New FSA liquidity rules aim to strengthen UK banking industry

buffers

Early in October, the Financial Services Authority (FSA) published its policy statement Strengthening liquidity standards. The core of the statement lays down clear rules on what constitutes an acceptable ‘liquidity buffer’ in terms of types of assets, amounts to be held and how different banks are going to be treated. The new regime will be easier for smaller and simpler banking firms, who will be able to hold a wider range of qualifying assets (including money-market funds offering same-day liquidity) and on a more flexible basis. The intention is that hedge funds who have operated as ‘shadow banks’ will also be affected by the new rules.

The FSA has three core objectives in tackling new liquidity regulations – maintaining systemic stability; securing the safety and soundness of financial institutions; and protecting the consumer. Its goal is to ensure banks have adequately self-insured against liquidity stress events. The idea is that imposing a liquidity buffer of the highest-quality government bonds will reduce central bank intervention in bad times.

There does not seem to be a mechanism in place to deal with one of the major lessons learnt from the Lehman Brothers collapse. How does the regulator stop a transfer of cash between, say, London and New York taking place the day before a bank collapses? Again, the devil lies in the detail. The policy statement does mention relationships between home and host regulator but does not present a cohesive picture of global regulation of universal banks. These banks are global in life but often largely national in death, and the havoc they cause is generally borne by taxpayers in the jurisdiction of their head office. There is no supranational regulator, so if there is a dispute between regulators over the implementation of liquidity rules, what happens? By way of comparison, the Markets in Financial Instruments Directive (Mifid), introduced two years ago to place financial services on a level playing field in Europe, is an example of cross-jurisdiction regulation with a provision for resolving differences between regulators in the form of the Committee of European Securities Regulators, which serves as an arbitrator. It is clear the goals of the FSA’s new liquidity policy will be fully met only if other regulators follow its lead.

Weighing up the new requirements
It is thought that full introduction of the new liquidity regime will collectively require banks to increase gilt holdings by £110 billion at an estimated annual cost of £2.2 billion and will provide a major boost for UK government gilt sales going forward.

There will be reporting and monitoring requirements. While this does not necessarily complicate operations, it will add another layer of bureaucratic control over banking activities. The new FSA liquidity rules are consistent with Basel II requirements. Firms’ senior managements are required to adopt a sound approach to liquidity risk management, and the new changes will mean substantial revisions to business models for many banks and financial groups.

The FSA’s proposals include phased implementation intended to be proportionate and differentiated by class of firm, systems and controls requirements. From October 1, 2010, the minimum liquidity buffer will rise in steps from 30% in year one to 100% in year four. These measures are intended to become effective at a time when the recessionary forces in the economy will have eased. Banks will then have several years to comply with the tougher liquidity rules.

Firms will be differentiated between those for which there will be individual liquidity assessment (ILA) and other simpler firms with standard requirements.

The Individual Liquidity Assessment Standard (ILAS) is a framework that consists of three components: an Individual Liquidity Adequacy Assessment (ILAA), a Supervisory Liquidity Review Process (SLRP) and an Individual Liquidity Guidance (ILG).

“A firm’s ILAA should be proportionate to the nature, scale and complexity of its business and documented so that it can be submitted to us upon our request,” the statement says. A firm’s liquidity adequacy assessment is based on the analysis of specific liquidity risks such as wholesale secure and unsecured funding, retail funding, intra-day liquidity, intra-group, cross-currency, off-balance-sheet and funding concentration. It is suggested the assessment is repeated once a year to keep it current. It is essentially a statement of how liquidity is managed (in the same way that the Internal Capital Adequacy Assessment Process is a statement of how capital adequacy is managed).

The FSA is maintaining a principles-based style. It prescribes the principles of compliance, it prescribes some of the indicator to assess compliance (for example, liquidity buffer), but leaves it to the single firm to describe the method used to implement the principles and achieve the goals the regulation sets out to achieve. These goals are included in its own risk appetite statement: “...our risk appetite in terms of the liquidity stresses we expect firms to be able to withstand without reliance on support from the public authorities”.

The Supervisory Liquidity Review Process depends on the risk profile of a firm (so, hedge funds and derivative houses, among others, will have a tighter supervision than an equity stockbroker). In addition to any other issue arising from day-to-day supervision (such as for capital adequacy or risk statement) the FSA will review a firm’s most recent ILAA, the systems and controls for liquidity risk, internal stress testing and contingency funding plan.

As a result of an SLRP, the regulator will provide the firm with an ILG. This will mostly concern the quantity of a firm’s liquid asset buffer and the firm’s funding profile.
This should mean more work for compliance and risk specialists as the report needs documenting and to be submitted to the FSA on request, also the liquidity policy needs to be consistent with capital adequacy, overall risk policy and any other compliance requirement already in place.

Implementation of the new rules should start from December 1, 2009. The policy statement however defines a transitional period with final deadlines ranging from June 1, 2010 to November 1, 2010 depending on the applicability of a simplified ILAS waiver and on the type of institutions.

New standards and systemic threats
The impact of future international standards will now almost certainly be influenced by the steps taken in the UK, and the FSA believes its rules are flexible enough to reflect new international standards once they have been agreed.

In particular, the Basel Committee is expected to agree on a global liquidity framework this month (December 2009) that will include simpler ratios and a minimum international level for liquidity.
The European Union’s Committee of European Banking Supervisors is finalising non-binding guidelines to ensure banks across the EU hold enough liquidity to survive the first month of a crisis without having to raise fresh capital.

The key question has to be whether the new liquidity system will provide protection from the potentially serious consequences of imprudent banking practices in the future. The key role performed by banks in the economy means they will always have a level of central bank protection available through the lender of last resort function supplying liquidity during a market-wide stress situation or even, potentially, an individual bank crisis if the bank is big enough.

The FSA rightly sees the need to switch part, at least, of the cost of rescues from being funded by the central bank and the taxpayer, to being met by self-insurance protection developed in the years of plenty and ahead of the next lean period.

However, this will pave the ‘path of good intentions’ if it is not met by an attention to systemic trends. Once again, the regulator will ask firms to stress test against specific scenarios; a firm can only do that with its own data. A regulator receives information from all the firms in the jurisdiction, and therefore it is perfectly placed to conduct stress tests and trend analysis across the whole market. If the FSA or any other regulator does not take it upon itself to perform regular systemic monitoring, it will be difficult to spot the difference between a single case and systemic problems before it is too late. If Lehman Brothers had been the only weak institution, the ‘credit crunch’ would not have been the largest financial crisis since 1929.

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