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The UK's tough liquidity rules stand in the way of global management and are expensive and time-consuming to comply with, say bankers. The bad news is that other jurisdictions are likely to adopt them.

It has been a tough start to the year for those involved in the liquidity risk-management function. Not only are the financial markets being challenged by a number of potential stress events such as politically instability in the Middle East, the aftermath of the devastating tsunami in Japan and the serious threat of a sovereign default event in Europe, but the rest of the world is set to follow in the UK’s footsteps in adopting game-changing regulation that could put smaller banking institutions out of business and will cost millions of dollars of compliance investment for the rest.

Moreover, if the approach taken by the UK Financial Services Authority (FSA) is anything to go by, regulatory change will be fast-paced and will leave little time for industry feedback or strategic implementations to be carried out. The UK regulator is acknowledged as being the lead prototype for Basel III implementation, and it has set a precedent of a fairly aggressive stance to pushing through change. The naming of 'responsible individuals' among top executives for the FSA to hold accountable for any compliance failures is an example of one such regulatory ‘stick’ in action.

Given the fundamental tenets of the risk-management function, it is no surprise that most heads of risk are wary of speaking publicly about a regulatory regime under which they are subject to being named and held personally accountable for their firm’s risk-management failures. However, a couple of senior risk managers at two global banks were happy to discuss the challenges they are facing in a candid and open manner, under the shield of anonymity.

Too much, too fast

One risk manager at a non-UK-headquartered global bank indicates that the speed of implementation of the FSA’s liquidity regulation has been without precedent in his 20-year career in the financial markets. The hurried nature of the changes also comes across directly in the language of the regulation itself, which has caused its own challenges. He says: “It is not a legal-type document and more of the metrics used are light touch, if not absent, despite the regulation taking a prescriptive approach. There is therefore significant scope for interpretation.”

This scope for interpretation has left risk managers with very little against which to benchmark their new liquidity risk-management systems and practices. “Where we have tried to open a dialogue with the regulators on this we have repeatedly faced pushback that there is no scope for discussion,” he continues. “The attitude is that you must comply and the fact that operational costs are rising directly as a result is proving to be concerning. We have found no voice of support from the industry on this and it seems somewhat cowed in its response as a whole. This is perhaps reflective of the fact that of the 6000 banks that register with the FSA, very few of them are truly global.”

This lack of industry coordination on the subject of liquidity risk is not just limited to firms active in the UK market, however. When examining the rather lacklustre responses to various European-level consultations on the subject – such as the Committee of European Banking Supervisors’ Consultation Paper on Liquidity Buffers and Survival Periods (CP28), which was published towards the end of 2009 and received only 11 responses – it is possible to draw the same conclusions with regards to a lack of engagement at a regional or global level.

Lack of understanding

The public profile of liquidity risk as a function may have increased significantly as a result of these regulatory changes but this does not necessarily mean it is maturing and developing in the right manner, says a senior risk management executive from another global banking institution. “The danger of the FSA rules is that they do not promote a deepened understanding of liquidity risk. They may raise the profile of the subject but they do not lead to seasoned or mature judgements related to liquidity risk. In fact, the prescriptive nature of the regulations reduces the amount of skill that is required,” he says.

A case in point is the introduction of one of the most controversial of the FSA’s new requirements: liquidity buffers. There was initial uproar about the subject within the UK banking community when the FSA first published its consultation paper on liquidity risk, CP 08/22, in March 2009. At the heart of the issue was the introduction of new requirements for self-sufficiency at an individual legal entity and branch level via the establishment of these liquidity reserves or 'buffers'. This entailed a new level of independence between branches and head offices, which meant firms had to hold liquidity reserves for each of their branches so the branch could manage a liquidity event by itself, should one occur.

Liquidity buffers must be under the control of the management situated in the country in question and the FSA is currently asking for named individuals to be registered with the UK regulator in order to establish a legal chain of control. The non-UK-headquartered bank executive notes this has been driven by the Lehman experience: “[The FSA] wants to have the right to put those named individuals in jail.”

Duff buffers

At an event hosted by regulation analyst JWG in July 2009, Rick Weinstein, former head of global structured credit at Dresdner Kleinwort, summed up the attitude of his contemporaries at the time: “The idea of a liquidity buffer is a nonsense; the FSA instead needs to ask banks to hold higher capital reserves. Banks also need to have formal best-practice procedures for how to go into liquidation in an orderly fashion.” Buffers, attendees agreed, were not likely to work as a means by which to prevent another liquidity crisis, and this is a perception that has persisted within the industry.

“Everyone is talking about the fact there is no longer scope for a global operating model for the management of liquidity as a result of these regulations,” says the senior risk manager. “Everything is set up for management through separate legal entities and then stitched together through a senior bank holding company at the top level. We are wedded to having subsidiaries as our primary legal operation and we believe instead that globally managed liquidity is economically sensible because it reduces risk materially and is in the interests of our shareholders. That is in direct conflict with both Basel III and the FSA in this area.”

Sensitivity test

This tension between what is economically sound from a business perspective and what the regulatory community requires from banks under the new regime has meant liquidity risk has become an especially sensitive topic for the industry as a whole. Board-level executives are increasingly referring to liquidity risk as a compliance, or even an audit function, whereas a value-adding risk function would typically be involved in the business decision-making process. In this instance, the senior risk manager reckons the liquidity risk function is viewed as a means by which to project manage the implementation of a prescriptive set of rules, which he feels is a development that cannot improve understanding of the practice as a whole.

“Liquidity risk is a sensitive topic because many firms do not agree with the legislation that is coming into force,” he says. “Core assumptions such as the failure of the financial markets in a two-week period might have some validity for the swap market but would not be credible for the spot market. Even in relatively complex markets, such as the repo markets, there is no evidence that they would shut down completely. There is evidence that haircuts may have moved and there is a flight to quality in terms of the assets that are put through, but for the markets to shut down completely, which is core to the FSA modelling, is an incredible assumption.”

Here he is referring to the FSA’s Individual Liquidity Adequacy Standards, which introduced the requirement that firms should conduct more testing for defined scenarios and sources of risk, such as extreme stress-tests replicating the conditions experienced during the onset of the credit crunch. A key part of this assessment is stress-testing a two-week idiosyncratic (firm-specific) event and a market-wide event (longer term) against a range of risk 'drivers', including wholesale and retail funding, intra-group funding, cross-currency liquidity and marketability of assets. However, as noted by the senior risk manager, the core assumptions that have gone into these prescriptive stress-testing procedures are not considered to be realistic in some cases or applicable to all scenarios.

Aside from questions of their validity, these scenario tests also necessitate the production of a huge amount of supporting documentation in order to meet the liquidity risk-reporting regime requirements. All institutions have had to spend money on data and, specifically, data quality and technology platforms, to be able to meet these new requirements. The senior risk manager says: “That is driven by the fact that a lot of reporting historically has been based around finance data, where there are books of record to reference, but the challenge with liquidity is that in order to assess the risk, you need to look at the flow data rather than month-end positions.”

Short notice

Some have opted to partner with specific vendors to be able to meet the onslaught of regulatory reporting requirements. Sumitomo Mitsui Banking Corporation Europe (SMBCE), for example, chose FRSGlobal’s platform. “With such tight time frames for implementation, we quickly realised time was of the essence for this project,” says Keith Haylock, assistant general manager at SMBCE. “Years ago, when the FSA only required three prudential reports, it would have been possible to handle this internally. But we knew the number of reports would rise to more than 500 with the new liquidity requirements, and the potential opportunity cost to a firm that cannot demonstrate adequate liquidity management and controls is significant.”

In addition to the number of reports the bank has been required to produce, the format and scope of the reports has changed. Management must be more 'hands-on' with the data being produced in its reports and it has to be able to facilitate this, he continues.

Unsurprisingly, these technology changes do not come cheap, whether developed internally or produced externally with a third party. The risk manager from the non-UK-headquartered bank says: “The costs that have been quoted have ranged from anything up to $450m on just technology, down to about $30m over a period of three years. I have not heard of anyone that is spending much less than $10m per annum (taking into account this does not include small building societies and similar firms).”

For now, the regulatory changes facing the industry represent a great deal of stress for liquidity risk managers in the short term and these reporting requirements are perceived by many as falling far short of expectations. “It is very easy at the moment to present good practices poorly and vice versa because of the prescriptive nature of the rules that the FSA has introduced,” says the senior risk manager.

Overall, the outlook is far from rosy, especially given the economic background against which all of this is set. The senior risk manager adds: “The FSA is asking us to produce the liquidity risk textbook at a time of great market volatility. It wants some legal accountability, but the documentation bit is the problem because it is holding it to arbitrary and prescriptive standards and it wants it produced at short notice. While for credit issues there has been a well-established industry response to regulation, the industry has not had time to produce a liquidity risk thought paper. That is weakening the entire process.”

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