University of Manchester

Meeting the challenge of liquidity risk

management in UK retail banking

Stuart Coe

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DECLARATION
This work has not previously been accepted in substance for any degree and
is not being concurrently submitted in candidature for any degree.

Signed………………………………………. (Stuart Coe)

Date………………………………………….

STATEMENT 1
The project being submitted is in partial fulfilment of the requirements for the
degree of MBA.

Signed………………………………………. (Stuart Coe)

Date………………………………………….

STATEMENT 2
This project is the result of my own independent work/investigation, except
where otherwise stated. Where other sources of information have been used
these are all formally acknowledged.

Signed………………………………………. (Stuart Coe)

Date………………………………………….

STATEMENT 3
I hereby give my consent for my project, if accepted, to be available for
photocopying, inter-library loans and electronic access, and for the title and
summary to be made available to outside organisations.

Signed………………………………………. (Stuart Coe)

Date………………………………………….

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ABSTRACT

Of particular interest to small and medium-sized UK banks, the primary

objective of this project was to evaluate the FSA’s proposals for future
regulation of liquidity risk management and provide practical advice to firms
on how they should respond.

In October 2003, the FSA released the near-final text of its Integrated
Prudential Sourcebook which included a section on the systems and controls
that it expected regulated firms to have over liquidity risk.

The new regulations require firms to clearly document responsibilities,

policies, procedures and contingency arrangements in respect of liquidity risk
management as well as have a thorough understanding of cash inflows and
outflows under both normal and stressed conditions.

The FSA also announced in October 2003 that it intended to extend the
liquidity section of the Integrated Prudential Sourcebook by introducing a new
minimum standards regime for liquidity and issued a discussion paper
outlining its current position. The discussion paper proposed the replacement
of the current regulations that require firms to always hold a defined amount of
liquidity and report actual liquidity exposures to the FSA at regular intervals.

The FSA has recently indicated that rather than formally take the discussion
paper forward to a formal consultation paper, it intends to broaden the debate
on its proposals and working groups will be set up to undertake further
research. This project reviews the original minimum standards proposals and
suggests an alternative approach that may be more acceptable to UK banks
whilst still meeting the FSA’s objectives.

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ACKNOWLEDGEMENTS

This project could not have been completed without the continual support and
guidance of my project supervisor, Professor Phil Molyneux of the University
of Wales, Bangor.

I am also indebted to the following individuals who have given freely of their
time to assist with the development of this report:

John Ashenhurst, Director of Treasury and ALM, Co-operative Bank

Judith Aspin, Head of ALM, Co-operative Bank

The opinions given, however, are my own and I am solely responsible for any
errors or omissions.

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CONTENTS

Chapter Title Page

1. Introduction 6

2. Overview of liquidity risk in banking 9

3. The current regulatory regime 15

4. The effectiveness of internal approaches to liquidity 20

risk management

5. Proposed new regulatory framework 27

6. An assessment of the new framework 36

7. Liquidity risk – the way forward for UK retail banks 41

8. Overall summary and conclusion 56

9. Appendix 1 – Example Liquidity Risk Management 57

Structure

10. Appendix 2 – Liquidity Risk Policy Template 58

11. References 66

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1. INTRODUCTION

In October 2003, the Financial Services Authority (FSA), the independent

regulatory body with responsibility for the UK financial services industry,
published two documents that are likely to have far-reaching effects on the
way UK retail banks manage liquidity risk in the future.

The two documents were:

Integrated Prudential Sourcebook (IPSB): near-final text on prudential

risks, systems and controls.
Liquidity risk in the Integrated Prudential sourcebook: a quantitative
framework.

The former sets out the systems and controls that the regulator expects
certain categories of financial firms to have over their key risks including
liquidity. This document is expected to go before the FSA board for approval
during 2004 with the requirements coming into force no later than 31
December 2004.

Separately in October 2003, the FSA set out, in the second document quoted
above, its current thinking on the framework that would be necessary for
quantitative liquidity regulation and which it proposed would be finalised and
form part of the IPSB by the start of the second half of 2006.

The overall philosophy of the FSA is that the systems and controls elements
of the IPSB will ensure that liquidity risk is appropriately managed within firms
even under stressed conditions whilst the quantitative framework will provide
minimum standards for all firms that the FSA can easily monitor.

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This project will provide practical guidance and identify the key success
factors for effective and efficient liquidity risk management within UK banking
under the FSA’s new liquidity risk management proposals.

To provide context for the project, a brief review of the need for liquidity
regulation within banking will be given at the outset. This will explain how
liquidity risk arises and describe the dangers of contagion in the banking
industry. To aid understanding, actual examples of bank failures and near-
failures will be given.

To gain an insight into the current status of liquidity risk management in UK

retail banking, a review will be undertaken of both current liquidity risk
regulation and the supplementary models that individual firms use to internally
monitor and manage their liquidity exposures. An assessment will then be
made of the extent to which the regulatory framework or firms’ internal models
have been primarily responsible for liquidity risk stability in the UK in recent
times. A detailed review of the proposed new regulatory framework will then
be undertaken as a pre-cursor to determining the extent of changes
necessary across the industry to ensure compliance.

Penultimately, and recognising that individual banks all have different

characteristics, practical advice covering the following will be given:

What firms need to do to prepare for the formal implementation of the

systems and controls elements of the liquidity elements of the
Integrated Prudential Sourcebook;
What actions firms need to undertake to start preparing for a new
quantitative liquidity risk framework; and
What opportunities exist to suggest further improvements to the
proposed quantitative framework to the FSA during both the discussion
and consultation phases.

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Distilled from the above exercise will be a list of key success factors for the
development of a compliant, effective and efficient liquidity risk management
model.

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2. OVERVIEW OF LIQUIDITY RISK IN BANKING

Introduction

To provide context for the entire report, this section explains what liquidity risk
is, how is arises and why it is so significant in the banking industry.

Liquidity risk defined

Although academics and banking practitioners all have their own individual
definitions of liquidity risk, it is useful to limit the debate to the definitions given
by the regulatory authorities in the United Kingdom and the United States -
respectively the FSA and the Federal Reserve.

The FSA (2003, p.3) define liquidity risk as ‘the risk that a firm, although
solvent, either does not have sufficient financial resources available to it to
enable it to meet its obligations when they fall due, or can secure them only at
excessive cost.’

In its publication, Commercial Bank Examination Manual, the Federal Reserve

(2003, section 1000.1, p4.1) defines liquidity risk as ‘the potential that an
institution will be unable to meet its obligations as they come due because of
an inability to liquidate assets or obtain adequate funding (referred to as
"funding liquidity risk") or the potential that the institution cannot easily unwind
or offset specific exposures without significantly lowering market prices
because of inadequate market depth or market disruptions ("market liquidity
risk").’

Drawing on the work of Dermine and Bissada (2002. p.98 – 99), a simple view
of the regulatory definitions can be developed.

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In a retail bank, the primary expected daily cash flows are as follows:

Table 1 – Liquidity cash flows

Positive (+) or
Cash flow
Negative (-)

Interest received from mortgages, loans and overdrafts +

New customer deposits +

Non-interest loan repayments (capital) +

Interest paid on customer deposits -

Deposits withdrawn -

New loans granted -

Operating costs (salaries, premises etc.) -

Net cash flow +/-

If the net cash flow is expected to be positive, the excess can be invested in
assets, for example, overnight on the money markets, to generate additional
income.

If, more seriously, the net cash flow is expected to be negative, the bank will
have to sell a marketable asset, for example, a bond, to release cash or make
arrangements to borrow short-term funds to meet the liquidity gap.

Liquidity calculations do, however, tend to assume normal trading conditions.

If expectations of cash flows, for whatever reason, prove to be, by a
considerable margin, incorrect, banks can and do face liquidity crises.
Examples of such scenarios include the failure of large corporate borrowers to

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meet their loan repayments or large depositors or groups of depositors
withdrawing their funds over a short period of time (a bank run).

Accentuating this potential problem is the possibility that, during periods of

sustained negative cash flow, previously available borrowing facilities with
other institutions are either withdrawn or become more expensive and assets
cannot be sold for their true market value.

Contagion Risk

Unlike the stance adopted for non-financial companies, public policy makers
believe that the risk of the failure of a single bank will, due to the volume and
value of inter-firm transactions and borrowing, severely affect the ability of its
counterparties to survive. In the most extreme circumstances there may be a
domino effect that has the potential to destabilise worldwide markets. In the
words of the Bank for International Settlements (1994, p.177) this is ‘the risk
that the failure of a [market] participant to meet its contractual obligations may
in turn cause other participants to default with a chain reaction leading to
broader financial difficulties’. Put another way and using a rock climbing
analogy, Eddie (now Sir Edward) George (1998, p.6), the previous governor of
the Bank of England, in a speech in 1998 said contagion or systemic risk
arose ‘through the financial exposures which tie firms together like
mountaineers, so that if one falls off the rock face others are pulled off too.’

Examples of liquidity crises

Although the FSA (2003, p.8) recognise that there has been a ‘lack of serious
instances [of liquidity problems in the UK] in the past few years’ it does state
that ‘over recent decades there have been a number of examples of liquidity
strains, having a wide variety of causes, and affecting firms both singly and in
clusters’.

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In her paper, published in the Bank of England’s first ever issue of the
Financial Stability Review (1996, p.38 – 43), Patricia Jackson identified that
twenty nine UK authorised banks had been placed in administration or
liquidation since 1982. In addition, and over the same period, the Bank of
England purchased two banks, Johnson Matthey and National Mortgage Bank
as part of its system support operations.

Jackson comments that, in all but the following five well-known cases, the
banks experiencing severe difficulties were small.

Table 2 – Five largest bank failures

Bank name Reason for failure

Johnson Matthey Poor asset quality. Bad and doubtful debts of
approximately 50% of asset portfolio.
BCCI Senior management fraud.
British and Problems within sister company (Atlantic computers).
Commonwealth
Barings Rogue derivatives trader.
National Mortgage Bank Poor asset quality accompanied by a heavy outflow of
short term deposits.

Of the five cases listed above, only two necessitated the assistance of the
deposit protection scheme, a scheme funded by UK authorised banks to
ensure that customers’ deposits, with a small discount, are repaid up to a
defined monetary limit.

Jackson’s detailed review of twenty-two banks that had failed or experienced

prolonged difficulties revealed that whilst liquidity was a factor in nine cases
(41%) it was the sole factor in only one case (5%). More commonly, difficulties
experienced were linked to poor asset quality (over-concentration,
specialisation, poor risk selection) and mismanagement (poor strategy,
systems and controls). The general picture is, therefore, reflective of the

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problems experienced by the five largest firms to fail in the period 1982 –
1996.

Although not explicit in Jackson’s paper, it is not unreasonable to draw the

conclusion from her research that although liquidity is crucial to a firm’s
continuation it is rarely the key factor in failures. Rather, other factors are
usually responsible for generating the liquidity strains that frequently prove to
be the pre-cursor to failure.

This view is implicitly shared by Logan (2001, p29) who, looking at bank
failures across a similar time horizon to Jackson, concluded that ‘the most
important leading indicators of future failure …. were found to be a high
dependence on net interest income, low profitability, low leverage, low short
term assets relative to liabilities and low loan growth’.

To find examples of the crystallisation of liquidity risk with material

consequences for other firms it is necessary to look overseas. The most often
quoted example is that of the Continental Illinois Bank which is described by
Kaufman and Scott (2003) in their critique of systemic risk and the role of the
regulator. The researchers note that when Continental, the largest
correspondent bank in the United States with almost two thousand three
hundred bank counterparties, failed in 1984, no bank suffered any losses.
Whilst, undoubtedly, the US version of the deposit protection scheme had a
role to play in ensuring banks suffered no losses, Kaufman, George and Scott,
quoting research undertaken by the US House Banking Committee state that
even if Continental’s losses had been ten times greater, only twenty-seven of
the two thousand three hundred banks with which it had a relationship would
have become insolvent.

Conclusion

Whilst there have been liquidity strains over recent decades as the FSA state,
it is suggested that these have primarily been the result of other failures within
firms. Further, whilst theoretically highly significant, there is an absence of

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evidence to suggest that individual firm failures caused by a lack of liquidity
will result in systemic effects that will have a detrimental effect on the entire
banking industry.

Notwithstanding the above, it is recognised that liquidity risk managers have

two crucially important tasks; firstly, to maintain sufficient liquidity to ensure
business as usual liabilities are met as they fall due without holding expensive
surplus funds and secondly to provide access to an additional source of
liquidity as ‘insurance’ for unexpected events whether these emanate from
credit, reputational or other risks. What, however, the liquidity manager can
never do is hold sufficient liquidity to cover every eventuality irrespective of its
severity.

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3. THE CURRENT REGULATORY REGIME

Introduction

Having considered the significance of liquidity risk and drawing on the

research of Chaplin, Emblow and Michael (2000), this section sets out how
liquidity regulation in the UK has developed over the past 25 years.

The key points of interest are:

A common liquidity regulatory framework was in place for all UK banks

from 1982 to 1996. This encompassed general principles for liquidity
management coupled with the requirement to prepare and submit to
the regulator on a regular basis a liquidity maturity ladder.
In 1990, the requirement for firms to formally agree their liquidity policy
with the regulator was introduced.
In 1996, a new regime known as the sterling stock regime was
introduced for large retail banks. This required a certain amount of
sterling liquid assets to be held to cover the potential that wholesale
funding may, in times of difficulty, be withdrawn by lenders.
In 1999, a revised maturity ladder approach was introduced for those
banks not subject to the sterling stock regime. The approach was a
refined version of the maturity ladder approach and became known as
the ‘mismatch’ regime.

Until the introduction of the new regulations later in 2004, UK banks are
required to comply with the FSA’s requirements as detailed in the Interim
Prudential Sourcebook. These state that a bank is required to:

be in a position to satisfy the FSA on an on-going basis that it has a

prudent liquidity policy; and
have adequate management systems in place to ensure the policy is
adhered to.

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The Sourcebook also details that the above will be checked regularly during
formal and informal supervisory visits as well as through the review of liquidity
returns that all regulated firms have to submit to the FSA on a regular basis.

A summary of each element of the current regime is set out below.

Liquidity policy

Limited in nature, the current regulatory regime sets out that a bank should:

provide a copy of its Liquidity Risk policy to the FSA for formal review;
include, within the overall policy, details of how it monitors and controls
foreign exchange positions (if these are considered significant); and
explain in its policy how it would manage liquidity in abnormal
(stressed) situations.

Management systems

Similarly limited, the FSA sets out in under a page its requirements for liquidity
risk management systems. In summary these are:

firms should agree with the FSA, how they will assess adherence to
their policies; and
firms should be able to monitor their liquidity position, at a minimum,
on a daily basis.

Regulatory reporting

Whilst the FSA does undertake supervisory visits which include the review of
liquidity management, its primary tool for monitoring a firm’s liquidity risk is the
regulatory reporting regime.

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All UK authorised banks are required to submit regular – monthly or quarterly -
returns to the FSA that summarise their liquidity position at a given point in
time.

Depending on its size and characteristics, a bank may be asked by the FSA to
produce regulatory returns based on either the mismatch regime or the
sterling stock regime.

Mismatch regime
This approach, which is the default for all firms, measures the mismatch
between expected cash inflows and outflows within different time bands. The
regime has the following characteristics:

mismatches are measured cumulatively;

guidelines are set for each bank by the FSA for the maximum level of
mismatch that should be present in the time bands of ‘sight to eight
days’ and ‘sight to one month’;
expressed as a percentage of total deposits, typical limits set by the
FSA for mismatches are 0% for the ‘sight to eight days’ time band
and -5% for the ‘sight to one month’ time band; and
although the FSA prefer to see firms reporting cash inflows and
outflows based on contractual agreements with lenders and
borrowers, it does accept, particularly in respect of retail assets and
liabilities, that it may be more realistic to make adjustments for
expected customer behaviour. As such, a bank may apply to the
FSA to report inflows and outflows both on a contractual and
behavioural basis. In these circumstances the mismatch limits apply
to the behavioural cash flows.

An example of the mismatch approach is shown below in both tabular form

and graphically in Table 3 and Figure 1.

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Table 3 – Example of liquidity mismatches

Time band
0 to 8 0 to 1 0 to 3 0 to 6 0 to 1 0 to 5
days month months months year years
Inflows (£m) 10 19 25 35 60 100
Outflows (£m) 9 20 21 37 61 95
Cumulative
1 -1 4 -2 -1 5
mismatch (£m)
Deposit base 100 100 110 125 135 150
Mismatch % +1.0% -1.0% +3.6% -1.6% -0.7% +3.3%

Figure 1 – Graphical representation of liquidity mismatches

-1

-2
0 to 8 days 0 to 1 mth 0 to 3 mths 0 to 6 mths 0 to 1 yr 0 to 5 yrs

Net cash flows (£m)

Sterling stock regime

This regime, the alternative to mismatch, is considered more appropriate for
banks with large retail deposit bases as it formally recognises that, despite
accounts being contractually repayable on demand, most customer balances
are relatively stable. For these firms, the FSA believes the focus of regulation
needs to be on ensuring enough liquid funds are held to cover both a sudden
inability to renew wholesale funding and requests for the repayment of a small
amount (5%) of retail deposits.

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The sterling stock regime can be summarised as follows:

a requirement to hold a sufficiently large stock of sterling liquid assets

that could be easily sold if funding is suddenly withdrawn as a result of
a real or perceived bank problem;
the key components of sterling stock are cash, Bank of England
balances, UK Treasury bills and gilts;
a bank should be able to survive a liquidity crisis for five days, a period
considered long enough to arrange alternative sources of funding;
over the five-day period, the bank should be in a position to liquidate
sufficient assets to cover a loss of all of its maturing wholesale funding
plus five percent of retail deposits; and
a minimum ‘floor’ of sterling stock is set by the FSA for each bank.

Under both the mismatch and sterling stock regime, firms are required to
advise the FSA of any limit breaches as soon as they occur.

Conclusion

The above review of regulatory arrangements for liquidity risk over the past
twenty-five years shows a single regime applied to all banks becoming two
distinct approaches in 1996 – mismatch and sterling stock. For those banks
able to take advantage of the latter, this is a more simplistic regime with
compliance reliant only on being able to understand wholesale outflows and
the value of retail liabilities.

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4. THE EFFECTIVENESS OF INTERNAL APPROACHES TO
LIQUIDITY RISK MANAGEMENT

Introduction

This section of the report starts with a review of the extent to which firms
overlay the current regulatory requirements to monitor and report on liquidity
risk under either the mismatch or sterling stock regime with their own more
sophisticated liquidity management systems and processes. Understanding
the quality and quantity of firms’ additional internal processes then neatly
leads to conclusions on the relative contributions of regulation and strong
internal management in preventing large numbers of liquidity related bank
failures in the UK over recent decades.

Research

The data for this section has been drawn from the following sources:

informal discussions with members of the Asset and Liability

Management Association, a body formed eleven years ago with a
membership covering forty financial institutions including all of the
major UK banks;

a review of the risk management section of the annual report and

accounts of major UK financial institutions; and

the report by the European Central Bank (2002) titled Developments in

Banks’ Liquidity Profile and Management.

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The research sought to:

understand which regulatory regime (sterling stock or mismatch) is

more prevalent. This is important as the general view is that the regime
historically used for large retail banks – sterling stock – is less onerous
from a data and management perspective but is also less aligned to the
new systems and controls requirements and proposed minimum
standards regime;

understand how firms internally manage liquidity risk in practice;

discover the quality of firms’ liquidity data. To effectively manage

liquidity risk, firms need to understand expected cash flows on both a
contractual and behavioural basis. In terms of the latter, this can only
been done if there is a good understanding of historic trends;

identify the extent to which scenario analysis and stress testing of

liquidity requirements is undertaken. Also, to understand what systems
and software are required to perform this type of analysis;

identify what internal liquidity risk management reporting is undertaken;

and

seek opinions on how critical individual banks believe the robust

management of liquidity is to avoiding bank failures.

The key findings from the research were:

Regulatory regime

With the exception of one very small bank, highlighted during discussions with
members of the Asset and Liability Management Association, all banks
reviewed were being regulated under the sterling stock liquidity regime.

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Liquidity management

All banks reviewed either through analysing statutory accounts or discussions

with members of the Asset and Liability Management Association adopt other
tools or methods, over and above those imposed by the regulator, to manage
their liquidity risk, including:

trying to replicate a mismatch approach. This mismatch analysis is

usually performed on a currency-by-currency basis using
behaviouralised cash flows;

using limit structures to ensure that mismatches are maintained within

set boundaries;

calculating and monitoring the ratio of liquid assets to total assets. As

pointed out at a recent presentation by Standard and Poors to industry
Asset and Liability Managers this is a key measure for rating agencies
who look for a liquid to total assets ratio of 20%; and

monitoring large depositor concentrations. Many banks maintain data

and run management reports on customers who regularly make large
deposits to understand their vulnerability to a decision not to roll-over
these funds upon maturity.

Stress testing and scenario analysis

Again, through discussions with Asset and Liability Management Association

members, it is clear that most large banks are able to undertake liquidity
stress testing and scenario analysis. Somewhat surprisingly, however, there
appears to be no off-the-shelf software available to assist with these activities.
With no specific software available, even the sophisticated banks are
undertaking their testing using standard spreadsheet and database packages.
Testing was found, generally, to encompass both internal and external
‘shocks’, with the test of most interest to management being the impact of a
ratings downgrade. This was considered key as it would impact both the
ability to raise and the cost of wholesale funding, a growing component of
overall bank financing.

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Smaller banks were found to be doing little or no stress testing or scenario
analysis.

Although recognising that stress testing capabilities are still being developed
by many banks, the European Central Bank in their paper Developments in
Banks’ Liquidity Profile and Management outline stress tests that firms could
usefully undertake. These include:

a downgrading of x notches;

a withdrawal of x% of customer deposits;

the inability to refinance x% of money market and/or commercial paper

funding;

a one-day fall of x% in a major stock index;

an emerging markets crisis; and

credit losses.

Liquidity data

Naturally, only those banks that have developed stress testing and scenario
analysis capabilities are able to access significant amounts of historical and
behavioural data. Whilst undertaking the research for this project, a number of
banks confirmed that they held over 5 years of data that had been and
continues to be used to assist in plotting future liquidity requirements.

Management information

Most banks advised that they produce an early morning report on liquidity
based on the previous day’s closing position. This is then supplemented by
some form of real-time daily position keeping which ensures an appropriate
end of day position is achieved.

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The production of liquidity risk management information is variable and, again,
usually reflects the size and sophistication of the bank. Although it is clear that
some monthly data is being produced in smaller banks, this, in one instance,
is limited to a monthly graph showing the level of liquidity compared to
regulatory and internal limits. In comparison, larger banks are formally
reporting liquidity positions and details of large deposits on a daily basis as
well as producing monthly reports, covering mismatches and the results of
scenario analysis and stress testing.

Of particular interest was that, those banks that are more actively managing
liquidity risk had developed a series of assumptions to enable management
information to be produced quickly and efficiently. For example, most had
undertaken trend analysis of their key products and identified those balances
that have little or no volatility. In these cases, the products were excluded from
dynamic or daily liquidity risk management information and separately
reviewed, say on a monthly basis, to ensure the previously identified trend
was continuing.

The significance of liquidity risk

In every discussion, practitioners made it clear that they felt very strongly that
liquidity is a very significant risk that needs to be managed closely. Most
commented that not only would there be severe consequences if liquidity was
not closely managed during ‘normal’ conditions but they felt they had a
responsibility to soften the blow of problems emanating from non-liquidity risk
events.

Drivers of robust liquidity risk management

Having considered both liquidity regulation and internal liquidity management

it is clear that the former has:

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 highlighted the importance of liquidity risk;

set a minimum benchmark for firms; and

outlined some basic expectations in terms of policy and controls.

Perhaps more significantly, however, firms, particularly the larger and more
complex ones, have:

seen liquidity as a key business risk in the same way major corporates
in any industry see the need to manage their cash flow as effectively
and efficiently as possible;

extended the regulatory requirements internally to include numerous

additional measures of heightening risk;

introduced internal limits to supplement regulatory minimum

requirements;

started to capture large amounts of data to enable them to look at

trends in liquidity;

understood that current trading conditions could be affected by a shock

– either to the their organisation or the industry as a whole – and,
hence, have developed scenario analysis and stress testing
capabilities; and

developed management information to ensure senior management and

the board understand liquidity exposures.

Conclusion

Clear from the research is that whilst regulation provides a minimum standard
for firms to adhere to, most have found this inadequate and developed more
internally demanding models to manage liquidity risk.

The primary enablers and drivers of the development of internal approaches

have been greater computer power, more general interest in risk management

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and the increasing cost of liquidity as most banks have become asset led
following the explosion in consumer credit.

Of particular interest is that despite the FSA abandoning the mismatch

approach to regulation for certain banks almost ten years ago, most
organisations use a more advanced version of this as one of their primary
tools in understanding and managing liquidity requirements and risks.

Notwithstanding that banks generally go far beyond their regulatory

responsibilities in managing liquidity risk, the FSA, in the research undertaken
as part of the development of their Discussion Paper 24, note that internal
models are not well enough advanced to be allowed to be used as an
alternative to the [FSA’s] proposed [minimum standards] framework. This
suggests that the FSA believes that the approaches used by banks, despite
being significantly more sophisticated than the current regulations demand,
are not as well-developed as it would like to see.

Whilst it would be wrong to underplay the significance of regulation, it is

suggested that firms’ own concern over liquidity risk and the relatively
advanced internal approaches developed to manage this risk are the key
reasons why there has been such a low number of liquidity risk-related
failures and near-failures in the UK banking industry in recent times.

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5. PROPOSED NEW REGULATORY FRAMEWORK

Introduction

This chapter of the project marks the turning point from a historical to future
perspective with this first forward-looking section reviewing and summarising
the key elements of the FSA’s detailed proposals for the future management
of liquidity risk.

As outlined earlier, the FSA’s proposed approach to future regulation of

liquidity risk management has two elements.

Systems and controls

Quantitative framework

The first element is documented in the near-final text of the IPSB and explicitly
sets out what systems and controls banks should have over liquidity risk. The
near-final text is expected to be both formally approved by the FSA board and
adopted by banks by the end of the 2004.

The second element – a minimum standards framework – reflects the

regulator’s belief that, in addition to robust systems and controls, each firm
should maintain a certain level of liquid assets to ensure they can pay their
liabilities under both normal and stressed conditions. Although the FSA issued
a ninety-two page paper in October 2003, explaining their current thinking on
how such a framework would operate, they do not expect to be in a position to
implement this, the replacement to the sterling stock and mismatch reporting
regimes, until at least 2006.

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In due course, both elements will be combined to form the liquidity chapter of
the IPSB.

Near-final text – Liquidity Risk Systems and Controls

The expectations of the FSA, as set in the liquidity risk section of the IPSB,
can be summarised as follows.

Governance
A firm’s governing body (usually the board) should assume responsibility for
liquidity risk management including ensuring that it approves the liquidity risk
policy and that this is consistent with the organisation’s overall risk tolerance.
If not included within the policy document, the governing body should
separately ensure that a framework is in place to identify, measure and control
liquidity risk at all times. It is also expected that the governing body will
receive appropriate liquidity management information on a regular basis to
enable it to perform its monitoring duties.

Senior managers should be appointed by the governing body with the

authority and responsibility to tactically manage liquidity risk. This group
should oversee the development, establishment and maintenance of
procedures that translate the governing body’s views into operating standards.

Firms are expected to document all aspects of their liquidity management

regime, including the governance structure, policy and procedures, stress
testing and scenario analyses, management information processes, internal
controls and the liquidity contingency plan.

Policy
Firms should have a liquidity risk policy which should include sections
covering the following:
the basis for managing liquidity (divisionally / centrally);

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 the degree of concentrations, potentially affecting liquidity risk, that are
acceptable;
the policy for managing liability-side liquidity risk;
the role of marketable, or otherwise, realisable assets;
the management of currency liquidity risk;
the management of market access; and
the management of intra-day liquidity.

Understanding liquidity flows

Under the new regulations, firms will need to have a greater awareness of
how cash inflows and outflows arise. This includes understanding the
expected behaviour, rather than the contractual profile, of wholesale and retail
banking assets and liabilities. The new regulatory framework also requires
firms to be cognisant of the opportunities that exist to influence and manage
liability maturity profiles, the potential impact of commitments such as
undrawn credit card facilities and guarantees and the risks associated with
currency exposures.

A further requirement is a clear methodology for calculating liquidity risk

exposures. Although the chosen methodology may range from a simple
calculation to a sophisticated model it should always be capable of measuring,
at a point in time, the liquidity risk a firm is exposed to as well as dealing with
anticipated changes such as new business volumes.

Intraday exposures
Where a firm is a member of a settlement system, robust systems need to be
in place to enable it to monitor its exposure at any given time. In addition,
given the significance of the volumes and values of payments and receipts
processed, firms are expected to ensure that liquidity risk stress testing and
scenario analysis incorporates (including extreme) intra-day positions.

For those firms that also provide clearing services to other institutions,
additional processes are likely to be required to keep track of clients expected
payments systems cash flows.

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Stress testing and scenario analyses
As previously indicated, regulation will, in the future, place more emphasis on
scenario analysis and stress testing and firms will be required to carry out
appropriate tests based on a range of adverse but realistic circumstances and
events (external and internal). The results of testing will determine what
contingency plans a firm needs to have in place. As a minimum, it is expected
that such plans will include:

the events or circumstances that will activate the plan;

assets that would be sold to meet liquidity needs;
the expected use of the firm’s assets as collateral to raise funds;
the expected use of securitisation;
ways of modifying the structure of liabilities;
the use of committed facilities;
the expected behaviour of credit sensitive liabilities; and
administrative policies and procedures for implementation of the plan.

Management information
Formal monitoring of liquidity risk, encompassing the provision of clear,
concise, timely and accurate reports to relevant functions will be necessary
under the new regulations. Specific reports are expected to be produced to
alert management to liquidity exposures that are close to or have breached
internal or external limits.

Internal Control
A detailed internal control framework for liquidity risk will need to be in place
incorporating clear limits for exposures. These limits should cover:

a. sterling exposures;
b. significant currency exposures;
c. the aggregate amount of sterling and currency exposures; and
d. liability concentrations in relation to:
i. individual, or related groups of, liability providers;

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 ii. instrument types;
iii. maturities; and
iv. retail and wholesale liabilities.

It is also expected that an annual independent review of liquidity risk

management will be undertaken by internal audit.

Market presence
Finally, firms will be required to develop and maintain relationships with major
retail and wholesale liability providers and, where feasible, test the access
they have to key markets.

In summary, the above shows a marked change in the level of interest by the
FSA in how liquidity risk is managed by banks. From the current regime,
which is embodied in a few short paragraphs, the FSA has clearly decided
that a step change in regulation is required.

Quantitative framework

The proposed quantitative framework sets out the FSA’s current thinking on a
minimum standards regime to replace the sterling stock and mismatch
sections of the Interim Prudential Sourcebook.

The preamble to the FSA’s discussion paper on their proposals sets out why
they believe it is necessary to introduce a new minimum standards regime. It
notes that there is the need to extend the coverage of regulation to a broader
group of financial institutions as well as address some of the known gaps
within the detail of current regimes. It is also responding to comments made
by the International Monetary Fund which has expressed concern over the
use of the sterling stock regime.

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The following summarises the salient features of the proposed new
framework.

The overall objective of the minimum standards framework is clear in that it is

seeking to ensure that firms can survive the outflow of liquid funds under
stressed conditions.

Under the proposed regime, firms would be required to measure their

contractual inflows and outflows and apply agreed stress factors or discounts
to determine the level of liquid funds that need to be held. Cash flows
associated with both unfulfilled commitments given and received would also
be captured under the proposal although in terms of the latter, it is assumed
that a firm would include inflows only if it judges it would genuinely be able to
access the funds in times of stress.

The stress factors within the proposal have been designed to translate
contractual cash flows into a more behavioural view based of how customers
and counterparties would behave if a firm was really experiencing liquidity
problems. As an example, the stress factor for wholesale balances is high as
under difficult conditions it must be expected that the counterparty will not
seek to roll-over their deposit for a further time period.

An additional level of discounting is suggested for currency exposures that

are offset by balances in other currencies.

Two sets of stress factors have been proposed – one set to be applied to
contractual outflows and inflows for a one week period and one set for a one
month period.

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Outlined in the proposal is the option for sophisticated firms to seek authority
to use ‘advanced adjustments’ to derive their expected cash flows instead of
utilising the standard model as described above. The proposal suggests that
pre-requisites for applying to use advanced adjustments should be:

the existence of highly effective systems for identifying, measuring,

monitoring and controlling liquidity risk;

the existence of an advanced risk measurement process for those

specific areas where an adjustment is requested. This process should
be being utilised on a daily basis; and

the acceptance of certain conditions attaching to adjustments, for

example, limits on the reduction that can be made by an adjustment.

The FSA has made it clear that they would expect few firms to apply to use
advanced adjustments.

Irrespective of whether individual banks are permitted to use advanced

adjustments, all firms subject to the regime would be required to ensure that
at the close of every business day, the difference between stressed inflows
and stressed outflows over both the one week and one month time period is
positive.

One concession within the proposed framework is, however, the option for
firms to simplify their liquidity risk management systems and calculations by
excluding cash flows that make less than 1% difference to its gap ratios.

Complementing the daily liquidity risk management requirements within the

proposal is the expectation that firms will undertake their own annual
Individual Liquidity Adequacy Review (ILAR). The primary objective of this
would be to formally confirm that the standard stress factors and any

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advanced adjustments continue to be appropriate. The proposal suggests a
number of scenarios in which standard stress factors may be inadequate:

liquidity risk systems and controls weaknesses;

concentrations of business that make the firm vulnerable;

support being given to other group companies; or

events such as a ratings downgrade.

As an incentive to perform the ILAR rigorously, the documentation produced

would be subject to formal review by the FSA.

For members of the Clearing House Automated Payment System (CHAPS) it

is proposed that there will be a core marketable assets requirement. This
simply means that a certain value of marketable assets would need to be held
by individual members at all times. Although the detail of this additional
requirement has yet to be determined, this is a potentially significant change
for CHAPS member firms as the current sterling stock regime allows them to
count the same liquidity towards both the regulatory minimum and the amount
needed as collateral to support their payments and settlements systems
involvement. Whilst the changes proposed are understandable, what is
unclear is whether they will be consistent with the FSA’s intention not to
increase the level of overall liquidity in the market.

On two relatively technical but important matters, firms would be able to

choose to treat repos and reverse repos as individual transactions or combine
them with underlying securities and short positions to form a portfolio of
transactions and contractual cash flows for derivatives, calculated on a mark-
to-market basis, would be captured in liquidity calculations.

Finally, a firm would be allowed to choose to have its liquidity adequacy

assessed on a group basis if, internally, this is how it manages the risk.

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Conclusion

Like other areas of risk where the FSA is introducing new regulations, the
proposed liquidity risk regime is significantly more comprehensive that
previously seen.

In terms of the systems and controls elements of the new regulations, the few
paragraphs of requirements embodied in the previous regulatory regime have
been replaced by fourteen pages of detailed and prescriptive rules – on the
face of it, a major change for regulated bodies.

Likewise, the proposed minimum standards or quantitative framework as set

out in the FSA’s ninety two page discussion paper is a far more
comprehensive regime than previously seen although does bring together two
disparate methods of determining minimum levels liquidity – the sterling stock
and mismatch regimes.

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6. AN ASSESSMENT OF THE NEW FRAMEWORK

Introduction

This section of the report makes an assessment of the proposed framework

and seeks to respond to the following questions:

How different from current best practice are the new proposals?; and
How effective will the new proposals be in reducing individual banks'
and systemic liquidity risk?

How fundamental are the proposed new changes?

The previous section of this report concluded that, compared to the previous
regulatory regimes for liquidity risk, the changes now being both enacted and
proposed are significant. What is, perhaps, more important from a
practitioner’s point of view is how different the proposals are from the systems
and processes financial services firms currently use to internally manage
liquidity risk.

Following the structure adopted throughout this report it is useful to consider

the proposed new regime in two parts:

Systems and controls

Minimum standards

In respect of systems and controls, Section 4 (The effectiveness of internal

approaches to liquidity risk management) outlined that, generally, firms’
internal processes and controls are more comprehensive than the current
regulatory regime. As such, most should, as one bank liquidity manager put it
recently, ‘easily be able to tick the boxes’ of the new systems and controls
regulations in respect of the following:

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 robust structures in place for the management of liquidity risk with clear
and documented responsibilities;
documented policies and procedures for managing liquidity risk;
good senior management understanding of the potential inflows and
outflows of cash;
a clear methodology utilised for calculating exposures;
the use of liquidity risk limits;
the production and use of accurate and timely management
information;
strong relationships with liability providers; and
an effective control framework over liquidity risk management.

Evidence from members of the Asset and Liability Management Association

points to less certainty over the ability to, at least easily, meet the
requirements for regular scenario and stress testing and contingency
planning. In terms of the former, although analysis and testing is performed to
varying degrees by the larger banks, it was generally acknowledged that this
was an area that required development, a task made more difficult by the
absence of any providers of liquidity risk software. The need for contingency
arrangements naturally flows from the results of scenario and stress testing
so, unsurprisingly, firms also felt there was some way to go before they could
be comfortable that they understood the actions they would need to take
during a significant stress.

In respect of minimum standards, the position is quite different. The proposals

contained in the FSA’s quantitative framework discussion paper, if introduced,
would mean fundamental changes for all. In essence, irrespective of the
regime a firm is currently required to comply with – sterling stock or mismatch
– the new proposals are significantly more comprehensive.

In balanced responses to the discussion paper, industry bodies, ranging from

the Asset and Liability Management Association to the British Bankers’
Association, have recognised the FSA’s preference for a single minimum

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standards regime and clearly acknowledged that the current regulations do
not capture all liquidity risks or apply to enough financial services firms. They
have, however, raised concerns over the apparent ‘one size fits all’ approach
for an industry whose members range from multi-national banks to small
investment houses and questioned the complexity of the framework given the
number of proposed asset and liability classes that will need to be separately
monitored and reported.
.
Further, an argument has been made that firms’ own risk management
systems may be effective in meeting the desired outcomes if more flexibility
was allowed including allowing the greater use of advanced adjustments to
reflect individual circumstances.

Although all acknowledge that stress testing is a necessary part of liquidity

risk management, concerns over the prescriptive nature of the proposal on
this subject given the range of firms that will be required to comply have also
been registered.

Finally, it has been pointed out that liquidity regulation in other countries is
much simpler and the introduction of the proposals may put UK firms at a
competitive disadvantage.

Despite their reservations, members of industry bodies do recognise the need

for a new minimum standards framework and continue to be pro-active in
holding substantive discussions with the FSA to develop a mutually
acceptable revised framework.

How effective will the new proposals be in reducing individual banks'

and systemic liquidity risk?

As has already been discussed at length, the proposals for introducing more
robust regulation for systems and controls and a revised minimum standards
regime will impact different firms in different ways.

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The systems and controls elements reflect current best practice in the industry
and, with the exception of scenario analysis and stress testing and associated
contingency planning, the more sophisticated firms are already, internally,
operating to these standards. There is undoubtedly more work to do in less
sophisticated firms to meet the new systems and controls requirements but
any hurdles that there are should not be insurmountable.

The proposed quantitative framework or minimum standards regime is

markedly different from its predecessors in terms of complexity and it is widely
acknowledged that the impact of its introduction across the industry has not
been fully quantified. In particular, the costs of new systems and processes to
gather data may be significant and the benefits, given that there will be no
overall reduction in funds held within the industry to cover liquidity risk, are
relatively opaque.

On the basis of the above, it is recognised that the systems and controls
element of the new regime will enhance industry liquidity risk management
considerably by ensuring current best practices are adopted by all firms.
Whether the proposed minimum standards framework will have a similar
effect is more debateable. It is not an unreasonable conclusion to draw that if
the systems and controls are effective, minimum standards reporting should
be a simple ‘backstop’, performed at a very high level and required only to
allow regulators to assess systemic risks.

Conclusion

The basis for the two sets of changes is acknowledged by the industry and in
terms of systems and controls the new regulations closely match the direction
of current best practice projects. Their formal implementation will set a new
benchmark for all firms whilst encouraging the more sophisticated ones to

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further develop stress testing and scenario analysis techniques which in turn
will enable them to plan more effectively for a liquidity crisis. It can be
concluded, therefore, that, overall, the systems and controls section of the
new regulations will enhance the management of liquidity risk across the
industry.

The same, however, cannot be so categorically stated for the proposed

quantitative or minimum standards framework. Although firms recognise the
weaknesses in the current sterling stock and mismatch regimes, there
remains insufficient evidence to persuade firms that the FSA’s current
proposals will result in more effective liquidity risk management.

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7. LIQUIDITY RISK – THE WAY FORWARD FOR UK RETAIL BANKS

Introduction

Having given an overview of liquidity risk, reviewed a number of firms’ own

liquidity risk management techniques and considered past and proposed
liquidity risk regulation, it is now appropriate to set out some practical advice
that all firms, but particularly smaller ones, can follow to ensure they both
comply with future regulation and follow current best practice.

Implementation of the Liquidity Risk section of the Integrated Prudential

Sourcebook

The following sets out in a practical manner the actions that firms should take
as soon as possible to ensure compliance with the Liquidity section of the
Integrated Prudential Sourcebook.

Overall management of liquidity

The first step in organising liquidity risk management is to formally allocate
and document responsibilities for the following:

approval and implementation of the Liquidity Risk policy;

maintaining the policy;
maintaining liquidity procedures;
preparing liquidity management information, including daily reporting;
managing daily liquidity;
understanding payment systems cash inflows and outflows;
maintaining a control environment for liquidity risk;
profiling (behaviouralising) the retail balance sheet and treasury books;
undertaking scenario analysis and stress testing;
maintaining contingency plans; and
managing market access.

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An example of how a medium sized bank with a traditional treasury function
with Front, Middle and Back Offices could organise these activities can be
found at Appendix 1.

Asset and Liability Committee (ALCO) terms of reference

Overall responsibility for managing liquidity risk typically lies with the
organisation’s ALCO, this usually being a committee of the main board.

The ALCO’s terms of reference should explicitly state that it is responsible for:
the approval and annual review of the organisation’s liquidity risk
policy;
ensuring that appropriate structures are in place to manage liquidity
risk;
reviewing liquidity risk management information on a regular basis; and
organising an annual internal audit review to provide assurance that
management have controls in place to identify, measure and control
liquidity risks.

Policy document
The FSA see the policy document as the cornerstone of liquidity risk
management.

A policy template covering the main elements of the new regulations can be
found at Appendix 2.

Understanding liquidity inflows and outflows

The key to operational liquidity management is understanding cash inflows
and outflows.

If firms are not doing so already, a spreadsheet or other simple software

should be used to:
calculate the most conservative or contractual timing of cash inflows or
outflows for each asset and liability line;

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 overlay the contractual position with possible cash flows from off-
balance sheet items such as:
o calls on undrawn commitments;
o calls on guarantees given;
o margin payments and receipts on derivatives.
behaviouralise the contractual cash flows or, put simply, translate the
contractual cash flows into those expected to materialise. The size of
this task should not be underestimated. To form robust assumptions
over the behaviour of cash flows requires significant amounts of historic
data which is rarely available unless a conscious effort has been made
to capture this over a long period of time.
The benefit of having historic data and being able to make behavioural
assumptions is that large elements of, particularly, the retail balance
sheet can usually be excluded from detailed liquidity analysis as daily
movements can be shown to be immaterial. Having captured data on
retail balances for many years and knowing that daily movements are
small, a number of large banks are known to exclude certain product
lines from their daily analysis and simply rely on a monthly check to
ensure volatility has not increased.

Data collection and manipulation are at the heart of liquidity risk management
and a core capability that the FSA expect all firms to possess.

Payments systems inflows and outflows

Whether firms are members of settlement systems, for example, BACS and
CHAPS, or these are activities performed on their behalf by larger banks, daily
liquidity management will be dominated by payment systems inflows and
outflows. It is, therefore, particularly important to ensure that these are
understood.

Whilst this is a challenge for firms who have their own client base to consider
it is particularly problematic for banks who act as agents for other large third
parties, for example, smaller banks who are not members of systems in their
own right, large corporates and government agencies.

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If not already in place, firms should start developing data capture systems and
modelling capabilities for payment systems flows. This will enable the historic
and expected future profiles of customer, counterparty and third party receipts
and payments to be derived. This information can then be used for daily
liquidity management as well as fed into scenario and stress testing models.

Maintaining a control environment for liquidity risk

The key elements of an effective approach to control are a thorough grasp of
the sources of cash inflows and outflows, identifying the events that could
result in the crystallisation of liquidity risk and designing controls to manage
the risk.

The following can be used as a starting point for establishing where liquidity
risk arises.

Cash inflows arise from:

interest / commission receivable;
loan repayments;
maturing assets;
saleable non-maturing assets;
new deposit liabilities;
margin receipts against derivative contracts;
credit facilities that can be tapped; and
securitisation.

Cash outflows arise from:

interest payable
banking liabilities falling due;
new loans granted;
operating costs;
margin payments on derivative contracts; and
committed lines being drawn down.

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Risk crystallisation could result from one or more of the following:
inadequate models for calculating exposures;
ineffective risk monitoring (systems, people, processes and
management information);
asset maturities do not match expected outflows;
assets are not marketable;
assets are worth less than anticipated;
commitments to lend to the firm are not honoured;
the repayment of liabilities is demanded earlier than expected; and
customer commitments (e.g. guarantees, stand-by facilities) are drawn
down unexpectedly.

With the potential causes of liquidity risk documented, it is relatively

straightforward to determine the controls that should be in place to ensure
liquidity risk is appropriately managed.

Internal controls should include the following:

clearly defined management accountability for liquidity risk;
a documented formal policy;
documented detailed procedures that are reviewed and updated at
least annually;
carefully designed and tested liquidity management models;
daily liquidity risk reporting;
a limit monitoring mechanism;
formal monthly reporting to ALCO (maturities, performance compared
to limits, list of large providers, asset quality reports etc.);
formal review of strategic plans, budgets and forecasts to understand
changing liquidity needs;
documented scenario analysis and stress testing; and
documented and, where possible, tested contingency plan.

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Finally, in terms of ensuring that the controls are operating as intended it is
important that liquidity management is subject to internal audit review at least
annually.

Producing management information

A pre-requisite to managing liquidity risk effectively is the production of
accurate and timely management information, a view clearly taken by the
FSA.

Although there should be daily management information produced as part of

an effective internal control framework, it also necessary for senior
management and ALCO to receive summary liquidity information.
Recommended management information for this group can usefully be split
between standard reports and supplementary reports. Standard reports
should include the following:

cash flow or funding gap report (outflows and inflows);

funding maturity schedule (liability term structure);

list of large providers of funding; and

limit monitoring and exception reports.

These should be produced on a monthly basis and form part of the

management information pack produced for ALCO.

Supplementary reports should cover asset quality and trends, changes to the
funding strategy, earnings projections, market conditions and the firm’s
reputation in the market.

It would be useful to produce the earnings projection and funding strategy

papers each time the financial position is re-forecast. The other
supplementary reports should be produced at least annually.

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Scenario analysis and stress testing
As described earlier, scenario analysis and stress testing are and will continue
to be challenging aspects of liquidity management.

Scenario analysis allows a firm to gain an understanding for the potential

peaks and troughs in liquidity risk under relatively normal conditions. Stress
testing seeks to identify the risk that needs to be managed under very severe
(abnormal) conditions.

From a practical perspective, it is important not to accept defeat in terms of

the firm’s ability to undertake scenario analysis and stress testing due to either
the absence of sufficient data or the inability to acquire specific liquidity risk
management software. Even large banks that have been gathering data for
many years and have significant IT and other resources at their disposal
acknowledge this is an area where there is still a substantial amount of
development work required.

For those banks that are just starting to consider this aspect of the
regulations, the starting point is as described in ‘Understanding liquidity
inflows and outflows’ above. Armed with this core data, the incremental
process of developing scenario analysis and stress testing capabilities can
begin.

Using either a spreadsheet or other simple software (ideally the same system
as used to capture liquidity flows) simple scenarios can be constructed, for
example:

What would the liquidity position be if commercial loans increased by

w% next month?;

What would be the liquidity position if x% of wholesale funding was not

rolled over for the next y days?; and

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 What would be the liquidity position if z% of retail deposits were
withdrawn?

From a simple base, and with practice, it should be relatively simple to

construct any number of firm specific (and realistic) scenarios.

The same model can also be used to develop stress tests. A frequently
modelled stress test is; what would the liquidity position be if the
organisation’s credit rating was reduced substantially and counterparties
refused to deposit funds with the bank?

It is recommended that firms construct both internal (firm specific) and

external (environmental) scenarios and stress tests. External scenarios are
notoriously difficult to model as numerous assumptions have to be made but
relevant scenarios / stresses, such as prolonged recession or the collapse of
the housing market, can usually be identified.

All scenario analysis and stress testing data inputs and results should be
retained for review by the FSA during supervisory visits.

For completeness, and as for any other system, spreadsheets or models used
should be thoroughly tested before use.

Contingency planning
The results of scenario analysis and, in particular, stress testing set the scene
for contingency planning.

The objective of contingency planning is to put in place arrangements that will

ensure sufficient liquid assets are available to meet the firm’s liabilities in all
realistic situations.

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A documented plan is required which should cover:

what constitutes a liquidity shortage requiring invocation of the

contingency plan;

who has prime responsibility for invoking the plan;

how assets will be used - sold, used as collateral, or securitised;

how liabilities will either be restructured or increased;

how committed facilities will be utilised;

how, logistically, the actions resulting from invocation will be managed,

for example, the location of the contingency team, human and physical
resources required and the handling of press enquiries.

Managing market access

Confidence in a firm’s ability to implement its contingency plan can be greatly
increased by managing effectively its access to markets. In essence,
managing market access means having a formal process of maintaining and
testing market relationships and usually takes the form of several of the
following:

maintaining a database of key liability providers;

meeting key providers formally and informally on a regular basis;

maintaining a market presence (borrowing from counterparties) even

when there is no liquidity requirement;

having in place committed facilities with other financial institutions;

delivering investor presentations which provide opportunities to

elaborate on recent financial results and strategic initiatives; and

maintaining good relations with the media through a Corporate

Relations Office.

Although potentially daunting for a small bank, the first four items are business
as usual activities. In terms of item five, any bank that has raised debt is likely
to have access to a merchant bank that has investor relations expertise.

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In the current climate of regular accusations of profiteering by banks,
maintaining good relations with the media is often difficult. This should not,
however, dissuade firms from attempting to build relationships with the key
financial journalists and, where the bank is prominent in particular parts of the
country, local newspapers.

Preparations for the implementation of the proposed quantitative

framework

The proposed minimum standards regime or quantitative framework set out in

the FSA’s Discussion Paper 24 could be argued to be a natural extension of
the new systems and controls requirements. Certainly, a significant amount of
the data required to complete the proposed new regulatory report detailed in
the discussion paper should naturally flow from a greater understanding by
firms of their liquidity positions. Against this background, however, and as
detailed above, firms and industry bodies have raised a number of concerns
over the new minimum standards proposals. Seemingly in response to these
concerns and internal exigencies, the FSA has very recently indicated that:

due to other demands, including the implementation of both the

Integrated Prudential Sourcebook and the new Basel accord, it will no
longer be treating the introduction of a new minimum standards regime
for liquidity risk as an immediate priority;

a consultation paper – the next stage on from a discussion paper – is

some way away;

there are other methods of setting minimum standards, other than

those detailed in DP24, that are worthy of consideration;

they would not want to see the UK’s competitiveness adversely

affected by the proposals and will be considering the positions taken by
regulators in other countries; and

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 international working groups will be set up with an expectation that they
will report in eighteen months time.

In view of the relative uncertainty over how and when a new minimum
standards regime will be introduced, firms should now focus on the systems
and controls element of the Integrated Prudential Sourcebook and in particular
data capture and scenario analysis and stress testing.

International approaches to liquidity risk

The desire of the FSA to review international approaches to liquidity risk

provides a brief opportunity to consider how other countries manage liquidity
risk as a possible pointer to the future route that will be taken. A timely
‘Strengthening Financial Infrastructure’ article in the December 2003 Bank of
England Financial Stability Review highlights the following:

most countries where there is liquidity regulation adopt a dual approach

of requiring both qualitative and quantitative standards to be met as is
the current situation in the UK. Only Germany (quantitative only) and
Spain (qualitative only) adopt a single approach;

in terms of minimum standards, there is a range of approaches

including stock requirement, mismatch and a mixture of the two;

the minimum standards regime proposed by DP24 has similarities to

the approaches adopted in Australia and Singapore; and

there is a wide variety of approaches in use across Europe.

The above suggests that there is no obvious choice for the FSA to bring the
UK in line with approaches adopted across the world or even across Europe.

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Possible improvements to the new revised regulatory regime

Whilst the systems and controls section of the Integrated Prudential

Sourcebook is virtually set in stone, the FSA continue to seek assistance in
developing the new minimum standards regime.

It is recommended that firms take this opportunity to work closely with the FSA
to influence the shape of the future minimum standards regime either
individually or collectively through the British Bankers’ Association.

It is suggested that the following line of argument would be useful to the

debate.

If all firms comply with the systems and controls elements of the Integrated
Prudential Sourcebook, the control of liquidity across the industry will be
substantially more robust than currently seen. This suggests that:

for firms already subject to liquidity regulation there should be an

opportunity to reduce the level of liquidity held;

the potential cost savings for firms having a lower liquidity requirement
will make them more amenable to the introduction of a revised
minimum standards framework and investment in new liquidity risk
systems;

the enhanced systems and controls that firms are in the process of
developing will clearly identify the minimum amount of liquidity the firm
needs to hold under a variety of scenarios and stresses. Firms’ own
systems are, therefore, likely to give a more accurate picture of
minimum standards than a prescriptive regime applied to all. Firms may
consider it worthwhile to suggest to the FSA that they be allowed to

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 use, subject to validation, their internal models for determining the
minimum liquidity requirement;

there should be a default system, perhaps based on an enhanced

sterling stock arrangement, for firms that do not have the capacity or
desire to fully develop their internal models; and

regulatory reporting should only be required at a very high level and be

focussed purely on allowing the FSA to assess systematic risks.

To summarise this section, firms have a real opportunity over the next twelve
months to influence the FSA on the subject of a new minimum standards
regime. It is suggested that the most desirable outcome would be that the
FSA allow internal models to be used by firms to determine their own
minimum standards with the associated regulatory reporting regime being
simple, high level, and limited to the provision of information that would allow
the FSA to assess systemic liquidity risks.

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Key success factors

For firms just embarking on their liquidity risk projects the following checklist of
key success factors may prove useful.

KEY SUCCESS FACTORS

As with all other elements of the Integrated Prudential Sourcebook, the

organisation’s senior management and board need to be made aware of the
significance of the proposed changes.

Board and senior management responsibility for implementing the new

liquidity requirements must be allocated.

The responsibilities for all aspects of future liquidity risk management must be
clearly documented and approved.

Liquidity data must start to be captured at the earliest opportunity.

Basic scenario analysis and stress testing should be undertaken as soon as

possible. It is far better to have made a start and have something to show the
FSA than to wait until a perfect system with perfect data can be developed.

Liquidity risk management expertise must be developed by involving those

with relevant experience in the development of scenarios, for example traders,
payments system managers and customer relationship managers.

Scenario analysis and stress testing results, policies and procedures should all
be formally documented.

Management information should start to be produced at the earliest

opportunity, even if, initially, there are gaps.

Firms should enter into dialogue with other banks. Following new regulation,
standard approaches tend to adopted by most firms. Time and effort will be
saved by sharing non-confidential information.

Good progress will be expected in all areas. It is unacceptable, for example, to

have perfect policies but to have done no work at all on stress testing.

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Conclusion

To summarise this section, whilst undoubtedly the delay in the introduction of

a minimum standards regime has lightened the burden for firms implementing
the changes to liquidity risk regulation, most readily acknowledge they still
have a number of activities to complete.

If, however, a practical approach is taken, all firms should be able to satisfy
the new systems and controls requirements prior to formal adoption by the
FSA.

In terms of the minimum standards proposals, firms should use their

enhanced understanding of liquidity risk as a base from which to enter into
meaningful dialogue with the FSA over the future shape of any new regime.

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8. OVERALL SUMMARY AND CONCLUSION

This project sought to uncover why liquidity risk is a major concern for
regulators worldwide, review the current regulatory regime for liquidity risk,
evaluate the proposed changes to these regulations and their likely impact as
well as provide practical advice and guidance.

The review of liquidity problems over the past twenty five years found that
whilst there have been notable failures across the world, the UK has been
relatively unscathed by serious liquidity crises. Notwithstanding this, there is a
general acceptance amongst firms that liquidity risk should be managed very
closely both to ensure business as usual transactions can always be
processed and to provide a cushion for potential internal and external risk
events.

The research phase of the project revealed that, in most firms, the systems
and controls in place exceed current regulatory requirements. Although,
overall, this bodes well for a relatively smooth implementation of the future
liquidity systems and controls requirements, there are challenges to be faced
in developing scenario and stress testing techniques and formulating
contingency plans.

The second element of the new proposals – the minimum standards

framework – will now be subject to further review and all banks are
encouraged to directly or indirectly participate in discussions to formulate
possible revisions. It is suggested that there are strong arguments for limiting
any minimum standards regime to simple, high level reporting purely for the
purposes of allowing the regulatory authorities to monitor systematic risk.

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 APPENDIX 1
EXAMPLE LIQUIDITY RISK MANAGEMENT STRUCTURE

ALCO
(Responsible for setting policy)

Treasury Director
(Responsible for overall
implementation of policy)

Asset and Liability Management Treasury Middle Office Treasury Front Office Treasury Back Office
(Responsibilities listed below) (Responsibilities listed below) (Responsibilities listed below) (Responsibilities listed below)

Understanding payments systems cash inflows and

Reviews of strategic plan, budgets and forecasts Managing daily liquidity
Preparation of daily position reports outflows (inc. behavioural)

Managing medium to long term liquidity needs Liaising with major customers and clearing service
Liaison with Head of Dealing Room following above reviews
Preparation of Liquidity returns (in accordance with ALM advice) to understand payment and receipt profiles

Maintenance of Liquidity policy Management of Bank of England account (Position

Maintaining access to markets
Maintenance of Liquidity procedures

Scenario analysis > 12 months and stress testing

Liquidity management information

Contingency plans Liquidity risk control environment

Treasury book maturity profiles

Retail book profiling (inc. behavioural)

Scenario analysis < 12 months

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APPENDIX 2

LIQUIDITY RISK POLICY TEMPLATE

Liquidity Risk Policy

Date: xx/xx/xxxx

Owner: …………….

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Contents Page number

1. Policy objectives
2. Basis of managing liquidity
3. Management responsibilities for managing liquidity risk
4. Limits and concentration
5. Liability management
6. Marketable assets
7. Currency liquidity risk
8. Intra-day liquidity
9. Stress testing and scenario analysis
10. Liquidity risk reporting
11. Internal controls
12. Market access
13. Contingency

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1. Policy objectives

The objective of this liquidity policy is to ensure that sufficient funds are
available at all times (normal and stressed) to meet demands from depositors,
fund agreed advances and meet other commitments as and when they fall
due.

In particular, the policy seeks to ensure that the bank:

always has a critical breathing space to gain an initial assessment

of the depth of any liquidity problem;

does not have to test the confidence of the organisation’s name in

the inter-bank market;

has sufficient liquidity to act as a buffer against transmission shocks

between the organisation and others in the banking system; and

always meets its regulatory responsibilities.

It is recognised, however, that in the event of a shock resulting in major

withdrawals of wholesale and retail deposits, the organisation cannot insulate
itself indefinitely from a liquidity crisis.

2. Basis of managing liquidity

The organisation’s liquidity risk will be managed on a centralised basis.

3. Management responsibilities for managing liquidity risk

(see Appendix 1)

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4. Limits and concentrations

Liquidity risk will be managed within the following risk limits:

Currency Limit

Minimum amount and minimum inflow /outflow

Sterling
ratio for all periods < 30 days.

Minimum amount and minimum inflow /outflow

US dollar ratio for all periods < 30 days.

Minimum amount and minimum inflow /outflow

Euro ratio for all periods < 30 days.

Minimum amount and minimum inflow /outflow

Other currencies ratio for all periods < 30 days.

Note: It also advisable to have an aggregate limit.

The following limits apply to concentrations

Concentration Limit

Exposure to a single x% of the organisation’s total liabilities.

liability provider (or
related group).

Product No more than x% of liabilities to be provided by a

single product

x% of customer assets with a maturity of > 1

Maturities year should be matched by liabilities of at least a
similar maturity.
No more than x% of liabilities will be provided by
Retail / wholesale split
wholesale funding.

Limit breaches should be reported immediately to the Chair of the ALCO.

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5. Liability management

Liquidity risk is increased when the maturities of liabilities are not matched to
the maturities of assets. Accepting that by the nature of retail assets and
liabilities, it is unlikely that maturity matching can be fully achieved, the
organisation manages this exposure by:

Setting concentration limits as above;

Taking tactical and strategic opportunities to acquire long term liabilities

through product development and wholesale funding mechanisms.

Although capital issues can provide an additional source of liquidity, the

organisation sees the key drivers for raising capital as business growth and
regulatory requirements.

6. Marketable assets

Marketable securities are a key element of the organisation’s liquidity risk

approach. They are used to both manage day-to-day liquidity requirements
and provide a liquidity buffer in times of stress. The organisation will:

maintain a stock of marketable assets of x% of retail liabilities plus y%

of wholesale liabilities;

not hold more than x% of a single bond issue;

not hold more than y% of any issuer’s total debt;

only hold debt rated at x or above;

not purchase debt, other than gilts, with a redemption date of in excess
of x years; and

only purchase debt denominated in the following currencies:

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 o Sterling;
o US dollar; and
o Euro.

7. Currency liquidity risk

It is the policy of the organisation to immediately hedge all significant currency

liquidity mismatches.

8. Intra-day liquidity

Intra-day liquidity is managed through the following:

Close monitoring of money market dealing;

Position keeping with the Bank of England;

Meeting industry deadlines for processing payments;

Forecasting values and volumes of payments originating from

organisations that the firm provides clearing services to; and

Maintaining close relationships and sharing information with retail

divisions and third parties whose clients generate payments.

9. Stress testing and scenario analysis

Normal levels of payment inflows and outflows will be subject to the following
scenario analyses on a quarterly basis to ensure that adequate liquidity is
being held:

xxxx

yyyy

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In addition, on a six monthly basis formal stress testing will be undertaken.

ALCO is responsible for approving scenario and stress testing parameters

and reviewing testing results.

10. Liquidity risk reporting

The following management information will be provided to ALCO each period:

xxxx

yyyy

11. Internal control

The following controls provide reasonable assurance that liquidity risk is

appropriately managed:

management accountability for liquidity risk is formally documented;

the firm’s liquidity policy is documented;
detailed procedures exist and are reviewed and updated at least
annually;
the firm’s liquidity management models have been tested and the
results retained;
daily liquidity risk reports are produced;
liquidity risk limits have been established and there is a formal
monitoring system to identify breaches;
monthly liquidity risk reports are submitted to the ALCO;
responsibility has been assigned for formally reviewing strategic plans,
budgets and forecasts to understand changing liquidity needs;
scenario analysis and stress testing parameters are approved by the
ALCO which also reviews testing results;

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 contingency plans have been documented and are reviewed at least
annually; and
the management of liquidity risk is reviewed annually by the
organisation’s internal audit function.

12. Market access

Market access is managed as follows:

a database of key liability providers is maintained;

meetings are held with key liability providers on a regular basis;

a market presence (borrowing from counterparties) is maintained even

when there is no liquidity requirement. This acts as market testing.

committed facilities of xx with other financial institutions are in place;

an investor relations programme is maintained which provides

opportunities to elaborate on recent financial results and strategic
initiatives; and

relations with the media are managed through the Corporate Relations
Office.

13. Contingency

A separately developed contingency plan is in place which documents:

the scenarios under which the plan is invoked;

the action that must be taken; and

the individuals responsible for directing actions required under the plan.

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Abbey plc, Annual Report and Accounts, 2003.

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Barclays PLC, 2003 Annual Report.

Bradford and Bingley plc, Annual Report and Accounts, 2003.

Chaplin, G., Emblow, A., Michael, I, 2000. Banking system liquidity:

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December 2003.

Co-operative Bank PLC, Annual Report and Accounts, 2003.

Dermine, J., Bissada, Y.F, 2002. Asset and Liability Management – A guide to

value creation and risk control. Prentice Hall Financial Times.

European Central Bank. 2002. Developments on Banks’ Liquidity Profile and

Management

Federal Reserve Board. 2003. Commercial Bank Examination Manual.

Financial Services Authority. 2001. Interim Prudential Sourcebook.

Financial Services Authority. 2003. Liquidity Risk in the Integrated Prudential

sourcebook: a quantitative framework.

George, E.A.J, 1998. The New Lady of Threadneedle Street. Governor’s

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Jackson, P., 1996. Deposit Protection and Bank Failures in the United

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