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Treasury Consulting > What the FSA doesn't tell you about PS 09/16

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Published: 3rd February 2010 by William Webster

The FSA insists that firms hold more liquidity. For many firms that means more Gilts and maybe a Reserve Account and that's an immediate drag on the NII. Whilst you can't disagree with the principles of regulation putting it into practice is a completely different issue. For smaller firms the problems caused are disproportionate. 

If the FSA doesn't like what you do or finds you out of line with other firms it will increase the ratio. Furthermore you need to ask the right questions and importantly get some answers before implementing PS 09/16. It's what the FSA doesn't tell you that causes problems. Let's see 19 of these issues.

19 issues and even more questions

1. Standard or Simplified ILAS

Many firms are looking to proceed down the simplified approach. But this requires a waiver from the FSA. How long will that take?  Some simple businesses fall outside the simplified approach does this apply to you and what are the implications for your firm? 

2. Type A and Type B

Retail deposits are classified into Type A and Type B. This is all about identifying "hot" money. Whilst the FSA has broadly indicated what it expects it leaves scope for interpretation. Are ISAs price sensitive deposits? Are term deposits type A or type B? How would you treat a deposit of £100K, is it all type A, or half type A? This may seem taxonomy - it isn’t. It has very serious commercial implications. How can you compete on price if the products you offer get classified as type A when those of a competitor are classified as type B?  

3. Intra day cash flows

The regulator emphasises the importance of being able to manage intra day liquidity positions. This sounds reasonable for large banks that have large multicurrency payments and pose systemic risk but what does it mean for smaller firms? How do you monitor intra day positions against expected cash flows and available resources? What happens if you are asked for evidence? 

4. Pipeline

The regulator wants 25% of undrawn facilities to be accounted for in the liquidity buffer. For many firms that's mortgages and loans, but just how do you measure and monitor this? Does it apply to all offers or those you expect to complete and drawdown? Again the commercial implications are far reaching.

5. Derivatives

Do you hedge with swaps? Many firms do and many counterparties ask for collateral. Have you signed a credit support agreement? If so what margin calls could you face and are they adequately factored into your liquidity requirements when you stress interest rates? What's more loan pre-payments trigger swap breakages so even if you don’t collateralise you could have a cash call. Could the regulator pick this up? I think so.

6. Early Warning Indicators

EWI are designed to give you the "heads-up" when liquidity risk is emerging. What do you use, how is it integrated into contingency planning and importantly what if the regulator asked to see it? You may be surprised to see what firms use.

7. Stress testing - liquidity "drivers"

The FSA identifies a long list of liquidity "drivers". These need to be considered even if you go down the simplified approach. But some of PS 09/16 just doesn’t apply to your business. How do you treat cross currency liquidity risk if you don’t go near the FX market?

8. Stress testing - profitability and solvency

Conversations about stress testing quickly turn to cash flow and liquidity. Stress testing also impacts on profitability and solvency and the FSA expects to see the stressed effect on these too. It's easily missed.

9. Stress testing - how long can you survive?

So you’ve determined the amount of liquidity you need to survive 2 weeks without mitigating action. But how long can you survive with mitigating action? What do you do with this information? What's the FSA looking for? Where and how is it reported to the Board and how does it fit with your risk appetite?

10. Stress testing - forward looking risk

Is your stress testing reliant on historic data? Many assumptions are based on what happened in the past and there is nothing wrong with that. But how does this vary with the "forward looking risk" that the FSA is so keen on? And how does the Board review stresses and debate them?

11. Stress testing - ILSA

Simplified ILAS firms must regularly carry out ILSA (Individual Liquidity Systems Assessment). An ILSA must include the results of stress testing. Have you considered that the simplified approach is not as simple as you expected?

12. Contingency funding plan

The CFP is about mitigating action in times of stress and it's unique to your business. It should contain details of implementation, who is responsible, whether it's tested and importantly it needs to be documented. What else does the regulator want to know? Is it consistent with your stress testing?

13. Funding plans

Firms should have diversified funding plans that can withstand stresses. But for smaller firms the idea of diversification is surely limited. So just how do you go about making use of all available sources?

14. Governance

The board must approve all liquidity policies processes and systems including a "liquidity risk tolerance" how do you do this and what's the practical difference between executive action and the board's input? What does the FSA want to see?

15. Liquid resources

The FSA gives you alternatives many firms will probably be restricted to Gilts and the Banks of England's Reserve Account. Have you applied for your reserve account yet?

16. Are Gilts risk free?

The short answer is no. Buy Gilts and you end up with market risk. You will see the effect in your gap reporting. So what maturity is best? Do you buy short dates (T-bills) and get almost a zero percent return, do you invest further out? Can you hedge with swaps? What problems does "asset swapping" cause you? If you make the decision without considering all the facts you could get a nasty surprise.

17. Turnover

Firms need to regularly turnover the buffer - it's an FSA requirement. Do you intend to turnover Gilts by way of sale or repo? Could sales incur losses? Is repo the answer?

18. Using repo

How does it work? Are you set up to deal in repo? What do you need to get it in place? Would you need FSA approval? How do larger firms make money from you? What margin calls and haircuts can you expect? How long do repos need to be?

19. Transfer pricing

Transfer pricing is at the heart of what the regulator is seeking. It means that the cost of managing liquidity risk is passed to the products that create this risk. Most firms have not yet thought through the implications in terms of product pricing. What will it eventually mean for the products you offer and your balance sheet?

Would you like answers?

Large firms are well placed to handle these questions and assess the impact on their business. For smaller firms it all ends up as a high level responsibility.  If you want some answers I would be pleased to hear from you.