Containing liquidity risks: Recommendations of the UK Financial Services Authority

The UK Financial Services Authority has recently come out with detailed guidelines for managing liquidity risk. Measuring and managing bank liquidity risk must receive as much attention as capital/solvency risk management. In the years running up to the recent financial crisis, this was not the case.

Key considerations in liquidity risk management.
§ Liquidity risk has inherently systemic characteristics. The simultaneous attempt by multiple banks to improve their liquidity position can contribute to a generalised collapse of liquidity.

§ Liquidity management has become increasingly complex over time. There is increased reliance on ‘liquidity through marketability’ alongside traditional liquidity through funding access. This makes it difficult to base good liquidity regulation primarily on one or a few standard ratios.

§ There is a tradeoff to be struck. Increased maturity transformation delivers benefits to the non bank sectors of the economy and is favourable to long-term investment. But the greater the aggregate degree of maturity transformation, the more the systemic risks and the more difficult for central banks to address liquidity crises.

Recommendations to deal with liquidity risk:

• There is a need for greater disclosures. For example, firms must be required to provide, for example, detailed maturity ladders, analysis of the assumed liquidity of trading assets, and analysis of off-balance sheet positions with liquidity implications.

• Individual Liquidity Adequacy Assessments (ILAAs) must be carried out for different assets.

• A liquid assets buffer must be maintained, whose minimum value (defined relative to balance sheet size) will be determined for each bank in Individual Liquidity Guidance.

• Firms must quantify and reflect in internal costing systems the liquidity risk created by participation in different categories of activity.

• Regulators must specify some stress tests, rather than leave it entirely to bank internal decisions. Stress tests must consider market-wide events as well as firm specific events.

• There must be a strong focus on the analysis of cross-system liquidity trends, with the publication of a periodic system-wide report.

A new regime

There can be considerable risk both for individual banks and for the system as a whole, if rapid asset growth is funded through increased reliance on potentially unstable funding sources. In the UK, between 2002 and 2007, growth of bank balance sheets was significantly correlated with the % of funding derived from short-term wholesale deposits. The new liquidity regime, should ideally result in:

• less reliance on short term wholesale funding,

• greater emphasis on retail time deposits;

• a higher amount and quality of stocks of liquid assets, including a greater proportion of those assets held in the form of government debt;

• a check on the unsustainable expansion of banking lending during favourable economic times.

These measures will naturally involve a trade off between a cost to the economy during ‘normal times’ and the benefits of the reduced probability of extreme adverse events. Given the scale of the economic fallout from the financial crisis, such a trade-off is justified in order to safeguard future financial stability.

A ‘core funding ratio’ as a prudential and macro-prudential tool.
The FSA has proposed a core funding ratio. Most developed countries have not used standard funding ratios (e.g. loans to deposit ratios) as regulatory tools for many years: but several emerging countries (e.g. Hong Kong and Singapore) have continued to apply regulatory constraints of this nature.