The impact of the Basel III liquidity ratios on banks: Evidence from a simulation study

Abstract

We construct a bottom-up simulation model that draws on a bank's stylized disaggregated balance sheet to measure the impact of both LCR and NSFR. The constructed balance sheet comprises fixed-income items, stocks, deposits, and off-balance sheet items. The simulation model accounts for credit risk, interest rate risk, and liquidity risk including their interactions. Regarding bank liquidity risk, the model accounts for withdrawal risk in non-maturing deposits, the call-off risk of irrevocably committed credit lines and market price risk of assets. Our main results are summarized as follows: First, the introduction of LCR and NSFR has no unambiguous impact on bank's equity return and balance sheet growth. Second, the introduction of the liquidity ratios helps to reduce default risk. Third, it is more difficult for banks to comply with the ratios' thresholds in macroeconomic stress scenarios than in other scenarios. Fourth, the reduction of maturity transformation can effectively close liquidity gaps within one year. However, this comes at the cost of a higher frequency of future negative net cash flows above one year. (C) 2019 Board of Trustees of the University of Illinois. Published by Elsevier Inc. All rights reserved.