FSA outlines new liquidity rules

The Financial Services Authority (FSA) has published its final rules on the liquidity requirements expected of firms in the future. The far-reaching overhaul, designed to enhance firms' liquidity risk management practices, is based on the lessons learned since the start of the credit crisis in 2007. The new rules, published after a six month consultation under the headline Strengthening liquidity standards (PS09/16), will require changes to firms' business models. Specifically, the new rules aim to ensure banks reduce balance sheet risk through mandating increased holdings of low yield liquid assets, especially government bonds. Wide-ranging requirements for risk identification, measurement and monitoring are also included, alongside control measures, risk reporting and contingency planning to strengthen a firm's ability to withstand shocks. New technology systems and procedures will be needed by financial institutions across the country.

The regulator expects the new rules will however bring about substantial long-term benefits to the competitiveness of the UK financial services sector. The FSA thinks London's competitive position depends on counterparties' perception of the financial soundness of the firms that operate in the UK. Low-levels of 'soundness' cannot provide sustainable long-term competitive advantage, hence the new rules, which it says are designed to protect customers, counterparties and other participants in financial services markets from the potentially serious consequences of imprudent liquidity risk management practices. The major aspects of the rules are:

• An updated quantitative regime coupled with a narrow definition of liquid assets;
• Over-arching principles of self-sufficiency and adequacy of liquid resources;
• Enhanced systems and controls requirements;
• Granular and more frequent reporting requirements; and,
• A new regime for foreign branches that operate in the UK.

Commenting on the moves, Paul Sharma, FSA director of prudential policy, said: "We must learn the lessons of the financial crisis and we believe that implementing tougher liquidity rules is essential to ensure we are in a better position to face future crises. In the current crisis some firms weathered the storm better than others. These firms tended to be those that had policies that were similar to those that we are introducing today, including holding assets that were truly liquid. Phasing the period in which firms will build up their liquidity buffers should mitigate the knock-on effects to bank lending."

The FSA will not tighten quantitative standards before economic recovery is assured. It plans to phase in the quantitative aspects of the regime in several stages, over an adjustment period of several years. This is to take into account the fact that all firms at present are experiencing a market-wide stress. The precise amount of liquidity that each firm will need to hold will be refined over time to ensure that the combined impact of higher capital and liquidity standards is proportionate.

"The FSA must at all costs avoid choking off the economic recovery by curtailing banks' ability to lend," stressed Simon Hills, executive director of the prudential capital and risk department at the British Bankers' Association (BBA). "These proposals oblige banks to hold high amounts of government bonds, rather than allowing them to diversify their assets. Self-evidently, any money held in these 'liquidity buffers' is money that banks cannot lend to individuals and businesses," he warned.

Local v International concerns
The qualitative aspects of the regime will be put into place by December 2009. The FSA says it strongly supports the international liquidity workstreams that are underway although it recognises that may be some time before there is global agreement on specific proposals. Therefore, the structure of the new FSA regime is sufficiently flexible to allow the UK regulator to amend it over time, to reflect any new international standards.

Significant investment in new systems and business intelligence software will be necessary for the FSA, in order for it to handle the huge volumes of intraday information that will result from the new regime. Similarly, financial institutions themselves will have to create daily, weekly and monthly reporting systems to get data from wide variety of sources. For banks and investment houses that haven't already put money into data mining, dashboards and so forth, a lot of capital expenditure may await, with numerous vendors no doubt chomping at the bit to serve their needs.

"Banks now face a major increase in costs which could impact profitability," agrees Pat Newberry, chair of the UK financial services regulatory practice, at the PricewaterhouseCoopers consultancy. "To alter liquidity ratios is getting right to the heart of a bank's business model and will result in a strategic shift in how a bank operates."

His colleague, Patrick Fell, a director at the PwC UK financial services regulatory practice, thinks that efforts towards better liquidity management at banks are commendable, but the FSA needs to adopt a proportionate approach. "Recent liquidity failures at banks do not necessarily mean firms of all types require a new intensity of regulation. The FSA's response shows that they have listened to these concerns by taking some investment firms out of the quantitative liquidity requirements."

"We believe regulators have to rely on each other to assess liquidity and that the FSA should back international efforts before it turns its own approach into reality. It is now looking for 'broad equivalence' of overseas regulators, but the interpretation on the ground will be what matters," he adds. "The challenge is how to prevent liquidity failures triggering bank failures in the future, without gumming up the international banking system. There is a real need to regulate as a worldwide entity."

With EU moves afoot to increase co-operation and integration across the continent, via measures such as the European Systemic Risk Board, centralised clearing mechanisms coming in for the global OTC derivatives markets, and other measures stemming from America and the G20 meetings this year, covering pay controls and the like, it seems a global regulatory framework is finally coming into place post-crunch. As ever though, how it's implemented will be what counts.

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