Liquidity Swaps

Published: 4th August 2011 by William Webster

Put a bank that has difficulty in raising liquidity in a room with an insurance company that's looking for yield and what do you get?

Answer: A liquidity swap

That's where the bank takes some illiquid assets and uses them as collateral to borrow some gilts from the insurance company.

It’s a nice little earner for the insurance company who receives a fee whilst the bank can switch the gilts through the repo market to get cash.

Latent liquidity in the insurance business is transferred to banks whilst pension fund assets get uplifted yield.

It’s a win-win situation or is it?

It's the topic of a Guidance Consultation from the FSA issued in July 2011. This considers how to identify such a transaction whether it is by way of stock loan, repo or total return swap. It then identifies the risks involved and suggests how these should be treated from a capital perspective.

These transactions are taking place and reading between the lines the FSA appears to see them as being useful provided risk management is robust.

Indeed a significant amount of the consultation looks at the risks incurred for both parties and makes it clear that firms with inadequate risk controls will be subject to additional Basel 2 capital add-ons.

This is all good regulatory thinking and is par for the course in the new intrusive regime but you have to ask yourself whether one party from the debate is missing. That's you. Not as a market participant but both as a taxpayer and saver.

In the event of systematic failure in the banking system what affect would liquidity swaps have? That's impossible to predict but the FSA does provide some clues on this by way of an Annex (Market Failure Analysis - The Rational of the Guidance).

If a bank failed, encumbrance of its assets by way of liquidity swaps potentially increases losses for both depositors and the FSCS.

Furthermore it leaves the insurer with illiquid assets (which will need to be held to maturity and in the process will incur greater credit losses than the gilts the insurer originally invested in).

Had liquidity swaps been widespread in 2007-8 then the FSCS would have incurred larger payouts and some insurance companies (who incidentally pay out pension annuities) would now be sitting on structured securities and illiquid assets instead of Gilts. There's no free lunch in these markets.

Given recent events the FSA should ask a fundamental question.

Shouldn't some types of business that provide the public with safe investments and annuities be prohibited from entering liquidity swaps?

Banks and insurers may think its ok. But this isn’t a market just between professionals. It's where the man in the street can get badly hurt through no fault of his own.

Sharpen up FSA.

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Policy Statement 09/16 Strengthening liquidity standards refers to earlier consultation papers CP08/22, CP09/13 and CP09/14 and the comments received. In general whilst the FSA acknowledges many of the issues raised little has altered in the final policy. Firms will be expected to be self sufficient for liquidity purposes. Senior management is responsible for reviewing the level of liquidity, compliance and reporting to the Board. The FSA highlights that many firms have been unable to identify and report contractual cash flows on a regular basis. This will be unacceptable. Non compliance will be treated with regulatory sanction. How a firm is subject to Individual Liquidity Adequacy Standards (ILAS) depends on the size of the firm and the risks it presents. The ILAS framework comprises an Individual Liquidity Adequacy Assessment (ILAA), a Supervisory Liquidity Review Process (SLRP) and Individual Liquidity Guidance (ILG). Firms are obliged in the ILAA to undertake robust stress testing. The purpose of this is to show that the firm fully understands its liquidity risk. ILAS firms will need to report the stress test results in their ILAA. Liquidity management systems, controls and stress testing are all board responsibilities. The ILG is the amount of liquid resources the FSA expects a firm to hold. This will contain "guidance" on the amount of the liquid asset buffer and the firm's funding profile. As an incentive for firms to improve their systems and controls, the FSA will increase the amount of liquidity the firm must hold. Deposits at the central bank and tradable securities issued by the central bank will count towards the buffer. Holding currency denominated bonds should take into account potential problems in the FX market. For this reason a domestic bank with mainly sterling liabilities must hold its buffer in gilts. The FSA now require firms to price the cost of liquidity into products. This should mean that the cost of holding the liquidity buffer is passed on to those customers that create a stressed outflow requirement. The new regime will be phased in. The scope and application of the new rules will depend on the importance of the firm and its ability to create systemic risk.