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Liquidity Risk – Regulatory Framework

Liquidity Risk – Regulatory Framework

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Liquidity Risk – Regulatory Framework

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

  2. Liquidity Risk – Regulatory Issues Overview • Current FSA regimes • Qualitative • Quantitative • Problems • FSA ideas for change and DP24 • International developments • Challenges

  3. 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

  4. Liquidity Risk – Regulatory Issues 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

  5. Liquidity Risk – Regulatory Issues 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

  6. Liquidity Risk – Regulatory Issues Existing FSA quantitative banking regimes • ‘Sterling stock’ regime for major retail banks (2) Maturity mismatch approach for other banks

  7. Liquidity Risk – Regulatory Issues 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

  8. Liquidity Risk – Regulatory Issues 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

  9. Liquidity Risk – Regulatory Issues 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

  10. Liquidity Risk – Regulatory Issues 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

  11. Liquidity Risk – Regulatory Issues 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

  12. Liquidity Risk – Regulatory Issues 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

  13. Liquidity Risk – Regulatory Issues 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.

  14. Liquidity Risk – Regulatory Issues 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

  15. Liquidity Risk – Regulatory Issues 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

  16. Liquidity Risk – Regulatory Issues 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

  17. Liquidity Risk – Regulatory Issues DP24 – main principles (2) • Scope for some firms to use own approaches • Embedded “Core Marketable Assets Requirement” • No more “double duty”

  18. Liquidity Risk – Regulatory Issues DP24 Feedback Generally agreed with – • Need for reform • Focus on cash flow mismatch • Integrated approach • Scope for group treatment

  19. Liquidity Risk – Regulatory Issues 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

  20. Liquidity Risk – Regulatory Issues 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

  21. Liquidity Risk – Regulatory Issues 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

  22. Liquidity Risk – Regulatory Issues 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

  23. Liquidity Risk – Regulatory Issues 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?

  24. Liquidity Risk – Regulatory Issues Bank of England reform of its operations in the Money Market

  25. Liquidity Risk – Regulatory Issues 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

  26. Liquidity Risk – Regulatory Issues 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

  27. Liquidity Risk – Regulatory Issues 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

  28. Liquidity Risk – Regulatory Issues 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

  29. Liquidity Risk – Regulatory Issues 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

  30. Liquidity Risk – Regulatory Issues European work - WGBD • Re-assess major groups LRM • Focus on potential impact on financial stability and cross-border banking activities • Report early 2007

  31. Liquidity Risk – Regulatory Issues International work – Basel Committee • New WG • Mandate: • Analytical stock take • Sharing of supervisory experience • No presumption of new standards

  32. Liquidity Risk – Regulatory Issues 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

  33. Liquidity Risk – Regulatory Issues Questions? Vincent.baritsch@fsa.gov.uk Tel: 020-7066-0526 Fax: 020-7066-0527

  34. Liquidity Risk – Regulatory Issues 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

  35. Liquidity Risk – Regulatory Issues Bank of England reform of its operations in the Money Market Overview • Voluntary remunerated reserve scheme • Standing facilities

  36. Liquidity Risk – Regulatory Issues Voluntary reserve scheme – LRM benefits • Secure repository – Highly rated • Liquidity buffer • Double duty

  37. Liquidity Risk – Regulatory Issues Standing Facilities – LRM benefits • Ability to borrow unlimited amounts against eligible collateral • Major role in banks CFP’s

  38. Liquidity Risk – Regulatory Issues 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

  39. Liquidity Risk – Regulatory Issues 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