Liquidity stress tests

New Liquidity Regime

The FSA has published a consultation paper (8/22) on the proposed new liquidity requirements that are expected to come into force in October 2009. It is a significant paper with 166 pages of detail. This note is therefore a short synopsis of the main features and is written generally rather than specifically for your firm.

Background

The overall Liquidity Adequacy rule says that “A firm must at all times maintain liquidity resources which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due. Such liquidity resources should be sufficient to withstand a range of severe stress events which could impair its ability to meet its liabilities as they fall due”.

The proposal is to strengthen and enhance this rule so that a substantial improvement in liquidity risk management is implemented (via enhancing the firm systems and controls) across the sector.

Who will it impact?

The new rules will apply to all UK incorporated banks, building societies, Full-Scope BIPRU investment firms, Limited Licence investment firms, Limited Activity investment firms, and branches of foreign banks operating in the UK.

The proposals will apply on a solo basis (standalone) for a firm to ensure that it is self sufficient in terms of liquidity and will also be applied to UK branches of foreign banks. In other words, liquidity must be considered without any dependence on other group companies or the parent unless permitted by the FSA via rule modification or waiver.

The proposed rules (collectively called the Overall Liquidity Adequacy Rule) will be applied dependent upon a firms newly defined term, being considered as either an “ILAS firm” or a “Non ILAS firm”:

All firms are to be divided between ILAS (Individual Liquidity Adequacy Standards) firms and Non ILAS firms – generally this will be driven from a firm’s existing prudential category and is likely to mean:

· ILAS firms = UKincorporated banks, building societies, Full scope BIPRU investment firms and branches of EEA and third country banks; and

· Non ILAS firms = BIPRU limited licence firms and BIPRU limited activity firms

All ILAS firms will require their liquidity resources and the adequacy of such to be assessed internally and reviewed by the FSA. This will require two processes to be carried out, namely:

The ILAA – Individual Liquidity Adequacy Assessment, and

The SLRP – Supervisory Liquidity Review Process (conducted by the FSA).

So, going forward, what changes?

The following briefly summarises the changes.

Systems and Control requirements (applies to all firms):

As the FSA’s goal is to deliver the core objectives of the enhanced liquidity policy through the systems and controls management process within a firm, it is no surprise that the following are included in their proposed rule changes:

A firm must have in place sound, effective and complete processes, strategies and systems that enable it to identify, measure, monitor and control liquidity risk.

A. Strategy & Process

A firm’s governing body must approve and review regularly (not less than annually) the processes, strategies and systems. This will include ensuring:

it has in place a robust framework to project fully, over an appropriate set of time horizons, cash flows arising from assets, liabilities and off-balance sheet items;

its processes, strategies and systems in relation to liquidity risk support the liquidity risk tolerance established by its governing body(Board of directors/partners committee etc).These tolerances will be part of the SLRP that will be required to be approved by the FSA;

its processes, strategies and systems in relation to liquidity risk to enable it to identify, measure, monitor and control its liquidity risk positions for:

all sources of contingent liquidity demand (including those arising from off-balance sheet activities);

all currencies in which that firm is active; and

correspondent, custody and settlement activities;

it sets limits to control its liquidity risk exposure within and across lines of business and legal entities;

it has in place early warning indicators to identify immediately the emergence of increased liquidity risk or vulnerabilities. These indicators should include a signal as to whether any embedded triggers in funding or security arrangements (e.g. warranties, covenants, events of default, conditions precedent or other such terms) are likely to/will be breached, occur or fail to be satisfied, or contingent risks will or are likely to crystallise, in either case with the result that access to liquidity resources may be impaired; and

it has in place reliable management information systems to provide its governing body, senior managers and other appropriate personnel with timely and forward-looking information on the liquidity position of the firm.

B. Funding diversification and market access

A firm is going to have to be able to demonstrate that it has access to funding which is adequately diversified, both as to source and tenor.

C. Pricing liquidity risk

In relation to all significant business activities, an accurate, quantified liquidity cost benefit and risk (which must be stress tested) analysis must be fully incorporated into:

(a) product pricing;

(b) performance measurement; and

(c) the approval process for new products.

D. Intra-day management of liquidity

A firm must actively manage its intra-day liquidity positions and any related risks so that it is able to meet its payment and settlement obligations on a timely basis and under normal and stressed conditions. Such stressed conditions to be based upon the methodology indicated above.

E. Management of collateral

A firm must actively manage its collateral positions, in relation to each asset class held and by all major currencies and jurisdictions in which it is active.

F. Stress Tests

A firm must conduct regular stress tests to analyse the separate impact of possible future liquidity stresses on the firms:

cash flows;

liquidity position;

profitability; and

solvency.

These stress tests should consider:

(a) short-term and protracted stress scenarios;

(b) institution-specific and market-wide stress scenarios; and

(c) combinations of (a) and (b).

The assumptions and scenarios behind these stress test and the results must be reviewed by the governing body regularly to ensure that the nature and severity of the events being tested remain appropriate and relevant to the firm.

G. Contingency funding plans

A firm must ensure that it has in place an appropriate contingency funding plan that has been approved by its governing body. Its aim should be to ensure that, in each of the stresses, it would still have sufficient liquidity resources to ensure that it can meet its liabilities as they fall due.

H. Additional requirements for ILAS Bipru firms

An ILAS BIPRU firm will be required to carry out an Individual Liquidity Adequacy Assessment (ILAA) which will be reviewed by the FSA (during the FSA’s Supervisory Liquidity Review Process (SLRP)). The results of the SLRP will be a firms Individual Liquidity Guidance (ILG) provided by the FSA to that firm and which needs to be adhered to.

An ILAS BIPRU firm must also ensure that its liquidity resources contain an adequate buffer of high quality, unencumbered assets with such buffer being available to meet the liabilities in times of stress. The amount of this buffer is calculated during the SLRP process and confirmed from the ILG

ILAA Stresses

There are two liquidity stress scenarios that have been identified by the FSA as requiring to be tested to ensure that a firm has sufficient liquidity, and these are a firm specific stress (idiosyncratic stress) and the second is a general systemic test (market wide liquidity stress). A third stress, will, of course, be a combination of the two to differing degrees.

The first liquidity stress is based upon an unforeseen, name-specific, liquidity stress in which:

financial market participants or retail depositors, or both, consider that in the short-term (two weeks) a firm will be or is likely to be unable to meet its liabilities as they fall due; and

over the longer-term the firm’s obligations that are linked to its credit rating crystallise as a result of a reduction in that credit-rating.

The second liquidity stress is an unforeseen, long-term, market-wide liquidity stress preceded by an unforeseen, short period of general disruption in the financial markets. In other words, a scenario similar to that that was apparent in the last quarter of 2008. This would include such events as sovereign defaults, infrastructure failure, major political controversy etc; the type of events that cause all institutions to alter their behaviour.

In considering the liquidity stress tests, the risks to be considered should include:

(1) wholesale funding risk;

(2) retail funding risk;

(3) intra-day liquidity risk;

(4) intra-group liquidity risk;

(5) cross-currency liquidity risk;

(6) off-balance sheet liquidity risk;

(7) franchise-viability risk;

(8) marketable assets risk;

(9) non-marketable assets risk; and

(10) asset diversification risk.

Liquid Assets Buffer

An ILAS BIPRU firm will have to ensure that its liquidity resources contain an adequate buffer of high quality, unencumbered assets such as consisting of:

government debt securities, issued by a Central Government of any EEA state, U.S.A., Canada, Japanor Switzerland;

securities issued by those international institutions listed in the “Red Book Operating Procedures” (appendix VI to the Bank of England’s Operations under the Sterling Monetary Framework: Operating Procedure; and

reserves in the form of sight deposits with a central bank of any EEA state, U.S.A., Canada, Japanor Switzerland.

Liquid Assets Buffer under Simplified ILAS

This will apply only to simpler mortgage banks and building societies provided:

a majority of that firm’s total assets are accounted for by loans secured on residential property;

its assets and liabilities are denominated exclusively in sterling; and

no less than 70% of its total liabilities are accounted for by retail deposits.

These firms that are operating simplified ILAS may calculate their liquid assets buffer requirement as the sum of:

the wholesale net cash outflow component;

the retail deposit component; and

the credit pipeline component

and thereafter the firm must hold assets equal to the size of that buffer in the form of unencumbered UKTreasury bills.

The simplified ILAS approach does not relieve a firm from the obligation to carry out an ILAA, consequently, where a firm’s own ILAA shows that its liquid assets buffer should be larger in size than that produced by the application of the above formula, the FSA will expect that firm to maintain a liquid assets buffer which is consistent with the results of its own ILAA.

I. Cross-border and intra-group management of liquidity

For firms that are part of groups, there are certain modifications or waivers to the proposed rules that could be available, notably:-

Intra-group liquidity modification – permitting a firm to rely on liquidity support from elsewhere in its group,

Whole-firm liquidity modification – permitting a branch to rely on the availability of liquidity resources from elsewhere within the firm but most typically from the head office, or

Whole-firm liquidity waiver – (Replaces current Global Liquidity Concession). This formally waives the entirety of the overall liquidity adequacy rule for a UKbranch.

J. Revised Reporting Requirements

All ILAS Firms will be required to report:

Enhanced Mismatch Report, - Weekly, with the ability to report daily

Pricing Data - Daily pricing, submitted weekly

Marketable Assets Report - Monthly

Funding Concentration Report - Monthly

Retail Funding Report - Quarterly

Off-Balance Sheet Report - Monthly

Clearing and Settlement Banks Only

Intra-day Liquidity Report - Daily

All ILAS and NON ILASFirms will be required to report:

Systems and Controls Questionnaire - Quarterly

So, in conclusion, what are the implications and timescales for you as firm? What do you need to do now?

The consultation process will close in the March 2009 followed by detailed new rules being introduced in April and becoming effective as from October 2009. The time scales for implementation of different sets of rules are summarized in the following table:

Requirements	Stage of implementation by October 2009
Systems and controls	Rules will apply in full.
Adequate liquidity and self sufficiency	Rules will apply in full.
ILAS	ILAS will apply in full. A firm subject to ILAS will therefore be required to assess the adequacy of its liquidity resources from October 2009. FSA will, however, agree a timetable with firms for the completion of the Supervisory Liquidity Review Process (SLRP). FSA will consult in Q1 2009 on any transistional arrangements arising from roll-out of the SLRP.
Simplified ILAS	It will apply in full. A firm meeting the criteria for simplified ILAS may therefore adopt that approach from October 2009.
Group wide management of liquidity	A firm wishing to benefit from an intra-group liquidity modification or a whole-firm liquidity waiver/modification and to have received approval from the FSA by that date. A firm without an intra-group or whole-firm liquidity modification as at the date that new rules come into force will therefore need to be self-sufficient for liquidity purposes.
Reporting	Transitional arrangements will be discussed as part of the consultation on reporting requirements.

Policy description	Description of policy	ILAS Firms				Non-ILAS Firms
		UK Incorporated Bank	Building Society	Full Scope BIPRU Investment Firm	Branches of EEA and third country banks	BIPRU Limited Licence Firms	BIPRU Limited Activity Firms
Adequate liquidity Resources and self-sufficiency	High-level requirement to maintain adequate liquidity at all times through own resources, without relying on other parts of the group	X	X	X	X	X	X
Systems and controls requirements	Framework setting out main systems and controls for requirements for liquidity risk management	X	X	X	X	X	X
Individual Liquidity Adequacy Standards (ILAS)	Quantitative standards for liquidity, resulting in the issuance of individual liquidity guidance	X	X	X	X
Simpler Firms	Standardised options for certain firms	X	X	X	X
Liquid assets	Standards around quality and quantity of liquid assets	X	X	X	X
Cross-group management of liquidity	Policy around where it may be appropriate for firms not to be self-sufficient including FSMA waiver process	X	X	X	X
Quantitative reporting	Granular and frequent liquidity data to provide a firm specific and marketwide view of liquidity risk	X	X	X	X
Qualitative reporting	Systems and controls questionnaire	X	X	X	X	X	X

Source: Financial Services Authority CP 08/22

September 29 2009

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