulting from the NBFI classication is a potential reduction in credit union
investment income. Davy estimates that, based on a number of assumptions, this could result in a reduction of investment income
of approximately 58 million per annum across the credit union movement in Ireland.
f Although implementation of Basel III will be introduced on a phased basis from 2015, Davy understands that certain deposit rates
available to credit unions are already negatively reecting Basel III measures.
f As the impact is signicant, credit unions may wish to consider collectively lobbying at national and at European level to have funds
reclassied to a more stable category, although there is no guarantee that this would be successful.
f In the event that credit unions proceed with an application to have their funds reclassied, representative bodies should inform and
educate their members. The Central Bank of Ireland and the Department of Finance should also be informed of the movements
issues and intentions.
f The above steps should be conducted in a relatively swift manner so that discretion may be exercised prior to nalisation of
proposals and full implementation by banks.
PLEASE NOTE: Until Basel III is nalised and fully implemented, there is no assurance that the assumptions referred to
above will materialise. Actual outcomes may differ.
caroline fox
Investment Analyst
T 01-614 9947
E caroline.fox@davy.ie
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 1
Section 1: Introduction & Background
Introduction
Basel III is a comprehensive set of global measures intended to strengthen global capital and liquidity rules with the goal of promoting
a more resilient banking sector
1
. Much of the commentary on Basel III tends to be focused on the more stringent capital requirements
that the worlds banks must hold in order to protect themselves against losses, but in addition Basel III introduces entirely new liquidity
requirements.
The purpose of this paper is to give an overview of the new liquidity framework and its consequences for the credit union movement, in
addition to highlighting the important implications that Basel III is likely to have for credit union investment portfolios in Ireland.
Background
During the 2007 nancial crisis, several banks, such as Northern Rock and Bear Sterns, suffered from a liquidity crisis due to their over
reliance on short-term wholesale funding from the interbank lending market. These institutions were unable to roll over short-term
nancing which resulted in a major liquidity event and their subsequent collapse which, among other factors, had a detrimental effect
on the global economy. Basel III measures have therefore been introduced with the aim of improving liquidity regulation with the
ultimate objective of protecting the global banking system thus averting the possibility of a similar crisis in the future.
Section 2: Liquidity Ratios under Basel III
Liquidity Ratios
Basel III introduces two new liquidity ratios which are intended to ensure that banks hold sufcient liquidity aside for crisis situations in
the event that wholesale funding markets shut down. It encourages a structural shift away from reliance on wholesale funding towards
a longer term and potentially more robust funding strategy. The ratios include a Liquidity Coverage Ratio (LCR) which addresses
short-term funding requirements in a time of stress, and the Net Stable Funding Ratio (NSFR) which concerns longer term funding
requirements.
i. Liquidity Coverage Ratio (LCR)
f The LCR is designed to strengthen the ability of banks to withstand adverse shocks in the short run.
f It requires banks to hold sufcient high quality liquid assets (cash, certain government bonds and other liquid securities) to meet
cash outows over a period of 30 days.
f It assumes that during a stressed scenario, a proportion of retail deposits are withdrawn, that there is limited access to wholesale
funding and it incorporates the impact of a number of other liquidity risk scenarios such as a ratings downgrade.
f It is designed with the intention that liquid assets cover the decit between cumulative cash inows and outows over the 30-day
stressed period.
ii. Net Stable Funding Ratio (NSFR)
1
Source: www.bis.org/publ/bcbs189.pdf
LCR: 100%
Stock of high quality liquid assets
Total net cash outows over the next 30 calendar days
NSFR: 100%
Available amount of stable funding
Required amount of stable funding
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 2
f Complementary to the LCR is the NSFR, which is a more structural measure and concerns long-term funding. It looks beyond the
30-day timeframe of the LCR and aims to reduce the use of short-term funding to nance less liquid assets.
f It encourages banks to have stable funding in place to support operations during a stressed period of one year on a rolling basis.
Stable funding sources would include capital and long-term debt instruments, retail deposits and maturity wholesale funding of
greater than one year, to match their medium and long-term lending.
f It establishes a minimum acceptable amount of stable funding (including long-term debt instruments, retail deposits and term
deposits greater than one year in maturity) based on the liquidity characteristics of an institutions assets and activities over a one-
year horizon. It requires the available amount of stable funding to exceed the required amount of stable funding over a one-year
period of extended stress. NSFR requires banks to fund long-term, illiquid assets with long-term, stable funding.
Classication of Deposits & Relevance to Credit Unions
Heretofore, banks have broadly treated credit union funds as stable deposits which have attracted competitive rates of return. Under
Basel III a number of different classes or funding sources are identied which are summarised in Table 1 (please refer to Appendix 1 for
further detail). Classes can largely be divided into retail (placed by a natural person) and wholesale (placed by a legal entity). Based on
Basel III criteria, deposits from credit unions fall into the wholesale category Non-Bank Financial Institutions (NBFIs), as highlighted in
Table 1. The implications of this reclassication are:
f LCR: The LCR assigns a specic run-off rate to each source of funding. A run-off rate reects the amount of funding due to mature
in next 30 days which is not rolled over and therefore is withdrawn from the bank. The NBFI class attracts a run-off rate of 100%.
f NSFR: In order to establish the available amount of stable funding of a bank, the NSFR assigns a factor to each source of funding,
called the availability factor. This factor represents the proportion of the balance today that is expected to be available to the bank
in one year in order to fund longer term assets. Accordingly, certain behavioural assumptions are built into the availability factor
relating to expectations regarding funding withdrawal. The NBFI class has been assigned an availability factor of 0%.
TABLE 1: The Treatment of Different Funding Sources under Basel III Liquidity Ratios
Deposit LCR
Run-off rate
NSFR
Available for NSFR
(assuming maturity
less than 12 months)
R
e
t
a
i
l
Stable Retail 3% 90%
Less Stable Retail 10% 80%
Retail Fixed Term Deposits 0% 90%
W
h
o
l
e
s
a
l
e
Small Business Customer:
f Stable
f Less Stable
3%
10%
90%
80%
Operational Relationships 25%
Deposits in an institutional network of co-op banks 25% Maximum of 75%
Non-nancial corporates, Public sector enterprises 40% 50%
All other legal entities, including NBFIs, banks, insurance companies 100% 0%
S
e
c
u
r
e
d

F
u
n
d
i
n
g
100%
Source: Basel III: International framework for liquidity risk measurement, standards and monitoring, December 2010 and Basel III: The Liquidity Coverage Ratio
and liquidity risk monitoring tools, January 2013
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Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 3
The most valuable sources of funding are those regarded as most stable and sticky, i.e. those that are unlikely to be withdrawn from
the bank. Those funds will therefore have lower run-off rates in calculating outows for the purposes of the LCR and high availability
factors in calculating available amounts of stable funding under the NSFR. Stable retail funding is perceived as the most valuable source
of funding to a bank and is likely to attract the highest deposit rates. Conversely, less stable wholesale funds, perceived as less valuable
to banks, will attract lower deposit rates.
The LCR is being introduced on a phased basis from 1st January 2015, with full implementation scheduled for 2018. While the NSFR is
to be introduced in 2018, the proposal is still to be nalised. Despite this timeframe for implementation, Davy understands that credit
unions have already been classied as NBFIs by some Irish banks; as a result, certain deposit rates available to credit unions have started
to reect this classication.
Section 3: The Impact on Credit Unions
i. Potential Reduction in Investment Income
In the current environment of ultra-low interest rates, one of the biggest challenges that credit unions face over the coming years is the
ability to generate meaningful income from investment portfolios.
Portfolio returns will vary from credit union to credit union depending on a number of factors, including asset allocation and the
maturity prole of the portfolio. In order to assess the impact of the NBFI classication, it is useful to contrast the current deposit rates
available to credit unions against retail deposit rates. Table 2 illustrates that the divergence in rates may be in excess of 1% in certain
maturities. We expect that this discrepancy may continue to grow and that, in general, rates available to credit unions may decline
towards the ECB rate (currently 0.75%).
TABLE 2: Comparison of Sample of Deposit Rates available to Credit Unions versus a Sample of Retail
Deposit Rates as at 25th April 2013
Credit Union
Deposit Rate (AER)
2
Retail Deposit
Rate (AER)
2
On demand 0.50% 1.97%
3 months 1.25% 2.02%
1 year 1.58% 2.30%
3 year 1.50% 2.28%
5 years 2.00% 2.11%
Methodology / Source: Compiled by Davy. The credit union deposit rates are sourced by taking the average rate available for credit union deposits
from a selection of Irish banks. The retail deposit rates are based on the average of a sample of rates available from a selection of Irish banks.
The effect of lower deposit rates on the returns of a credit union portfolio can be assessed if it is assumed that a credit union invests
100% in cash deposits today in line with the maturity prole outlined in Table 3. Based on the average rates available from banks today,
the average income return on a credit union portfolio is likely to be approximately 1.31% gross per annum, which is 0.83% lower than
the return on a similar portfolio based on retail deposit rates.
The implications of the above classication is that deposits from credit unions will no longer be as attractive to the banks, especially
those deposits with maturities of less than one year.
WARNING: Past performance is not a reliable guide to future performance. These gures are estimates only.
2
AER is the Annual Equivalent Rate. Interest may be subject to DIRT at the
prevailing rate (for more information, please visit www.revenue.ie).
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 4
TABLE 3: The Potential Effect of the Discrepancy between Credit Union Deposit Rates and Retail
Deposit Rates on the Return of a Sample Portfolio
Duration % Portfolio Credit Union
Deposit Rate (AER)
2
Retail Deposit
Rate (AER)
2
Within 3 months 35% 0.88% 1.99%
3 months 1 year 25% 1.42% 2.16%
1-3 years 25% 1.54% 2.29%
3-5 years 15% 1.75% 2.20%
Average Return 1.31% 2.14%
Methodology / Source: Compiled by Davy. The above rates for each term are calculated by using the average of the rates available as represented
in Table 2. For example, the credit union deposit rate for Within 3 months, is calculated by taking the average of the credit union deposit rate
for On Demand and 3 months from Table 1.
When the impact of lower returns is considered on credit union portfolios of varying sizes, the estimated reduction in annual income
per annum is signicant as seen in Table 4. For example, the annual income on a portfolio of 100 million may be expected to be in the
region of 830,000 lower per annum, if the portfolio was entirely invested in cash.
At credit union movement level, there is approximately 7 billion in surplus funds. If these funds were invested entirely in cash, it could
result in a reduction in income of approximately 58 million per annum in overall terms.
TABLE 4: The Potential Effect of the Divergence in Returns on a Range of Sample Portfolios as well as
on Total Portfolios within the Credit Union Movement in Ireland
Portfolio Size Gross Average Return (AER)
2
per Annum
Estimated
reduction per
annum Credit Union
1.31%
Retail
2.14%
Sample Portfolio A 20,000,000 262,000 428,000 -166,000
Sample Portfolio B 50,000,000 655,000 1,070,000 -415,000
Sample Portfolio C 100,000,000 1,310,000 2,140,000 -830,000
Impact at credit union movement
level
7,000,000,000 91,700,000 149,800,000 -58,100,000
Source: Davy
ii. Credit unions may struggle to pay competitive dividends. Credit unions are already struggling with bad debts and loan
arrears. For those credit unions invested predominantly in cash, the sustained downward pressure on loan demand in addition to
rapidly declining income on investment portfolios may result in an inability to pay competitive dividends in the years ahead.
iii. Credit unions may reach further out the risk spectrum in order to achieve higher portfolio returns. Based on a sample of
credit union portfolios where Davy acts as the investment advisor, we estimate that on average approximately 80-100% of credit
union portfolios are allocated to cash deposits. In the event that cash deposits yield the minimal returns outlined in Table 1, we
expect that credit unions may look to increase their portfolio exposure to higher yielding asset classes such as bonds and in some
cases equities. This is likely to increase the price and interest rate risk of portfolios and may result in signicantly more volatility in
annual portfolio performance.
WARNING: Past performance is not a reliable guide to future performance. These gures are estimates only.
2
AER is the Annual Equivalent Rate. Interest may be subject to DIRT at the
prevailing rate (for more information, please visit www.revenue.ie).
WARNING: Past performance is not a reliable guide to future performance. These gures are estimates only.
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 5
iv. Credit unions may review lending standards and increase risk. Due to the limited returns available from cash-based
investment portfolios, lending standards could become compromised which may negatively impact loan-book quality.
Section 4: Can Credit Unions Apply for a Reclassication?
Basel III provides for certain run-off rates or parameters to be determined at national level. While most roll-off rates, draw-down
rates and similar factors are harmonised across jurisdictions as outlined in this standard, a few parameters are to be determined by
supervisory authorities at national level. Where this is the case, the parameters should be transparent and made publicly available
3
.
Basel III is being implemented in the EU through the Capital Requirements Directive (CRD) IV and the Capital Requirements Regulation
(CRR). These proposals have yet to be nalised and as a result, the treatment of retail / SME deposits is still in draft form. While
Member States will have to transpose the directive into national law, the regulation is directly applicable, which means that it creates
law that takes immediate effect in all Member States in the same way as a national instrument, without any further action on the part
of the national authorities.
Therefore, Ireland will not have national discretion in determining the treatment of credit union funds. For that reason, potential issues
identied need to be raised at European level (perhaps with the European Commission or the European Banking Authority, EBA).
The EBA appears to be aware of some of the potential issues of implementing strict uniform criteria across different national jurisdictions
in the EU. In their recent discussion paper regarding retail deposits under draft CRR
4
, they asked Do you believe it would be appropriate
to allow derogations from the application of outow rates on the basis of uniform strict criteria? (Question 17).
The responses included the following from the EBA Banking Stakeholder Group: Yes, in some cases it would be justied such as when
the behaviour of depositors depends on country-specic factors, like historical preferences or the legal framework. However, as this
might increase the complexity of the regulatory framework, the scope for derogations should be carefully assessed from a cost/benet
perspective
5
.
To our knowledge, however, there has been no special case made for credit unions to date, not just in Ireland but in Europe, despite the
signicant adverse implications it could potentially have for the movement.
Grounds for Credit Unions to Seek Reclassication
Davy believes that there are number of important reasons that may lend support to any application to have credit union funds
reclassied:
f Credit union surplus funds are derived from 2.3 million retail investors in Ireland, which in itself suggests that the funds are more
stable in nature than the current classication of NBFI.
f Credit unions have historically been treated as sticky, stable deposits by the commercial banks.
f In contrast to corporate deposits, which JP Morgan estimates have fallen by 40% in Ireland since 2008
6
credit unions have increased
their deposits with the Irish banks during the period 2008-2010 and beyond.
f Credit unions are not as sophisticated as other entitites which fall into the same category, for example banks and other NBFIs such
as insurance companies, money market funds, and pension funds who are likely to be more creative in managing and moving their
deposits.
f Basel III provides for certain run-off rates or parameters to be determined at national level.
3
Source: www.bis.org/publ/bcbs188.pdf
4
Source: www.eba.europa.eu/cebs/media/Publications/Discussion%20Papers/
DP%202013%2002/DP-on-retail-deposits-subject-to-higher-outows.pdf
5
Source: www.eba.europa.eu/cebs/media/Publications/Discussion%20Papers/
DP%202013%2002/responses/%7BBSG%7D-EBA-Banking-Stakeholder-Group.
pdf
6
Source: J.P. Morgan Flows and Liquidity, March 22, 2013
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 6
f It is noteworthy that there is precedent for reclassication. Australia has exercised national discretion with regards to the treatment
of self-managed superannuation (pension) funds (SMSF) and while Basel III text directs that such monies should be included
as wholesale funds in the category of non-bank nancial corporates, the Australian Prudential Regulatory Authority (APRA)
has proposed that they should be included as retail deposits. However, as they are considered to be operated by sophisticated
investors, APRA envisages that the appropriate run-off assumption for SMSF deposits will fall within one of the less stable retail
deposit run-off categories
7
.
Section 5: Suggested Next Steps
In the event that credit unions intend to seek a reclassication, Davy suggests that the following steps are considered:
i. Inform and educate the credit union movement of the potential implications of Basel III through representative bodies and
investment advisors.
ii. Contact the Central Bank of Ireland (CBI) and the Department of Finance to inform them that you intend to formally approach
them with a view to seeking a reclassication of credit union funds.
iii. Build a case to argue that there are solid grounds for credit unions to be moved to a more retail like classication. This case should
include:
f Background to the credit union movement in Ireland.
f A rationale as to why it is an exceptional case and different to other non-bank nancial corporates.
Collate qualitative data / behavioural analysis to establish the run-off factor of credit union funds experienced by the Irish
banks during 2007-10. This information could potentially be sourced from the main pillar banks.
iv. Monitor the implementation of Basel III to check if national discretion is likely to be exercised to reclassify certain groups of
investors.
v. Lobby MEPs to make appropriate representations at EU level.
Section 6: Conclusion
It is clear that the implications of credit unions classication under Basel III are considerable at a time when the movement is already
facing signicant challenges. It is important, however, that credit unions are fully informed of the impending changes that may
affect their long-term stability. It is also essential that cases for reclassication are uniformly represented across all the credit union
representative bodies. This should be done in a relatively swift manner so that discretion may be exercised prior to nalisation of
proposals and full implementation by banks.
7
Source: www.apra.gov.au/adi/Documents/ADI_DP_IBLR_November_2011.pdf
Davy Credit Unions Basel III Liquidity Standards: the Implications for Credit Union Investments 7
Appendix 1
Different Funding Sources and their Treatment under the Basel III Liquidity Requirements
Funding Source Liquidity
Coverage Ratio
Run-off Rate
Net Stable
Funding Ratio
Availability Factor
for Available
Stable Funding
(assuming a
maturity less
than 12 months)
Retail:
Deposits placed with
a bank by a natural
person.
Stable Retail:
Deposits covered by an effective deposit insurance scheme or by a public guarantee and where:
f the depositors have established relationships with the bank that make deposit withdrawal highly
unlikely; or
f the deposits are in transactional accounts (e.g. accounts where salaries are automatically
deposited).
3% and higher 90%
Less Stable Retail:
Supervisory authorities are expected to develop additional buckets of less stable retail deposits. These
jurisdiction-specic run-off rates should be clearly outlined and publicly transparent. They could
include deposits not covered by an insurance scheme or guarantee, high value deposits, deposits from
sophisticated or high net worth individuals, deposits that can be withdrawn quickly (e.g. internet
deposits), foreign currency deposits.
10% and higher 80%
Retail Fixed Term Deposits:
The maturity of xed or time deposits with a residual maturity or withdrawal notice period of greater
than 30 days will be recognised if the depositor has no legal right to withdraw deposits within the
30-day time horizon of the LCR.
0% 90%
Unsecured
Wholesale Funding:
Liabilities and general
obligations raised
from non-natural
persons (i.e. legal
entities, including
sole proprietorships
and partnerships) and
are not collateralised
by legal rights to
specically designated
assets in the case of
bankruptcy, etc.
Small Business Customers:
Deposits and other extensions of funds made by non-nancial small customers that are managed as
retail exposures and are generally considered as having similar liquidity risk characteristics to retail a/cs,
provided the aggregated funding raised from one customer is less than 1 million.
f Stable
f Less Stable
3%
10%
90%
80%
Operational Relationships:
Funds from both nancial and non-nancial customers which qualify are those that are demonstrated
to be specically needed for operational purposes, e.g. clearing, custody or cash management
relationship in which the customer is reliant on the bank to perform these services as an independent
party.
25%
Deposits in Institutional Network of Cooperative Banks:
A group of legally autonomous banks with a statutory framework of cooperation with common
strategic focus and brand where specic functions are performed by central institutions and/or
specialised service providers.
25% Maximum of
75%
Non-nancial corporates and sovereigns, central banks and public sector entities:
All deposits and other extensions of unsecured funding from non-nancial corporate customers (that
are not categorised as small business customers) and sovereign, CB and PSE customers.
40% 50%
Other Legal Entities:
Funding from other institutions including Non-Bank Financial Institutions (NBFIs), banks, securities
rms, insurance companies, duciaries, beneciaries, conduits and SPVs.
100% 0%
Secured Funding:
Liabilities and general
obligations that
are collateralised
by legal rights to
specically designated
assets in the case of
bankruptcy, etc.
100%
Sources: Basel III: International Framework for liquidity risk measurement, standards and monitoring, December 2010
Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools, January 2013
www.davy.ie/creditunions
Davy,
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Dublin 2, Ireland.
T +353 1 614 8957
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