The liquidity trap

Amid the chaos that followed the global financial meltdown, one outcome has long been predictable: the dramatic tightening of global banking regulation. But the recent move undertaken by the UK's Financial Services Authority (FSA) to drastically improve liquidity risk management threatens to make things worse rather than better, complain some in the banking sector.

In a politically daring move, the UK watchdog has become the first major regulator globally to tackle liquidity risk head on, through stringent new rules that represent the most drastic and far-reaching regulatory development since the inauguration of the Basel Capital regime. Many bankers believe, however, that the new FSA 'Strengthening Liquidity Standards' regime constitutes a severe and potentially damaging over-reaction.

To say nothing of the demanding timelines set by the FSA, the new rules require little short of an operational and technological revolution. The associated IT expense alone, expected to exceed £2.4bn ($3.9bn), may "kill off" smaller firms, says one IT chief - and this is merely one item on an extensive multi-year bill.

If the FSA has its way, the banking industry will be forced to hold bloated liquid asset buffers, the financing costs of which may seriously dent the UK banking sector's long-term profitability. The requirement for UK-based subsidiaries to be funding self-sufficient, meanwhile, may lead to distributed pools of trapped liquidity that threaten to reduce the efficiency of international banks' global liquidity management, increasing each firm's group-wide third-party credit exposure and balance-sheet leverage, according to the Institute for International Finance (IIF). For smaller and, in particular, foreign banks, the IT requirements alone may simply prove too onerous to bear, warn critics.

As the controversy surrounding the FSA's new regime grows, the very future of London as an international centre is at risk, say lobby groups. Some banks, both foreign and international, are seriously considering vacating the City or relocating parts of their London-based businesses, leading many market watchers to question whether the FSA is unwittingly leading the City of London in the wrong direction.

The FSA steps out

The abundance of liquidity available to Western financial markets in the years leading up to the crisis seemed to obviate a straightforward question: what if traditional sources of market liquidity simply evaporated? For an industry that had grown accustomed to luxuriating in cheap and highly available cash, this prospect was barely conceivable. Yet it was illiquidity that dealt the final deathblow to institutions such as Northern Rock and Lehman Brothers: liquidity risk, it transpired, was the silent killer.

Once invisible, liquidity risk is now the prevailing global regulatory imperative and several regulators are growing noisy on the subject. The revamped Financial Stability Board has been charged with defining a global standard for liquidity reporting, while the European Commission and the Committee of European Banking Supervisors are also in the process of reviewing their liquidity standards. Meanwhile, the Basel Committee on Banking Supervision (BCBS) is expected to add liquidity provisions to the next version of Basel II.

But while there has been much noise, little action has followed: many domestic regulators, including those in the US, Canada, Australia and parts of Europe, are eagerly awaiting direction from the BCBS before they act. This makes the FSA's move to develop its own liquidity risk standards especially bold. In December 2008, the City watchdog became the first major regulator globally to move decisively on liquidity risk when it published one of three consultation papers outlining new rules for strengthening liquidity standards. In these draft proposals, the FSA has put forward what are widely regarded as drastic and far-reaching new rules that broadly translate into two sets of qualitative and quantitative requirements.

Quality and quantity

Under the qualitative aspects of the regime, banks, building societies and investment firms must implement a number of systems and controls, including liquidity position monitoring, detailed and robust contingency funding plans and extensive stress testing. More radical, however, are the quantitative requirements which oblige institutions to build up and hold an enhanced liquid asset buffer. Even more controversial, however, the regulations demand that all UK-based operations, including branches and subsidiaries, are free-standing and funding self-sufficient.

There are also extensive reporting requirements under which the majority of firms will have to submit a range of detailed reports on a monthly, weekly, and in times of market stress, daily basis to the FSA. Critically, UK-based subsidiaries and branches will be expected to report on a local basis, unless exempted under the FSA's waiver regime. The FSA also stipulates that senior management and the board must be fully conversant with their firm's liquidity position.

Finalisation of the new rules is due this month, but the implications are already clear: the FSA is attempting to prompt a major cultural and infrastructural shift in the way in which banks understand and manage their liquidity risk.

The regulator hopes that its provisions will dramatically raise firms' tolerance to market shocks that may limit sources of funding. From an infrastructure perspective, institutions will be required to assemble a wholly integrated view of their liquidity risk exposure across the multitude of businesses within their group: from the Latin American credit card business to the London-based commodities prop desk, banks will be expected to gather detailed and accurate data on liquidity positions at high speed. This will require not only that existing data is vastly enriched but that the data may also be accessed, aggregated and deployed on a near real-time basis, and then used to feed a range of demanding stress-test scenarios. Finally, this information must be plugged into a risk-reporting framework that is understood and signed off by the board and used, in turn, to report to the FSA.

PJ Di Giammarino, CEO of JWG-IT

An information revolution

This post-crisis vision of liquidity risk management entails a near information revolution. In an April/May survey undertaken by JWG-IT, a City think tank specialising in the IT implications of financial regulation, 64% of bank respondents did not believe that their existing IT systems could be easily adapted to satisfy the new requirements. This is not surprising. After all, they demand group-level information aggregation, something of a rarity among complex and unwieldy global institutions.

Don DeLoach, CEO of Aleri, a provider of liquidity stress-testing software, says: "Banks have traditionally managed and monitored liquidity flows on a subsidiary basis, with myriad cashflows going in and out, with different structures, formats, timings, staff and systems, to support that." He adds: "A bank can rarely tell you its overall position or balance of payments in currency denominations, let alone a holistic view, or what it looked like 15 minutes ago."

It is this demand for near real-time information that is also an area of additional concern for IT directors, adds Nigel Walder, CEO of Business Control Solutions, a financial services consultancy. Under the new regime, banks must be able to report, where necessary, on a daily basis, although they are generally only equipped to report quarterly or monthly, he says. The depth, breadth, detail and speed of the data requirements are onerous as it is: combined with the added demands of designing and feeding extensive stress-testing models, the operational and IT implications of the FSA regime are more than a little intimidating.

Picking up the tab

The Banker approached several institutions regarding the FSA's new liquidity risk provisions. None were willing to comment publicly. Privately, however, the mood in the industry is mixed, says Andrew White, global head of risk management at Thomson Reuters.

Few bankers dispute the necessity to strengthen standards, but some are little short of outraged at the scale of the imposed burden. After all, complying with the FSA's regime is no trivial task: it is operationally expansive and complex, IT-intensive, and politically charged. But the most off-putting prospect in present times is the price tag. In the words of one disgruntled head of IT architecture at a major US bank that has started work on the requirements: "It is going to kill off a few firms when they see the IT bills: that's for sure."

According to estimates drawn up by the FSA, organisations at the smaller end of the scale, principally building societies, may get away with spending as little as €50,000 each. But further up the scale, where banking groups operate a vast number of subsidiaries, institutions may be left with an upfront bill ranging from €3.3m to €7.4m. Long-term, this looks like an unlikely bargain, however.

The figures do not include the ongoing running costs associated with frequent reporting requirements and stress testing, which may exceed €700m, according to JWG-IT calculations extrapolated from FSA data. Nor do they include the inevitable contingent costs that most regulation-driven IT projects clock up due to the initial uncertainty typically associated with regulation in its embryonic stages. The Banker has learnt of at least one conscientious US bank, for example, whose initial IT work on the new requirements had to be reversed due to revisions that the FSA made in its second consultation paper.

Aggregate figures for the initial industry outlay are at this stage wide ranging: IT consultancy Atos Consulting has put the cost of compliance at a conservative €300m to €700m. At the other end of the spectrum, the JWG-IT has put the final figure at a hefty €2.4bn, or thereabouts. Put another way, the FSA's new requirements may eventually cost up to three times that of the Markets in Financial Instruments Directive (MiFID), another IT-driven regulatory initiative that at the time of its unveiling was regarded as unprecedented in its resource intensity.

The FSA disputes the think tank's costings and argues that much of the required spend would have been necessary regardless of the FSA's specific requirements. "All viable futures will involve the industry spending a significant amount of money improving the quality of its own information management in respect of liquidity risk," says Paul Sharma, director of wholesale and prudential policy at the FSA.

But for international firms, the FSA's bill is not the only concern: it is the global implications that have rattled some IT chiefs. "If these liquidity risk measures go global, or if the Federal Reserve even asks for two-thirds of what the FSA has asked for, the bill will be astronomical," says the lead IT architect quoted previously.

Selwyn Blair-Ford, liquidity risk specialist at risk software provider FRSGlobal

Time is tight

If money is a problem, time is no less tight. Following some resistance from lobby groups, the FSA's initial deadlines have been pushed back, but they remain highly aggressive: the watchdog expects all UK-incorporated firms and branches of overseas banks to comply with the qualitative aspects of the regime by Q4 of this year, while the quantitative requirements will be phased in during Q1 and Q2 of 2010.

Technical experts and bankers agree that these deadlines are ambitious at best, unrealistic at worst. "The FSA's requirements have taken on board every decent paper written on liquidity prior to the crisis," says Selwyn Blair-Ford, a liquidity risk specialist at risk software provider FRSGlobal. "Nobody wrote anything in those papers which they thought could or would be implemented in anything less than seven years."

To meet the October deadlines, says Mr Blair-Ford, firms had to begin work in January when many were only just digesting the FSA's initial December 2008 consultation paper. Others, it seems, may not have been aware of its existence. Despite the drastic scale and cost of the FSA's new requirements, it is clear that industry awareness, let alone readiness, is still somewhat lacking. In its April/May research, the JWG-IT group found that in only 41% of cases had any individual at the firms questioned heard of, let alone encountered, the FSA's December consultation paper. "A lot of banks are doing nothing and there is a low appetite for change," says PJ Di Giammarino, CEO of JWG-IT.

As if implementing a multi-year project in little more than a year were not taxing enough, the majority of firms are required to do so following major budget cuts and extensive job losses. According to one investment banking IT manager, the rate of non-compliance looks to be very high. "Some banks have really basic infrastructure issues: they all know that the FSA timeline is unachievable," he says.

According to the FSA, however, the aggressive deadlines are vital if the industry is to bring its liquidity risk management up to speed in line with the next credit cycle. "It is critical just for management of liquidity risk, let alone for regulation, that high-quality information is available as soon as possible, and more or less at the same time as when credit growth begins to resume quite sharply," says Mr Sharma.

The London conundrum

If the FSA's requirements demand an IT infrastructure overhaul, this is the least of its excesses, say some. The fiercest criticism focuses on the long-term implication for banking business models, resulting from the requirement that UK-based subsidiaries and branches must, unless otherwise exempted, be funding self-sufficient and provide liquidity reports to the FSA on a local basis. "There are UK subsidiaries or branches that rely upon a promise from their parents for their liquidity: if, for whatever reason, we in the UK cannot assess the quality of the promise, clearly it will not be reasonable for us to rely on it fully," says Mr Sharma.

It is clear that the FSA's rules are structured to address the Lehman Brothers scenario, in which the investment bank's UK-based assets were swept overnight to New York, prior to the firm's failure. This proved a devastating blow to UK creditors of the bank, who are widely felt to have been unfairly disadvantaged during the bankruptcy proceedings. The FSA also hopes to inoculate the UK banking market against foreign viruses that may be borne by UK subsidiaries.

But the inoculation may prove worse than the sickness. Like Lehman Brothers, most international banks manage their liquidity cross-border. By attempting to ring-fence liquidity within the UK, the banking system will be rendered less - not more - resilient, claim critics. Industry association the IIF has been particularly forceful on this point: in its July report, the IIF said that other domestic regulators have unveiled similar designs to ring-fence local assets in what could lead to globally distributed pools of trapped liquidity. Such conditions "unduly increase each firm's group-wide third-party credit exposure, balance-sheet leverage and capital needs," reads the report. In conclusion, it said, the financial system would be less efficient.

Lacking lustre: some claim that FSA regulatory reform is making London a less attractive proposition for foreign banks

Exceptions to the rule

The FSA has outlined a waiver regime under which subsidiaries and branches may apply for exemption from self-funding and local reporting. Instead, the FSA will demand proof at group level that the London entity will be adequately funded by its parent. In this scenario, a Japanese bank with one small London subsidiary, for example, may be required to show the FSA its entire global liquidity position, translated into a language and format agreeable to the FSA. For market watchers, this seems practically and politically unworkable. Scott Eaton, an independent consultant and former global head of principal trading at ABN Amro, seriously doubts that the FSA would be able to act meaningfully upon the swathes of data it is demanding - a further source of resentment among many bankers.

It is not yet clear which firms will qualify for a waiver, and the waiver regime remains cloudy at best. If the FSA is not generous with its waivers, however, the attractiveness of London will be cast in doubt. The vast majority of UK subsidiaries, particularly the slew of foreign branches located in London to service a specific clientele, will have to reassess their UK business, says Mr White. "Do they really want to take on the costs of regulation when their presence here may not even be profit making? Immediately, banks need to assess what they are doing here."

The British Bankers Association (BBA) warns that smaller foreign banks are already voicing concerns that the new provisions will be too costly to bear. "Some small foreign banks have said that these quantitative liquidity requirements may well be the straw that breaks the camel's back," says Simon Hills, director of the prudential capital and risk team at the BBA. They may decide to exit the London market, he adds. If the FSA is too generous with its waivers, however, it may find itself over-burdened: of the 650 institutions active in London, some 500 are expected seek a waiver, which will be a great deal of work for the regulator and the City alike. For this reason, and the practical challenges of demanding global visibility on parent company liquidity positions, Bill Cuthbert, founding director of Liquidatum, a liquidity risk consultancy, believes that waivers may prove problematic for the FSA.

Mr Sharma stresses that the waiver regime will not involve a "binary" demarcation between institutions that are granted a waiver and those that are not. In some circumstances, the FSA may allow an institution some, if not total, reliance upon the rest of the group for its liquidity, he explains. As such, institutions will be evaluated on a case-by-case basis. But this ambiguity simply implies more work for all parties concerned, not less.

Buffeting the buffers

The FSA may be willing to negotiate on the waiver regime. But there is likely to be less room for manoeuvre regarding the liquidity buffers, which are of critical importance to senior policy-makers. Under the FSA's provisions, UK-based entities will have to hold a larger liquid asset buffer, ultimately comprising a greater proportion of 'marketable' assets such as G-7 government bonds that may be cashed in quickly during times of market stress.

But bankers believe that the composition is simply too restrictive. Focusing on G-7 government bonds alone is likely to have a detrimental impact on many banks' business models, says the BBA. In other words, it is going to be expensive. The FSA has not set a blanket ratio for the liquid asset buffer, which will be determined relative to a bank's overall funding model. Nonetheless, forcing banks to hold a greater proportion of cash and low-yield bonds may considerably reduce their overall return on assets, because the cost of financing the assets may outweigh their yield.

According to analysts at Credit Suisse, the liquidity buffer is a major issue. Rough calculations undertaken by the bank's equity research team using sample data taken from a range of European banks suggests that every additional 5% holding of cash and government bonds, representing about €1000bn of incremental liquid assets, translates into a decline in sector net interest income of €5bn to €10bn, or 2% to 5%, of pre-provision profits.

For foreign and international banks operating in emerging markets, it may also be more prudent to match liquidity exposures in those markets with government bonds dominated in the same currency, in order to reduce currency risk. These types of bonds currently sit outside the prescribed asset buffer. The concept of demonstrating the 'marketability' of assets is also a thorny one as this is dependent on a bank's ability to access facilities, such as repo windows, not presently available to smaller branches and subsidiaries. This problem could be overcome if smaller banks had access to the Bank of England's Operational Standing Lending and Deposit Facilities, a suggestion made by the BBA.

There is some sympathy on this matter among policy-makers, but the finer details of this issue have yet to be worked through. There is less sympathy, however, for the general view that a number of London's smaller foreign banks may be disadvantaged under the new regime. In the words of one policy-maker who believes that many critics have somewhat missed the point: "It is a truism that when you raise standards, those who are less able to meet them are disadvantaged."

The cost of unilateralism

Policy-makers acknowledge the hefty costs associated with the new provisions. And they do not take the subject of London's competitiveness lightly. According to a policy-maker close to the FSA who advised the regulator on the new regime, the question of London's future as a financial centre "weighs very high" in the minds of government officials.

For the FSA, however, the notion that strengthening liquidity standards should come only at the expense of London's attractiveness is nothing short of perverse: after all, it was the previous regime that advantaged Lehman Brothers' New York clients at the cost of those based in London. "Some increase in the local liquidity resilience of entities in London would seem to me to enhance rather than diminish the competitive position," says Mr Sharma. "Zero local protection is an extremely uncompetitive position to be in," he adds.

The international political landscape for the new regulation is not set, however, and there is a feeling among the industry that the FSA has acted with rash and risky unilateralism in taking the international lead. Lobby groups argue that the FSA's stance could prompt a fragmentation of international rules. The BBA has pushed for a top-down approach, led by the BCBS, with many banks expecting that higher-level discussions would soften the FSA's stance. At the very least, bowing to the BCBS may produce greater global standardisation and therefore reduce costs for global firms.

But these hopes have proved in vain. Mr Sharma denies that the FSA is an outlier relative to other regulators, and stresses that it supports global co-ordination. The Banker understands that the Bank of England is also pushing for equally rigorous standards internationally. But the feeling among senior policy-makers is that somebody had to make the first move, in the hope that other countries catch up. "It is quite clear that we need more local liquidity resilience, in respect of firms in the UK, than we have had previously. There is no point delaying the introduction of that extra resilience, especially when delaying with reference to an international timetable which itself is not clear," says Mr Sharma.

It remains to be seen how far the FSA will go with its proposals. There is, however, a palpable air of resolution among policy-makers, who feel that the industry's memory has proved all too short. But if the regulation goes too far, the consequences, intended or not, may prove far-reaching and dramatic.