In the UK, the Financial Services Authority (FSA) is strengthening prudential regulation to help restore confidence in the UK markets, as well as ensure that the financial system is able to cope with future shocks. In an attempt to address the shortcomings of the current liquidity regime, the FSA has issued proposals on how it intends to regulate firms’ management of liquidity risk, its information needs for assessing firm-specific and market-wide emerging liquidity risks, and its phased implementation approach for the new liquidity regime, which is expected to begin in the fourth quarter of 2009.

While financial institutions have had governance, processes and systems in place to help them manage their liquidity and assess and mitigate future liquidity risks, these have clearly proven inadequate in the face of financial crisis.

The regulatory focus is, therefore, primarily on better risk governance and more sophisticated measurement techniques. Stress scenarios are key tools in assessing liquidity risk and stress outputs need to be used in pricing of products and contingency funding plans, for example.

Key Observations

Prior to the current financial crisis, capital was seen as the primary factor in a financial institution’s viability. Capital and liquidity are now considered to be of equal importance to the stability of the financial system as a whole. The recent proposals by the FSA on the new liquidity regime will set higher prudential standards for the management of liquidity risk, resulting in better corporate governance, enhanced measurement techniques and better management practices.

The proposals outline an approach to determining an appropriate liquid buffer, as well as the role of internal controls and management actions to mitigate unexpected shortfalls in liquidity. Stress testing is a key component of the approach. The effort required in the design of appropriately severe stress scenarios, the corresponding parameters to apply to these scenarios, as well as ensuring transparency in the use of the outputs in the business and decision making processes, cannot be underestimated.

Higher prudential standards will require financial institutions to maintain much more robust practices for measuring and managing liquidity risk. As a result the level of sophistication in the practices of an institution will also have an impact on the size of the costly liquid buffer approved for the institution by the regulator.

An outcome of these proposals for financial institutions is likely to be that they will need to adapt their business models to ensure that current and all reasonably possible future liquidity needs are continuously met. The progress already made in this area will determine the incremental effort required, although some amount of cultural and infrastructural change is likely to be inevitable.

Future liquidity reporting will require more granular data to be reported more frequently. As a consequence, additional investment in existing or new systems will be necessary. The anticipated cost of implementing these systems could be substantial for certain institutions.

This data will be used by the regulator in its own internal stress testing exercise to improve understanding of the dynamics of the firms they regulate and overall systemic risk. As a result, an integrated data and systems architecture will help to deal more efficiently with the regulatory challenge, as the same dataset would be used for an institution’s internal stress testing exercise, as well as for its external reporting.

What is Liquidity Risk?

Liquidity risk is the risk that a financial institution does not have sufficient liquid funds to enable it to meet its obligations as they fall due, or can secure them only at an excessive cost.

Effective management of liquidity risk, therefore, enables a financial institution to meet its cash flow obligations in all reasonably foreseeable circumstances. Central to assessing and managing liquidity risk are robust cash flow models and appropriate stress scenarios.

What is the FSA Saying About Liquidity Risk Management And Reporting?

Underpinning the rule set is the requirement for financial institutions to have adequate amounts and types of liquid resources to meet liabilities as they fall due in all circumstances, and be self-sufficient to meet local liquidity requirements at an entity level unless this requirement is waived by the regulator - which may be difficult to obtain in the short term, given the Lehman experience. The rules, therefore, envisage:

• An enhanced role for the governing body in liquidity risk management.
• The creation of an individual liquidity adequacy assessment (ILAA) process.
• An enhanced use of stress testing in this process.
• Better measurement and management of liquidity risk as a result of stress outputs.
• Improved contingency funding plans.
• More granular and frequent reporting of liquidity positions.

Figure 1: The Key Requirements of Liquidity Risk Management That Will be Implemented by Financial Institutions

The Increasing Importance of Stress Testing

Stress testing is being increasingly emphasised by regulators as a critical component of a financial institution’s risk management tool set, as it enables a better understanding of its liquidity risk profile and helps to shape its liquidity risk appetite. The results of stress testing exercises will also inform the individual liquidity guidance set by the regulator.

As part of the ILAA, financial institutions will be required to undertake three types of stress scenario (Figure 2) that will help to assess the liquidity risk of each institution in various stressed conditions. That is, the extent to which current liquidity exposures will continue to conform to the liquidity risk tolerance in these stressed circumstances.

Figure 2: Three Types of Stress Scenarios to be Used

For each of the above stress scenarios, 10 sources of liquidity risks have to be considered. Figure 3 shows these risks, together with a brief description for each risk.

Figure 3: Sources of Liquidity Risk

As Figure 3 shows, financial institutions have to assess the impact of the above scenarios on cash outflows, liquidity position, profitability and solvency post available mitigating actions and internal controls.

When Does the New Liquidity Regime Come Into Effect?

The new liquidity regulation is expected to come into effect from fourth quarter of 2009 although the complete rule-set will be implemented in stages by September 2010. Table 1 shows by when each component of the new regime should be implemented for various types of financial institution.

Table 1: Phased Implementation Approach

Individual liquidity adequacy standards (ILAS) are quantitative standards for liquidity that will apply to various types of financial institutions

How Will Financial Institutions Benefit?

Effective implementation of the rules is likely to lead to the following benefits:

• A clear statement of the liquidity risk profile in comparison to risk tolerance.
• A consistent framework for measuring and managing liquidity risk across the enterprise and, for groups, group companies.
• An improved measure of risk used in product pricing and a more informed assessment of business line impact on liquidity.
• Transparency of sources and application of liquid funds by counterparty, product, tenor, business areas and entities.
• An understanding of concentrations in sources and applications of liquidity and identifying opportunities for diversification.
• Assessing the scope for transferability of funds and collateral across entities to enhance funding capacity and a more efficient use of group liquid resources.
• Identification of appropriate measures to manage liquidity risks, such as changes to limit structures.

What Issues do Financial Institutions have to Address?

The current level of sophistication in risk management processes and systems in individual financial institutions will determine the extent of changes required. While firms have been implementing measures since the onset of the liquidity crunch to manage emerging liquidity risks, further work is inevitable to satisfy the higher regulatory standards underpinning the proposed rules. Specifically, this is likely to involve:

• Updating internal risk governance to include the establishment of liquidity risk tolerance, review of stress scenarios and the funding strategy, and approval of contingency funding plans by the governing body. The key challenge will be in implementing a comprehensive and easily understandable approach to setting liquidity risk tolerance, particularly for diverse institutions, and in designing appropriately severe stress scenarios to reflect the nature of the businesses.
• Implementing a robust and well-documented ILAA process. It will need to address adequately the main areas that are likely to be reviewed by the regulators in their assessment of adequacy of liquid resources.
• Enhancing internal stress scenario testing processes to accommodate the three types of stress scenarios; to derive stress parameters to implement these scenarios; and to consolidate the results to provide a group-wide position.
• Ensuring transparency and greater use of the stress results in the management of liquidity risk, such as enhancing contingency funding plans and funding strategy to ensure that it reflects diversification of funding sources, and managing the resultant changes required to the business models.
• Ensuring that liquidity risk is managed at an entity level and that it satisfies local liquidity requirements while, at the same time, ensuring efficient use of liquid resources at group level.
• Improving internal systems to be able to produce the new data for liquidity reporting, which is likely to require consistent and integrated view of data across the organisation, and be able to cope with daily reporting, when required.