Policy Statement 10/5

Published: 21st April 2010 by William Webster

Policy Statement 10/5

A specialist sourcebook for building societies: Enhanced supervisory guidance on financial and credit risk management March 2010

The following refers to treasury management

What's it about?

This PS follows on from CP09/17. It's about how the FSA expects building societies to manage their treasury business. The resultant Building Societies Sourcebook (BSOCS) isn't too complicated but putting it all into practice may prove to be a challenge.

A society is expected to align itself with one of five approaches used to define treasury risk management.

The five approaches are:

• Administered
• Matched
• Extended
• Comprehensive
• Trading

The FSA is using these models as a yardstick of what it expects to see in terms of products used, balance sheet management, risk reporting and management structures.

Where a difference arises between a society and its chosen approach it is likely to prompt a discussion with the supervisor. From this discussion will follow any changes that are deemed necessary. Changes may include altering risk management processes, the business undertaken or the approach assigned to the society.

Remember this is guidance. The regulator may allow you to fall outside what is expected provided there is justification. Be prepared to answer questions.

The clear message to senior management is, the FSA will be "encouraging" societies to enhance their capabilities where it is considered necessary.

This Building Society Sourcebook (BSOCS) will clearly influence how societies manage and run their treasuries so let's look at eight issues and consider how you may be affected.

1. Risk Limits

The FSA refers to section 5 of the 1986 Act whereby a society has the purpose of lending money for residential mortgages on a secured basis. Funding is expected to come from members.

A society is not expected to engage in trading financial risk to make profits. This necessitates that a risk-averse approach to maturity mismatch and structural risk is adopted.

From a Board perspective this means risk limits should ensure that:

1. Exposures to changing interest rates are minimised or

2. Where exposures are incurred they do not threaten the ongoing viability of the society even under stressed conditions.

A society's treasury policy statement is expected to reflect this.

2. Treasury investments and liquidity risk management

Societies should have a liquidity policy statement. This should include an introduction and sections on objectives, operational characteristics, risk management, maturity structure, categories of assets and activities.

If you compare your liquidity policy statement to what is expected it is likely you will find that that additions and alterations are required.

Treasury investments can be held for a number of purposes and the FSA identifies three categories they are:

1. Assets held in the liquid assets buffer

2. Assets held operationally for cash flow management

3. Assets held to generate income

The FSA provides a table for treasury investments under each of the treasury approaches. Societies on the Administered and Matched approach are particularly restricted in what they can do. There are also restrictive limits on investments these are expressed as a percentage of Share and Deposit Liabilities (SDLs).

3. Funding

Wholesale markets can provide longer dated funds with a specific maturity date but this incurs refinancing risk. Furthermore a society that increases its reliance on wholesale funding not only increases its refinancing risk but also reduces the security of its members. This is because although the public sees society deposits as "safe" or even safer than bank deposits they are in fact subordinated.

In accordance with the 1986 Act societies should have a limit whereby at least 50% of funding comes from members' accounts.

Wholesale funding is divided into three categories:

1. Offshore/overseas retail accounts

2. Deposits from non-financial/non-individuals

3. Wholesale market funding

The regulator is expecting boards to impose an overall limit on wholesale funding and sub limits by each category.

The maturity profile of wholesale funding should be staggered so that large portions of funding do not mature at the same time. The FSA applies  limits to funding with a maturity of three months or less. These limits are linked to a firm's SDLs.

The FSA expects building societies to make use of the Bank of England Reserve Account in order to manage their buffer requirement.

If you are going to use repo the appropriate risk management needs to be in place. If you are on a matched approach the FSA expects you to talk with them before you do repo. Societies on more sophisticated treasury risk management approaches are free to use repo without approaching the regulator. Firms using repo should obtain full legal advice before agreeing documentation.

The FSA does not expect societies on the Administered or Matched Approaches to have external credit ratings. This is because ratings need careful management and rating changes could leave a society vulnerable.

The FSA provides a detailed table for each treasury approach. This lists the funding instruments and applicable limits.

Where a society differs from its chosen approach it should expect dialogue with the FSA in order to ascertain whether it needs to realign its risks and controls.

4. Financial Risk Management

A society should have a policy statement on financial risk management. This should explain how the treasury supports the core business, the treasury "approach" that is adopted (preferably supported by an independent external opinion or one obtained from internal audit). Copies of this policy statement should be read by all involved in treasury.

In order to undertake risk management a society should have systems and procedures that allow it to identify, monitor and control market risk. There should be counterparty credit limits and systems that reflect net interest income and product margins.

This information should be reported to the board on a regular basis.

Key risks that societies should manage and control include:

• Maturity mismatch
• Bunched roll over dates on wholesale or retail funding
• A limited number of funding providers
• Prepayments (behavioual versus contractual risks)

Interest rate risk and how it affects both net interest income and economic value (NPV of the balance sheet) should be reported. Reporting needs to include the following risks:

• Repricing mismatches
• Yield curve risk (changes in the shape of the curve)
• Basis risk (see below)
• Balance sheet composition-the extent to which a society is able to widen the margin on administered products should it need to do so in order to cover losses
• Optionality-particularly options embedded in products
• Currency risk

There is a simple message for Societies on basis risk. That is, if you incur basis risk you should be capable of monitoring, managing and reporting it. This includes being able to determine how independent changes in bank rate, Libor and administered rates can affect your business now and in the future.

The FSA refers to limits being set to confine structural risk within levels that are prudent.

Limits set by Board policy should be treated as absolute. Reporting to the executive should be immediate and action is expected. Clear guidelines should be in place to cover what happens in the case of limit breaches.

The FSA also expects that a society's financial risk management policy to cover:

• Settlement risk
• Counterparty risk
• Operational risk

5. Risk management systems

IT systems are expected to have the appropriate level of security and access rights.

A society should have systems that measure maturity mismatch and structural risks including the effect of an interest rate shock.

This information should be reported to management and the Board.

Systems should also capture and record transactions, manage settlements and monitor credit and settlement risk.

6. Stress testing

Regular stress testing should be taken into account when limits and policies are established and reviewed by the board. It is likely that limits that do not consider stresses will demonstrate to the regulator that crucial information is not available or is not being used.

7. Counterparty risk

Counterparty limits should cover principal amounts, positive mark-to-market values on derivatives and settlement risk.

Dealing personnel should not set or increase limits and deals should only occur with counterparties that have limits.

Societies with active treasury operations should consider having a separate credit risk committee responsible for producing a credit policy statement.

The credit risk policy should explain how credit information is kept up to date. There should be a system that prompts review if a counterparty's credit risk deteriorates.

In all cases there should be a counterparty list that is reviewed at least annually (and more frequently if required).

8. Independent review & controls

It is a board responsibility to ensure that a Society's internal audit function has sufficient skill and resources to undertake treasury audit work.

Specific reference is made to internal audit being able to evaluate controls over maturity mismatch, structural risk and treasury management procedures.

Internal audit may be outsourced but the process should be integrated into the society's audit procedures and there should be reporting lines to the audit committee.

The FSA provides a Financial Risk Management table. This details the governance structure, risk analysis, funding limits, hedging instruments, credit limits, systems and controls that are expected under each of the five treasury approaches.

Societies that differ can expect the regulator to question whether such mis-alignment is appropriate. The resultant regulatory dialogue may lead to a plan for the society to re-align itself with the chosen treasury approach.

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