The market liquidity of designated 2B equity securities under the Basel accord : empirical evidence from South African Commercial Banks

Abstract

The financial market liquidity of an asset has always been an important concept in banking and financial markets because it keeps leveraging in check. From a regulatory perspective, liquid assets reduce herding where market participants can easily trade reducing violent pricing. Despite the abovementioned relevance, the challenge has always been to effectively determine the liquidity state of an asset using an appropriate approach in other to make informed decision or develop suitable policies. In the case of the Basel III framework, estimating the financial market liquidity of the supposed level 2B common equity high quality liquid assets (HQLA) and estimating whether the liquidity coverage ratio (LCR) and Net stable fund ratio (NSFR) needs to be improved remains an unresolved issue. Proper representation of the above liquidity standard measures will ensure effective corporate investment strategies in addition to meeting short term obligations. Acquiring a pool of assets to act as cushion against short term obligations depends on the extent to which these assets can be sold without significant price movements. In other words, exotic assets should not be considered as collateral for meeting short term obligations, or some form of elusive risk measure should be assigned for these assets. This is the premise on which the LCR and NSFR should be based. Therefore, the objective of this study was to test and validate the market liquidity of the level 2B common equity in the LCR and NSFR. Market liquidity measures where modelled and tested empirically to rebuff or validate whether the LCR and NSFR needs to be improved. This was achieved by regressing specific indicators against widely accepted cognitive measures of liquidity. This study used a panel data spanning over a period of 5 years from May 2016 – May 2021 to investigate the liquidity state. Using a fixed effect model, the findings of this study indicates that the common equity securities that qualifies to be included in level 2B HQLA category lack market depth and market resilience displaying low levels of market tightness. This was evident in the significant relationship between the specific independent and dependent variables used in this study although there was no significant relationship between transaction cost and price effect. Therefore, there was sufficient evidence that the LCR and NSFR measures for liquidity management in the banking sector needs to be improved which can also be extended to other markets. An improved LCR and NSFR was suggested in addition to a specialist system in order to capture the volatility of the level 2B equity securities and improve the market liquidity of these assets. It was also suggested that the Basel Committee for Banking Supervision (BCBS) should amend their current approach of estimating liquidity to include the model that integrates the short run and long run effect and the contingency funding plan in the banking sector. Finally, because the new LCR and NSFR framework introduced in this study provides a pragmatic standard for liquidity management, it should be included in Basel IV.