Liquidity risk primer
The market turbulence of 2007/2008 led to unprecedented liquidity problems both at a market level and for individual firms. International regulators have identified shortcomings in liquidity risk management practices, not least in the application of stress testing under extreme liquidity events, and in the adequacy of contingency planning.
Previously something of a backwater, liquidity risk management is now high on the regulators' agenda and is fast becoming a top change imperative for banks and investment firms. Events in the UK have spurred the regulator to claim first-mover advantage. JWG-IT's assessment is that the FSA's consultation position is consistent at this time with the global view expressed by the Bank of International Settlements, the Financial Stability Forum and the private sector.
The issuance of the FSA Consultative Paper (CP) 08/22 "Strengthening liquidity standards" on 4 December 2008 fired the first shot at treasury, finance, risk and reporting and technology departments by posing 97 questions about demanding new liquidity risk management requirements. Crucially, the October 2009 deadline for implementation is remarkably tight, especially for larger firms. The FSA estimates operational costs to firms as £150-£200 million. For large firms, implementation costs are estimated to be £6-£9 million with ongoing costs of £1-£2 million annually.
The question on the minds of the front and back-office professionals alike is 'Are the global implementation requirements going to be clear and consistent?' The answer is uncertain as the opportunity for regulatory arbitrage in this area is high. Policy makers could take alternative views of both the depth of the requirements and the urgency to implement the changes, especially when the competitiveness of financial markets is at stake.
Regardless of the final shape of global liquidity risk requirements, 2009 will prove a challenging year for senior management of banks and investment firms. Our analysis thus far has shown three major change imperatives introduced by this regulation. First, a firm has to be able to collate, on an 'on-demand' basis, a wide range of highly granular data relevant to all assets, liabilities, contingent assets/liabilities, derivatives positions and other off-balance sheet activities. Second, a firm has to be able to apply extensive stress testing at three levels, defined by the FSA across a range of stress scenarios approved by the firm's senior management. Third, a firm must be able to document its full compliance with the new liquidity risk management standards from the appropriateness of its liquidity risk tolerance, through the adequacy of processes, systems and controls to the adequacy of the liquid assets buffer.
In sum, The FSA has taken a position that will require firms to demonstrate how well they know their business and which will change the firms' business models globally. UK branches and subsidiaries of non-UK firms who may wish to rely on group liquidity arrangements will a face particular challenge as the FSA has made it clear that "... every firm must be self-sufficient for liquidity purposes unless prior permission from us allows otherwise". (1)
At this point, it is not clear how many firms are positioned (or in 2008 were even fully aware of the requirement) to implement the new liquidity risk management capabilities. This analysis report summarises JWG-IT's initial findings on the challenges of liquidity risk management at the very start of the implementation journey. One thing is clear: the implementation challenges will be significant and firms would be well advised to 1) establish detailed implementation plans early and 2) work with the industry to define what 'good liquidity risk standards implementation looks like.'
(1) UK FSA Consultation Paper 08/22: Strengthening liquidity standards 12/08 2.12 p.14
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