LCR rollback puts onus on liquidity stress tests

Risk USA: Stress tests may attract more scrutiny if LCR and NSFR are scaled back

Will regulators examine internal liquidity stress testing practices more closely?

Internal liquidity stress tests may attract more scrutiny if US regulators move ahead with a plan to ease liquidity and funding requirements for smaller banks.

On October 31, the US Federal Reserve unveiled a proposal that would exempt domestic banks with between $100 billion and $250 billion from the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). Meanwhile, US banks with $250 billion to $700 billion in assets would see their LCR and NSFR requirements cut to a level between 70% and 85%.

These firms will still be required to conduct internal stress tests, which may take on greater importance in determining appropriate liquidity levels.

“They’re putting a lot more emphasis on internal liquidity stress-testing,” said Alexander Craig, head of US liquidity and structured interest rate risk oversight at RBC. “Outside of the regimen of the LCR and NSFR, the internal stress tests require you to think about your business and the risks you need to solve for.”

US banks are also required to conduct regular, independent reviews of their liquidity risk management processes, including stress-testing practices and assumptions. Those reviews could also come under closer scrutiny.

“As they roll back the intensive review of LCR compliance, will there be additional focus from the regulators on internal liquidity stress-testing?” Craig wondered. “Will there be more pressure on us to make sure we are watching them?”

Craig was speaking on a panel at the Risk USA conference in New York on November 9.

The LCR requires banks to hold sufficient high-quality liquid assets (HQLAs) – such as short-term government debt – that can be sold to meet outflows in a 30-day stress scenario. Banks must also hold enough stable funding to cover the duration of their long-term assets to comply with the NSFR.

The Fed estimates that a 70% LCR will allow US banks with less than $700 billion to reduce HQLAs by around $77 billion.

Eliminating the LCR and NSFR will trim paperwork and reporting requirements for smaller banks, but risk management standards are unlikely to change much.

“We would be happy with lesser regulations but our risk management processes aren’t going to change,” said Vineet Gumasta, regional head of balance sheet risk at Rabobank, speaking on the same panel. “We may not need to file certain things or we may not need to provide certain things to the risk committee on a periodic basis. [But our] processes are here to stay. We are not going to roll back.”

Fellow panellist Steven Hageman, senior treasury and risk management executive at Societe Generale, agreed. “The fundamental rules won’t change,” he said. “It may reduce the number of reports we do, but we still need to do stress-testing. We still need to understand risk and systematically review that risk.”

The Fed is expected to issue a proposal on regulations for foreign banks in the near future, although it is not clear whether these will provide the same relief as for US banks.