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    EBA Analyzes Impact of Unwind Mechanism of Liquidity Coverage Ratio

    November 19, 2020

    EBA published a report analyzing the impact of the unwind mechanism of the liquidity coverage ratio (LCR) for a sample of European banks over a three-year period, from the end of 2016 to the first quarter of 2020. The impact is evaluated in terms of both the quantification of the Level 1 component of high-quality liquid assets (HQLA) and the quantification of the LCR. The functioning of the mechanism under particular situations and the opportunity to change some technical aspects of the mechanism have been also discussed in the report. The analysis shows that the impact of the unwind mechanism on the LCR is practically null; it is also not possible to affirm that it could have an effect on the stability and orderly functioning of financial markets. Overall, the empirical evidence does not support the hypothesis that the unwind mechanism has a detrimental impact on the business and risk profile of credit institutions.

    The report provides an introduction to the rationale and the functioning of the unwind mechanism, including providing some theoretical examples. The empirical analysis is based on common reporting (COREP) data covering a sample of about 120 credit institutions in each year. The sample covers both globally active institutions and other credit institutions. The report includes scenario analysis in which it is assumed that the amount of central bank reserves has been substantially cut. Furthermore, an analysis of alternative definitions of the unwind mechanism and an analysis of the functioning of the unwind mechanism in the event of reverse repo operations has been presented. 

    The report shows, via theoretical examples, that, in the absence of the unwind mechanism, it would be possible for institutions to improve the amount of HQLA (and potentially the LCR) by borrowing liquid assets through short-term repos, particularly when transactions are undertaken with the domestic central bank. The case of reverse repo operations has been studied, showing that, theoretically, in this case the unwind mechanism may produce an increase in the amount of HQLA that might not be justified from a prudential point of view. For this reason, it could be helpful to include, in the regulation, the systematic comparison between the amount of HQLA with application of the unwind mechanism and the amount of HQLA without, in order to take the lower one. However, it has been empirically shown that the materiality of these situations is limited. In the observed period, and with the available sample of credit institutions, it was not possible to detect detrimental impact on the stability of the institutions.

    In aggregate terms, it was found that the unwind mechanism has an effect on only the determination of the amount of Level 1 assets and this effect is positive, whereas the effect on the LCR is null. In addition, at the bank level, few cases could be detected in which the unwind mechanism caused a relevant reduction in the LCR; in all these cases, the LCR would also have been lower than the minimum without the unwind mechanism. The report highlights that, at the end of 2020, through the Euclid project, EBA is going to receive data on regular basis, not only from a subset of banks but from all the EU banks. It is recommended that the analysis be extended over the next years to gain more experience and to be able to include in the sample smaller banks after the Euclid project has entered into force.

     

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    Keywords: Europe, EU, Banking, LCR, HQLA, Unwind Mechanism, COREP, Liquidity Risk, Basel, EBA

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