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In PS 9/16 and BIPRU 12 the FSA defined what a firm could count towards its liquidity buffer. This was mainly high quality government debt. For firms with Sterling balance sheets it's meant a Reserve Account, T-bills and Gilts. At the time this was sensible. If you recall Mr. Market had a near death experience and about the only thing that could be sold or repoed carried a government label. It's now time to ask whether the buffer restrictions in their current form are desirable. The widespread use of holding Gilts by banks may under certain scenarios destabilise the system. If you recall the FSA uses three liquidity stresses - idiosyncratic, market wide and a combination. In a market wide stress where UK banks seek collectively to sell or repo their Gilt holdings isn't a disorderly market the probable outcome? If this in itself isn’t enough to review what's held in bank buffers is not the intertwined nature of UK banking and the UK Government unhealthy? Rapid liquidation of Gilts by UK banks could disrupt Gilt issuance. Failure to curb public debt could also increase yields leading in some cases to losses on buffer assets. You will see I haven't addressed the cost of holding the buffer but when you buy insurance you expect it to cover your risk not potentially add to it. On balance the buffer requirements have hard wired additional instability into the system when it is under extreme stress. That obviously wasn’t the intention but now times have moved so should the rules. One problem remains, who would buy all those Gilts?

Over twenty years ago I recall having a discussion with fellow dealers about how big our risk limits should be. We concluded that it was straight forward. The risk limits ought to be based on how much the bank could afford to lose. Whilst 14 standard deviation events were known about, for limit purposes they were ignored. Why? Largely because if you based your business on extreme events, then 99.99% of the time you would be taking less risk than you considered appropriate. This view was reinforced by the fact that even if it was a very bad day the size of the risk would not jeopardize the bank because trading was only a very small proportion of the bank's activities. Fast forward twenty years and two things have altered. First, the exposure banks have to fluctuating market prices is now far greater. This is caused by a number of factors including the type of business conducted, leverage and accounting rules. Second, "fat-tails" are an accepted part of market behaviour and must be assessed and quantified by using stress testing. Put these together and on a bad day you lose a lot more money than anticipated. A fact not lost on regulators who are significantly increasing the amount of capital and liquidity banks are being asked to hold. So how do you look at risk? Do you see it as what happens 99.99% or 0.01% of the time? If you move from the former to the latter it makes you much more aware that your risk limits should be moving down rather than up. The natural corollary of this is that profits from risk taking will fall. This puts greater value on earnings from the franchise.

I was recently asked about covered bonds. This was timely since the Treasury has just published a review of the UK's regulatory framework for covered bonds. It appears that covered bonds are now seen by regulators as part of the solution to mortgage bank funding problems. In particular comfort is drawn from the fact that investors are more willing to lend to banks provided there is solid collateral. Could this lead to unforeseen problems? 1. Bank senior debt holders are undoubtedly in a more risky position than they used to be. It is most likely that in bankruptcy they will face a bail-in and haircut. Risk averse investors will therefore be attracted to covered bonds despite their lower returns. Q. Will banks and building societies that can't issue covered bonds (mainly because they are too small) be priced out of prime mortgage lending? 2. Covered bonds ring fence assets in bankruptcy. Unsecured creditors including senior debt holders therefore face potentially lower recovery rates. Q. Will this lower recovery rate be fully reflected in any future bail-in? How certain are we that the taxpayer will not end up footing at least some of this bill? 3. In the crisis it was apparent that over reliance on one source of funding, be that wholesale or structured, led to failure. Q. Is it possible that in the future some banks or mutuals become over reliant on covered bond markets? What structural limits does the regulator anticipate for individual firms and collectively? 4. It has been mooted that covered bonds should be eligible in the liquid asset buffer. Q. Is this a good idea? Or does it create the sort of round robin funding problem that existed in the inter bank market? I don’t pretend to know the answers to these questions. But what I do know is that some basic questions weren't asked last time. Could it happen again? You bet it could.

If you have been working in or around treasury for the last two or three decades you will have seen some remarkable changes. One that is striking is how and where you come across complexity. At first complexity arose with products. It's why derivatives became controversial. Making things opaque helped disguise how much was made out of customers. With a spreadsheet an understanding of interest rates, cash flows and volatility you had a licence to print money. Enticing punters into the "too good to be true" was the name of the game and it's still popular. Caveat Emptor. Next risk management became complex. VaR appeared. It looked simple but underneath, the algorithms and assumptions went unchallenged. Some "knuckle dragging" traders thought it was nonsense. But it fooled many. We know what happened. Leverage worked - but not quite in the way we anticipated. Now regulation is complex. The objective is laudable and as a tax payer I can't disagree. But to have the benefits of a free market and at the same time control behaviour is wishful thinking. Unless you split up banks and make them smaller (which by my estimation won't happen) the problem continues. The politics dictate that the outcome will be partial and messy. What can we learn from this? Complexity promises to solve problems but history tells us that it ends up increasing risk. This is because it's easy to get suckered into something you don’t understand because you can't or won’t ask the right questions. Treasury is risky. If you feel a little uncomfortable and need to know more about it this course just may help you.  www.barbicanconsulting.co.uk/treasury_building_societies

In the UK, Bank rate is 0.50% this is the lowest it has ever been since records began over 300 years ago. According to many economists this is the worst economic period since the 1930s. Wages haven't kept up with prices and real incomes have declined. Policy makers explain their fear of a "double dip" and all the problems that deflation can bring. Every time there is a hint of a rate increase voices say it will damage any hope of recovery. Isn't there something very puzzling here? We aren't taking about putting rates up from 5% to 6%, just 0.5% to 0.75% or maybe 1%. Perhaps we are missing something. Is it that rates are so low because bank balance sheets are still in a mess? It's a well known fact that as a result of leverage bank capitalisation is far lower than ideal. This can be resolved via a combination of retrenchment, earnings and equity. For the highly leveraged bank cheap money is just what's needed. It allows you to earn more through carry and wider margins. This eventually recapitalises the balance sheet at no cost to the taxpayer so it's politically more acceptable. That's unless you are a saver. If the strength of bank balance sheets gives you some insight into how long it will take rates to normalise it's going to be some time yet. There is just one problem. Running interest rates this low hasn’t been tried before. Combined with QE could it lead to unknown consequences? It's quite clear that the inflation target has been allowed to drift. If higher wage demands eventually result then the central bank will be required to act even if it's just to preserve its own credibility. The permutations of scenarios are infinite. So if you do run a bank balance sheet enjoy the carry. But do keep a close eye on interest rate risk on the trading desk and in the banking book. It could be the latter that causes pain in the future.

When I see board risk packs there is more on liquidity, market and credit risk than ever before. That's a good thing, it promotes discussion. One of the key ingredients is the ability to look forwards rather than backwards. Indeed the question "what will the balance sheet look like over five years" is routinely asked as part of the capital and liquidity process. However looking forwards is not easy. Forward prices are a poor indicator of future spot rates. Economic models fair no better; take a look at the Bank of England's fan charts. Tomorrow's weather will probably be like today but who knows what next week will bring? Markets have grappled with these problems for years. When the perception of risk is low more is put on the table and when it's high everyone gets stuck in the exit at once. Nothing new here but with "the light touch" being as popular with regulators as a 1980's "Relax" T-shirt, regulatory volatility is high and it's something we don't have much experience of, that is until recently. It can lead to two things. First it can materially affect the way we look at risk. Second, reversal of direction by regulators can turn a sensible strategy upside down. Let's look at an example. Liquidity risk management has been materially altered by regulation. The way liquidity is measured, managed and reported has been transformed. But could it be turned upside down again? Could net stable funding ratios alter the relative size of buffers and the restrictions within? If this happened what could be the cost if you wanted to alter your buffer? If interest rates increased at the same time what difference would this make? Of course it's not just liquidity that's affected it is almost every area of the balance sheet. Higher regulatory volatility means past decisions (the business you currently have) is now more risky. Furthermore today's decisions face a more uncertain future. As a result of these regulatory ambiguities clients face a dilemma. Sitting on the fence waiting for things to unfold is an option but the current level of uncertainty can present some very attractive opportunities. Do you tread water and risk drowning or swim for the shore which may be currently beyond reach? Given that treading water is only a temporary respite swimming must take place. Before striking out a board should ask "what is the potential exit cost should future regulatory decisions make today's decision unattractive?" and "Can we afford this?" Routinely asking questions about the potential cost of regulatory changes is not easy and I'm not going to pretend you can put a "value at risk" on it. But the discussion is worth having and may help you pin point excessive regulatory exposures before they happen. In other words if you swim and half way through the tide turns can you survive?

Two banks I visited this week had contrasting views on the need for graduates in their financial markets division. Both banks were large Europeans and it makes the comparison interesting. The first bank had hired very few graduates in the last four years. It preferred to take on seasoned professionals. They could hit the ground running and were effective from the first day. The only problem was that the salary bill was skyrocketing. The second bank continued to hire graduates - several thousand over the same four year period. They found that raw talent could prove effective within 18 months. It was relatively inexpensive and it kept people on their toes. It also provided a wider pool of internal talent to draw on for senior management. In times of excess volatility thinking on your feet is a prerequisite. But when things settle who will be better positioned? Those that firefight or those that think about the future?

Last year the FSA published the new sourcebook for building societies. There were 5 treasury approaches and 3 credit risk approaches. You compared what you did with what was expected and then waited. Now we are getting the response. In some cases I understand the FSA isn't too happy. That means remedial work. One key issue is the way that risk is managed (or not managed) in treasury. If you look at this from the FSA's perspective there isn't room for error. Either risk is managed or it is eliminated. This shouldn't be a surprise. It was flagged in the sourcebook. In July 2010 I mentioned that some societies would be required to engage in a programme to improve risk management. Let me put some flesh on this. Risk management is not about waiting and hoping. It is about being constructive in proofing your business against the possibility of excessive losses. It means identifying all the risks you face. That's more than market, credit, liquidity and operational exposures. It is how your business is affected by these risks. It requires you establish risk appetites. How much risk do you want to take with the risks you have identified? Express this qualitatively and quantitatively. Reference it to profitability and reserves. Risk reports should be concise. Add scenarios and stresses. They capture more extreme outcomes, the ones that really threaten continuity. Work out what your response would be. Make sure everyone knows what would happen. Limits should be clear. You should see what has happened and importantly what may happen. Use the risk reports to stimulate debate. Do you need to take further action as a result of what you see? Document the discussion. It's all good stuff. But there's just one problem. How do you do it? Yes it's a lot harder for societies. You can't throw unlimited resources at it. You certainly can't leave it to one person.  The FSA won't tell you what to do. But I can tell you what they are looking for. It's this. Independent risk management. This is where the whole board is actively engaged in risk management and takes expert guidance that is truly independent of those that procure risk. There are well known ways to do this. The poignant thing is it's easy to spot when it doesn't happen.

It's something that I flagged last year. Bank senior debt may have a few surprises in store for those that hold it. There is increasing pressure to make sure that in the event of another crisis (and that's just a matter of time) senior bond holders take a haircut. Whilst banks complain that this will increase their cost of issuance it's only right. After all bond holders have been paid a credit spread for taking risk - a risk that was ultimately borne by the taxpayer. In this case haircuts are a great way of imposing discipline. It means banks that have strong balance sheets will end up paying much less to borrow than those that remain over leveraged. It will also make investors look very closely at what they have invested in. Of course it isn’t in place now but could be in the future. Now this creates uncertainty - something markets don’t like. So if you are an investor in bank senior debt be warned. Just the risk of future haircuts may impact on today's price. Is it time to review what's in your bond portfolio?