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Liquidity Risk – Regulatory Framework. London, 8 th August 2006 Vincent Baritsch Wholesale and Prudential Policy Division UK Financial Services Authority. Liquidity Risk – Regulatory Issues. Overview. Current FSA regimes Qualitative Quantitative Problems FSA ideas for change and DP24

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liquidity risk regulatory framework

Liquidity Risk – Regulatory Framework

London, 8th August 2006

Vincent Baritsch

Wholesale and Prudential Policy Division

UK Financial Services Authority

overview

Liquidity Risk – Regulatory Issues

Overview
  • Current FSA regimes
    • Qualitative
    • Quantitative
  • Problems
  • FSA ideas for change and DP24
  • International developments
  • Challenges
stress testing and contingency funding plans sysc 11 applying to all crd firms

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

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
deposit takers

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
existing fsa quantitative banking regimes

Liquidity Risk – Regulatory Issues

Existing FSA quantitative banking regimes
  • ‘Sterling stock’ regime for major retail banks

(2) Maturity mismatch approach for other banks

existing regimes sterling stock

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
existing regimes mismatch 1

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
existing regimes mismatch 2

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
existing regimes mismatch 3

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
investment firms regimes

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
problems with the sterling stock regime

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
problems with the mismatch regime

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.
problems with investment firms regime

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
fsa ideas for change

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
dp24 main principles

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
dp24 main principles 2

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”
dp24 feedback

Liquidity Risk – Regulatory Issues

DP24 Feedback

Generally agreed with –

  • Need for reform
  • Focus on cash flow mismatch
  • Integrated approach
  • Scope for group treatment
dp24 feedback 2

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
dp24 feedback 3

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
dp24 feedback 4

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
dp24 feedback 5

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
after dp24 where next

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?
international context

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
international developments

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
joint forum results 1

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
joint forum results 2

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
the future

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
european work wgbd

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
international work basel committee

Liquidity Risk – Regulatory Issues

International work – Basel Committee
  • New WG
  • Mandate:
    • Analytical stock take
    • Sharing of supervisory experience
  • No presumption of new standards
challenges for fsa

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
questions

Liquidity Risk – Regulatory Issues

Questions?

Vincent.baritsch@fsa.gov.uk

Tel: 020-7066-0526

Fax: 020-7066-0527

existing regimes other

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
bank of england reform of its operations in the money market35

Liquidity Risk – Regulatory Issues

Bank of England reform of its operations in the Money Market

Overview

  • Voluntary remunerated reserve scheme
  • Standing facilities
voluntary reserve scheme lrm benefits

Liquidity Risk – Regulatory Issues

Voluntary reserve scheme – LRM benefits
  • Secure repository – Highly rated
  • Liquidity buffer
  • Double duty
standing facilities lrm benefits

Liquidity Risk – Regulatory Issues

Standing Facilities – LRM benefits
  • Ability to borrow unlimited amounts against eligible collateral
  • Major role in banks CFP’s
references

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
other regimes

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