Liquidity Risk – Regulatory Framework London, 8 th August 2006 Vincent Baritsch Wholesale and Prudential Policy Division UK Financial Services Authority

Liquidity Risk – Regulatory Framework

London, 8th August 2006

Vincent Baritsch Wholesale and Prudential Policy Division

UK Financial Services Authority

Overview• Current FSA regimes

– Qualitative

– Quantitative

• Problems

• FSA ideas for change and DP24

• International developments

• Challenges

Liquidity Risk – Regulatory Issues

Stress testing and contingency funding plans – SYSC 11 applying to all CRD firms

• New requirements in force since end-2004, amended for CRD

• Apply to deposit-takers, insurers, all BIPRU investment firms

• A firm must carry out stress tests and scenario analyses for liquidity risk …

• … and must estimate the resources it would need in each of the scenarios considered

• Depends on “nature, scale, and complexity” of a firm’s business

• Considerations for branches and subsidiaries


GENPRU 1.2 – Adequacy of financial resources

• Applies to all BIPRU firms

• Maintain adequate liquidity resources to cover all liabilities, including contingent and prospective liabilities

• Realistic valuation methodologies

• Stress testing and CPF’s

• Manage major sources or risks, including liquidity risk

• Document risk assessments


Deposit-takers

• Deposit-takers must maintain a policy statement on liquidity management

– Should cover both normal and crisis management

– Should include details of the bank’s contingency funding plan


Existing FSA quantitative banking regimes

(1) ‘Sterling stock’ regime for major retail banks

(2) Maturity mismatch approach for other banks


Existing regimes: sterling stock • Five working day survival period

• Assumes no renewal of wholesale funding, outflow of 5% of retail deposits

• Covers sterling cash flows only

• Net outflows must be covered 100% by a stock of high-quality liquid assets

– defined as those eligible in Bank of England Open Market Operations

• Some allowance for holdings of other banks’ CDs

• Additionally, agreed floor for the stock (£ amount, not ratio) – ‘belt and braces’

• Consolidated reporting


Existing regimes: mismatch (1)• Applies to UK banks (solo) including all overseas

branches, and to UK branches of overseas banks

• Contractual cash flows (worst case) allocated to maturity bands

• Mismatch ratio for each time band calculated as net cash flow / total deposits

• Individual limits set on cumulative mismatch ratios out to 1 week and 1 month

• Quarterly reporting but daily requirement – breaches to be notified to FSA immediately


Existing regimes: mismatch (2)• Marketable assets assumed to deliver cash inflows on

sale/ repo rather than maturity

– Normally within the 1 week time band

– Minimum criteria include – • Prices regularly quoted• Asset regularly traded• Can be sold or repo’d on an exchange or in a deep and liquid

market for cash

– Subject to a range of discounts according to volatility, eg • 0 – 10% for Zone A central government debt• 5 – 15% for ‘qualifying’ Zone A non-government debt• 20% for equities listed on a recognised exchange• 20 – 50% for certain Zone B securities


Existing regimes: mismatch (3)

• FSA can agree ‘behavioural adjustments’ on some cash flows. Eg -

– reduces outflow on undrawn credit card commitments from 100% to 75%

– inflow allowed of 90% of committed lines received

• ‘Global liquidity concessions’ possible for overseas branches

– FSA to be satisfied with home country liquidity supervision

– Branch integrated with head office

– Home supervisor happy with the arrangement


Investment Firms regimes

• Illiquid assets either deducted from capital, or 8% charge (on top of market risk charges) + liquidity adjustments

• Aim is to promote orderly winding down in a crisis by ensuring sufficient liquid resources are available


Problems with the Sterling Stock regime

• Focus is on the immediate, first week period;

• No general requirements in relation to the non-sterling parts of firms' business;

• Relatively limited set of assets qualifying as part of the stock and has some undesirable behavioural and market-structural consequences; and

• Double duty of regulatory stock of sterling liquid assets with intra-day collateral needs for payment systems


Problems with the Mismatch regime

• Increasingly divergent from banks LRM;

• Discount factors and hair cuts applied to instruments are based on limited criteria;

• Is not tailored for different kinds of firm; and

• Marketable assets allowed are based on potentially outdated material.


Problems with investment firms regime

• Illiquid asset regime / liquidity adjustment relatively penal and not risk sensitive

• For many firms changes resulting from CRD may mean no effective liquidity buffers, except those from P2

• Unlevel playing field


FSA ideas for change

• FSA Discussion Paper 24 – October 2003

• DP, ie ‘greener’ than a Consultation Paper

• To be part of FSA’s integrated prudential sourcebook

– FSA as the single regulator

• All firms with significant liquidity risk – and all areas of business giving rise to risk

• Shortcomings in predecessor regimes


DP24 – main principles

• Maturity ladder with stressed cash flows

• Stress factors to approximate stress behaviour

• Limits on 1 week and 1 month gaps

• Normally solo, but recognition of groups


DP24 – main principles (2)

• Scope for some firms to use own approaches

• Embedded “Core Marketable Assets Requirement”

• No more “double duty”


DP24 Feedback

Generally agreed with –

• Need for reform

• Focus on cash flow mismatch

• Integrated approach

• Scope for group treatment


DP24 Feedback (2)

Concerns –

• Attempting a standard stress

• Including stress in quantitative approach

• Level of detail, degree of prescription

• Too little room for firms’ own approaches


DP24 Feedback (3)

More concerns – • Insufficient allowance for group-wide

management of liquidity risk

– Firms don’t like solo requirements within ILGs

– Does not fit well with central liquidity management – “trapped pockets of liquidity”

– Problem of standardising intra-group flows


DP24 Feedback (4)

Yet more concerns -

• Requirement for core marketable assets

• Impact of ending double duty

• Investment firms unhappy –

– too banking-oriented

– and not flexible enough


DP24 Feedback (5)

Other concerns –• Treatment of marketable assets• “Continuation of business”

– Some don’t like whole concept– Many concerns about debt buyback assumptions– Should not assume new wholesale placements

• Concerns about currency treatment


After DP24 – where next?

• Wait and see what international work brings

• Why do we need a Pillar 1 approach?

• Pillar 2 and/ or Pillar 3?


Bank of England reform of its operations in the Money Market


International context• Qualitative

– Basel Committee paper on sound practices for managing liquidity in banks (2000)

– IOSCO - Sound Practices for the Management of Liquidity Risk at Securities Firms 2002-

– IAIS – Guidance Paper on Investment Risk Management, 2004

– CRD (Capital Requirements Directive) Annex V to be implemented across the EEA

• Quantitative – no agreed international standard


International developments

• Joint Forum Working Group on Risk Assessment and Capital

– Looking at how firms manage the funding of liquidity risk and how it is regulated

– Stage 1 (2004) drew on regulators’ existing knowledge

– Stage 2 (2005) filled in gaps in knowledge with a detailed questionnaire for firms

– Range of Practices Paper published on the 3rd May 2006 http://www.bis.org/publ/joint16.pdf


Joint Forum results (1)

• Diversity of approaches across sectors• Centralisation – range of practices

– Across entities/ countries/ sectors• Diversity of approaches within sector• Main sources of liquidity risk

– reliance on volatile or concentrated sources of funding

– rating triggers


Joint Forum results (2)• Stress testing

– Firm-specific vs. general

– How severe?

• Contingency funding plans

– Reliance on secured funding

• Impact of regulation

– Liquidity rules in each jurisdiction

– Limits on intra-group flows


The future

• Lessons from DP24

• Basel Committee

– International Standards?

• EU involvement

• Balance in a proportionate way –

– Efficiency of firms’ own approaches

– Benefits of harmonisation

– Prudential concerns


European work - WGBD

• Re-assess major groups LRM

• Focus on potential impact on financial stability and cross-border banking activities

• Report early 2007


International work – Basel Committee

• New WG

• Mandate:

– Analytical stock take

– Sharing of supervisory experience

• No presumption of new standards


Challenges for FSA

• Promote compatibility of international approaches

• Understanding of internal models and how they could be used

• Need for simple back stop?• Ensure sectoral comparability• Group implications• Pillar 2 / Pillar 3


Questions?

[email protected]

Tel: 020-7066-0526

Fax: 020-7066-0527


Existing regimes: other

Building societies

• Must hold ‘8 day liquidity’ > 3.5% of total share and deposit liabilities

• 8 day liquidity includes CDs, CP, bank deposits

• Limits on inter-society holdings


Bank of England reform of its operations in the Money Market

Overview

• Voluntary remunerated reserve scheme

• Standing facilities


Voluntary reserve scheme – LRM benefits

• Secure repository – Highly rated

• Liquidity buffer

• Double duty


Standing Facilities – LRM benefits

• Ability to borrow unlimited amounts against eligible collateral

• Major role in banks CFP’s


References

• Sterling stock and mismatch regimes – See Chapters LS and LM in

http://fsahandbook.info/FSA/html/handbook/IPRU-BANK

• Stress testing and CFPs– See sections GENPRU 1.2 and SYSC 11 in

http://www.fsa.gov.uk/pages/library/policy/cp/2006/06_13.shtml


Other regimes

• Building societies regime– See Chapter 5 in

http://fsahandbook.info/FSA/html/handbook/IPRU-BSOC

• Securities firms regime– See sections 10-60 to 10-74 in

http://fsahandbook.info/FSA/html/handbook/IPRU-INV


Documents

Liquidity Risk – Regulatory Framework London, 8 th August 2006 Vincent Baritsch Wholesale and Prudential Policy Division UK Financial Services Authority