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Liquidity Calibration

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Published: 23rd November 2010 by William Webster

Is a two tier liquidity regime in place?

At a conference in January 2010 I warned that firms on the simplified ILAS regime could find it worked against them. My premise was as follows.

It would never be in the regulator's interest for the formula used to calculate a firm's buffer (BIPRU 12.6.9R) to produce a result that was lower than that from rigorous stress testing.

Furthermore the simplified approach left no room for negotiation but the standard ILAS approach introduced subjectivity and therefore room for compromise.

This has serious consequences.

Firms that adopted the simplified approach did so in order to keep the cost of regulation proportionate to their business. But the price is to hold more in the buffer. This increases costs, leads to less competitive retail products and could eventually be enough to put you out of business.

On 11th March 2010 the FSA issued a calibration statement. The gist was that for full ILAS firms it was premature to set an upward path on minimum liquidity buffers. Ostensibly the argument was that economic recovery was too fragile although it's pretty certain that extensive bank lobbying was an important contributor in this decision.

The quantitative requirements for simplified ILAS firms were unaffected. From 1st October 2010 to 30th September 2011 the relevant floor was 30% of the simplified buffer requirement.

On 18th November 2010 the FSA made a further statement on liquidity calibration:

 "............the FSA does not believe it is appropriate to set industry-wide transition requirements for the UK’s larger banks at this stage, although they should expect to at least meet any new international standards by the currently proposed implementation date of 1 January 2015".

This is a further concession to larger banks who have successfully argued that to exceed international standards would put them at a competitive disadvantage. But there is no mention of smaller firms.

My understanding is that as it stands the simplified ILAS approach will continue to be implemented in accordance with the transitional provisions. What does this mean for you if you are on this approach?

  1. The international standards referred to may well impose less onerous buffer requirements on the larger banks than those contained in BIPRU 12.
  2. The UK regulator is likely to calibrate the buffer of large banks in accordance with international standards.
  3. Smaller firms will continue to implement the simplified approach and will hold higher buffer levels for what is ostensibly the same liquidity risk.
  4. Smaller firms will find it increasingly difficult to compete on price in the retail market.

As it stands this is not good news if you prepare an ILSA.

Can you do anything?

If you are in a simplified firm these questions need answers:

Why have we got into a situation where for the same risk we will be holding more buffer than larger competitors?

Why can't we apply rigorous stress testing (similar to the standard approach) and if this produces a buffer that is lower than the simplified formula why can't we use the lower figure?

Why can't the FSA be more forthcoming in what it wants from stress testing in smaller firms and also provide us with some reasonable industry data whereby we can get a better understanding of the risks we face in our balance sheet?

These are best pursued through your trade association. 

Displaying 1 to 6 of 6 results in total.

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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.

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A contractual cash flow report for a bank will show you that liabilities have shorter maturities than assets. That's because running liquidity risk generally makes money. But it has risks. Lack of confidence can lead to a real shortage of cash. That's why banks hold liquidity buffers. But measuring liquidity risk goes beyond what is contracted. It needs to assess the behaviour of markets and individuals. It's why stress testing is in vogue. Stress testing can't predict the future but it can give you an estimate for your liquidity buffer. It's likely to be a lot bigger than previously and it's going to cost your firm more, that's unless you can pass the cost on through transfer pricing.

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