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Liquidity How It's Shaking Down-speech

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Published: 27th November 2010 by William Webster

Liquidity How it's Shaking Down

Slide 1&2

Good afternoon. It's my pleasure to be with you today and I will be talking to you about liquidity and how it's shaking down. There's some good news and I hope that it will be of some relief after the past three years! First the agenda which may appear a little unusual.

Slide 3

1. A bit of history

However my talk doesn’t start in Canary Wharf in 2007. It starts a long time ago in Kuala Lumpur in 1941.When the Japanese had just invaded Malaya and the British were in retreat.

At this time Freddy Spencer Chapman a polar explorer and mountaineer investigated the possibility that left behind parties could undertake guerrilla activities against the Japanese.

He was convinced that small parties of trained soldiers could inflict heavy damage disproportionate to the resources they required.

In 1942 despite the fact that the authorities couldn't spare the men Chapman went behind enemy lines for good.

Field Marshall Wavell compared Chapman to Lawrence of Arabia writing that Chapman

"...never received the publicity and fame that were Lawrence's lot but for sheer courage and endurance, physical and mental, the two men stand together as examples of what toughness the body will find, if the spirit within is tough; and as very worthy representatives of our national capacity for individual enterprise." He also recommended Chapman for a VC.

What's special about Chapman is that he stayed behind Japanese lines for three and a half years over a thousand miles from the British Army.

He lived in the jungle which in itself is unhealthy. In this time he contracted tick typhus, scabies, blackwater fever, dengue fever, pneumonia and malaria as well as all the discomforts of bites, ulcers and sores. He went on to survive the war and returned to the UK. He also wrote a book of his exploits "The Jungle is Neutral".

He explained that one of the difficulties with the jungle is that a soldier that is not used to it sees it as a threat. Private solders die within a few days, officers survive a bit longer.

Slide 4

But if you can identify with the jungle and use what it has to offer you can survive and then draw benefit from what you have learnt. It's a type of Darwinian thinking and it's why to Chapman the Jungle is Neutral.

What's all this got to do with liquidity? It's this.

When we first glimpsed plans of the new regime it was the jungle. It frightened us.

For some the thought of entering the regulatory rain forest sapped our strength, others just buried their head and said "it will go away".

For societies who in many cases are small even the simplified approach proved to be not quite as straight forward as we anticipated.

It's here where I draw a comparison with Chapman. I think that some of you felt and still feel you are in a hostile environment where survival isn't guaranteed and support has not been forthcoming.

If I echo the words The Jungle is Neutral perhaps we can look at the new liquidity regime and find that there is some good news and yes, it does confer some advantages which I am now going to address.

Slide 5

2. Reasons to be cheerful

The following is drawn from my experience of working with bank and building society clients helping them manage their risks.

With regard to liquidity in particular I've noticed that there is a certain resignation that something must be done. The question is how?

There's usually a short time frame and limited resources so it often ends up on your plate. Having gone through the process many executives tell me about the benefits. Let's look at this in more detail.

Slide 6

3. Preparing your assessment

Yes believe it or not it's good news. Progress is made by writing things down.

Although there is a format from the FSA and you may be critical of it. You can now address the risks that you face and in this respect every assessment is different because every firm is different.

It involves stresses and behaviour and you need to understand them because liquidity risk is not simple.

If you truly believe your risk is low and you are prepared to meet any challenge you can use that as the basis for your buffer.

If you think that you have mitigants you can include them.

If you have altered your balance sheet it can reduce your buffer.

If the discipline of having to prepare makes you think. Being subjected to regulatory scrutiny makes you think again.

This is a big improvement on the old ratios.

Slide 7

4. Challenging long held assumptions (that no longer apply)

Liquidity risk is full of assumptions. Here are a few we have dispensed with:

  1. Markets are always open
  2. Wholesale deposits are liquid
  3. The Bank is the lender of last resort
  4. AAA is risk free

I believe the processes in BIPRU encourages us to at least challenge assumptions on a regular basis. This improves our flexibility to deal with change and increases our chance of long term survival.

Slide 8

Here are a few assumptions that you may wish to review in the years to come:

  • Senior debt holders get repaid
  • Wholesale deposits are always unsecured
  • Gilts are risk free
  • The Reserve Account will always pay BBR
  • Idiosyncratic risk lasts 14 days
  • Retail funding is safe

Pay careful attention to those where there is a universal consensus. History suggests it's these that cause problems.

Assumptions can get us in trouble because we see them as laws.

Slide 9

5. Improving Board decisions

The Board has always been responsible but when it came to markets and risk many were heavily dependent on one or two members and their expertise. In established business this is unhealthy.

When we consider liquidity risk debate is good. It's a risk that contains much uncertainty. Our experiences and assumptions differ. The way I see liquidity may differ from the way you see it. We may both be right. But we may be looking at things from completely different perspectives.

BIPRU 12 not only encourages this it firmly puts the responsibility for liquidity with the Board. Better decision making involves exchanging our views.

Slide 10

6. Understanding the causes of liquidity risk

Before the crisis several liquidity regimes prevailed. Compliance centred around 8 day liquidity and holding a percentage of your assets as prudential liquidity.

This latter requirement became compromised, ratios fell and the quality of liquid assets deteriorated as firms searched for yield.

No one asked what caused liquidity risk because liquidity wasn’t seen as a risk. Fundamental assumptions about markets were unchallenged by all. This isn't the case today.

Now you have to make a detailed analysis of the 10 drivers of liquidity risk and more importantly how they affect you.

This is not an idle exercise. Every executive I've spoken with tells me it is a good thing because:

  1. There is a framework to help you identify the risk drivers
  2. It has helped uncover liquidity risks in unanticipated places
  3. Its allowed you to consider how you deal with those surprises

Collectively I'm sure that we are now familiar the following:

  • Concentration risk to certain types of retail deposits deemed to be Type "A"
  • An over reliance on one or two types of instant access accounts
  • Reliance on best buy products
  • Potential problems in payment systems
  • Liquidity calls from collateral positions

This analysis means you have a better understanding of what creates the risk, the buffer and therefore your cost.

As a result it's starting to alter the way we run the business. We have sought to reduce exposure to the things that create liquidity risk by modifying what we offer and do.

The approach may not be as scientific as the regulator would like but you are avoiding mis-priced risk and this is good.

Slide 11

7. What happens in stress?

The new regime is about survival under stress. We now hold more liquidity for those drivers that demand liquidity under stress and we must hold that liquidity all the time because we don't know when stress can occur.

I believe that asking what happens under an idiosyncratic or market stress is good.

How do you assess retail withdrawals in times of firm stress if you have never experienced it? It's a difficult one. To be honest there isn't a right answer. How many of you have used an intuitive "guess" only to find it leads to a buffer way in excess of what you anticipated? Moderation then follows but it is still helpful. Why?

Because it forces you to look at the risks individual products create. For example bunched rollover dates on retail deposit funding. That may have been something you used to accept, you may still accept it but if you do it has a cost and that cost creates an incentive to do something about it. This is an advance.

Slide 12

8. Improved ALCO & Board reporting

In information packs liquidity was one of the most under represented risks. The paucity of reporting meant that discussion about liquidity risk, if it occurred, was difficult to have. It isn't any more.

The quality and frequency of reporting has substantially improved. So much so that you can now see the buffer fluctuating with the changes in your balance sheet. You can also see through a variety of early warning indicators when you may be entering a period of uncertainty and you can also see how your planning affects your future liquidity requirements.

One great improvement is a simple measure...

Slide 13

9. Days of survival:

Three years ago if I'd asked you how many days you could survive under normal and under stressed conditions the answer wouldn't have been forthcoming. Now, (I hope), it is.

This simple measure is an estimate but it focuses your mind. It's also versatile. You can use it in your definition of risk appetite, your risk limits and how you measure up to the regulatory requirements under idiosyncratic and market stresses.

Slide 14

10. Buffer assets

Buffer assets are now defined in simple terms - government risk. This is controversial but you can't dispute the reasoning behind the decision. When you need cash you need assets that can be sold. The crisis proved our assumptions about markets needed to change. They have.

The opportunity to foster closer ties with the Bank of England and use the Reserve Account has helped. Despite its initial cost it has provided firms with a suitable asset paying BBR without increasing market risk.

Furthermore I believe the regulator is now more in tune with the cost of holding the buffer. A quantum leap has been replaced with a flight path.

This is good. It means that we can steadily increase the quality of assets without a rapid deterioration in income.

An increase in the quality of the buffer should also mean a smaller buffer. For those firms that have been holding significant wholesale deposits perhaps it is time to use that money to fund retail assets with more attractive margins.

Slide 15

11. Dusting off the CFP

We know that the best made plans often fall by the wayside in the event. However preparing your CFP makes you think. How do we deal with the stresses we have identified? Who will be involved? This will give you more flexibility and a greater chance of taking rapid mitigating action should you need to. This improves your chance of survival.

I suspect in some instances the CFP needs a little TLC and on this topic may I refer you to BIPRU 12.4.13. It's a useful CFP checklist.

Slide 16

12. Recognising the links

Discussion and analysis of liquidity has helped us identify how our business is not a series of individual parts but a collective of moving parts that affect each other.

A simple example will help explain. Pipeline risk means that you may have a future call on your liquidity. Just to write business without taking this into consideration ignores risk and it can get you in trouble.

That's why all areas of the firm are now affected by your policy. Information flows between departments has undoubtedly improved and this information has led to better decisions being made or at least decisions that consider the effect beyond just the constraints of one department or individual.

Slide 17

13. Leverage

If I asked today what caused the crisis I'm sure we could come up with a number of plausible reasons. But at the heart of the problem was leverage. Too much risk was taken with too little capital.

Increasing liquidity requirements should in future help keep the leverage created by maturity transformation in check. If this postpones another crisis that alone is a reason to be cheerful.

Slide 18

13. Summary

I've focused on liquidity. A year ago there was a lot of concern and uncertainty. Today the picture is much better. As a result of the changes I am much more optimistic. I'm sure you too will agree that in terms of your liquidity risk you are in a much better place than you were. That's because you can see some of the benefits and I've talked about them.

In the words of Freddy Spencer Chapman "The Jungle is Neutral".

Thank you.

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