In a consultation paper released yesterday, the FSA warned banks that they would have to "significantly reshape their business model over the next few years" to bring liquidity risk under control.
In the wake of the collapse of UK mortgage lender Northern Rock, the FSA said it wanted to cut banks' reliance on short-term wholesale financing in favour of funding through retail deposits. Banks should pay closer attention to the stickiness of their funding sources - the likelihood that they will disappear when the economic or market climate changes - and aim to source more funding from long-standing depositors, domestic counterparties, corporations with passive treasury policies and repos, rather than from foreign investors and commercial paper issuance, for example.
The FSA also blamed UK firms for inadequate stress testing. "Firms tend to underestimate the potential extremity of liquidity stresses," it said, pointing out that a previous market study had found that "many respondents... had not anticipated the simultaneous closure of several sources of funding, or a chronic liquidity stress, or the combination of a name-specific and market-wide stress".
And UK branches of international firms would no longer be able to rely on the parent company to provide liquidity - under the proposed new rules they would have to be able to show that they could support their own operations. The FSA cited the failure of Lehman Brothers International (Europe), the UK branch of Lehman Brothers, and warned that "when a group gets into difficulty, liquidity which was believed to be available to the whole group can be 'hoarded' by the parent or, in some cases, seized by local authorities intervening to protect their own depositors".
The most prominent recent case of such an intervention came in October this year, when the UK government used powers of asset seizure granted by anti-terrorist legislation to freeze the assets of Icesave, a UK online bank owned by the failed Icelandic bank Landsbanki.