On 5 October the Financial Services Authority (FSA) became the first major regulator on the world stage to publish a tough, new liquidity regime, which will come into force on 1 December 2009. New liquidity reporting and quantitative requirements will be phased in gradually over several years, however, and the build up of liquidity buffers will only be implemented once the economy has stabilised. Other countries are not expected to introduce tighter liquidity regimes until late 2010.
The new rules will affect all UK banks and building societies, branches of European Economic Area (EEA) and other overseas firms operating in the UK, and investment firms. The transition will impact business models by, for example, discouraging reliance on short-term wholesale funding and increasing the quality and quantity of liquid asset buffers.
The key elements of the new regime include the following:
- over-arching principles of self sufficiency and adequacy of liquidity resources;
- enhanced systems and control requirements, which implement the Basel Committee's updated Principles for Sound Liquidity Risk Management and Supervision;
- new quantitative requirements, coupled with a narrow definition of liquid assets;
- a new modifications regime for branches and subsidiaries; and
- granular and frequent reporting requirements.
This client alert summarises those key elements and the various implementation deadlines. The FSA's policy statement, which includes the updated Prudential Sourcebook for Banks, Building Societies and Investment Firms (BIPRU), can be found here.
Adequate Liquidity and Self-Sufficiency (BIPRU 12.1 and 12.2)
The FSA has reaffirmed the existing approach in the Handbook IPRU (BANK) LM that UK banks are expected to stand alone and should monitor and manage their own liquidity separately from the liquidity of other institutions in the group. This self-sufficiency approach has now been labelled as the overall liquidity adequacy rule.
As a result, branches would have to hold local operational liquidity reserves. Such reserves will ensure capacity to meet local outflows and will act as an early warning of liquidity problems to the FSA who would be notified if the reserve began to be used.
The FSA may agree to modifications of the self-sufficiency requirement for branches if it can agree cross-border supervision arrangements that do not discriminate the interests of UK creditors.
Systems and Controls Requirements (BIPRU 12.3 and 12.4)
All BIPRU firms will be subject to liquidity risk management, stress-testing and contingency funding plan (CFP) requirements in BIPRU 12.3 and 12.4. Firms are required to implement robust systems and controls to identify, measure, manage and monitor the liquidity risks to which they may be exposed. Reliable management information will ensure forward-looking information on the firm's liquidity risk and should include early warning indicators to identify increases in liquidity risk.
The FSA has indicated that firms should consider implementing appropriate transfer pricing mechanisms that align commercial incentives in relation to individual products, business lines or strategies with the associated liquidity risks that each pose. The FSA also expects firms to actively manage their collateral positions, by understanding what assets have been provided as collateral, whether these assets are able of being re-hypothecated, whether they can be mobilised for liquidity purposes in a timely manner, and which assets are available for collateralisation.
Firms will be required to have robust stress-testing and CFPs to demonstrate compliance with the rules, and should consider a range of factors including the impact of stresses on pricing assumptions and shorter and longer term stress scenarios, as well as covering institution-specific and market-wide stresses. Stress-test results should be used to develop firms' CFPs which should identify a range of potential funding sources that could be used in the event of a liquidity stress.
The systems and controls requirements will come into force for all Individual Liquidity Adequacy Standards (ILAS) BIPRU firms (which include sterling stock banks and building societies) and non-ILAS BIPRU firms (exempt full scope, limited licence and limited activity BIPRU investment firms) on 1 December 2009.
However, UK branches of overseas banks with a Global Liquidity Concession (GLC) will not be required to apply the systems and controls requirements until 1 November 2010.
Individual Liquidity Adequacy Standards (BIPRU 12.5 and 12.9)
Once the FSA has completed its Supervisory Liquidity Review Process (SLRP) and following an internal validation process, firms will receive individual liquidity guidance (ILG). The ILG will contain guidance about the quantity of a firm's liquid asset buffer and the firm's funding profile, which, if accepted by the firm, must be monitored on a daily basis to ensure conformity. Once a firm becomes aware that it either fails to meet or is likely to fail to meet its ILG it must notify the FSA immediately to explain why, and implement its CFP.
The firm must submit a liquidity remediation plan within two days of it notifying the FSA. This plan must set out the firm's forward estimates of the evolution of the size of its liquid assets buffer and of its funding profile, as well as the management actions it intends to undertake to remedy the failure to meet its ILG. The FSA will track the progress of the plan and the plan will help the FSA's assessment of whether the firm meets the Threshold Conditions.
Standard ILAS firms will be required to complete an Individual Liquidity Adequacy Assessment (ILAA), at least annually, which should be proportionate to the nature, scale and complexity of a firm's business and documented so that it can be submitted to the FSA upon request. The ILAA should consider the effect the stresses would have on different sources of liquidity risk identified by the FSA. These include wholesale secured and unsecured funding, retail funding, intra-day and intra-group liquidity risks.
Quantitative Standards for Simpler Firms (BIPRU 12.6)
Simpler firms need not conduct ILAAs and may use a wider range of liquid assets in their buffers, which includes all liquid assets that standard ILAS firms can use, together with investments in qualifying money market funds that meet certain criteria.
Mortgage banks and building societies with simple business models will remain eligible for the simplified ILAS regime. Simple retail banks, banks with a 'money box' style business model, where deposits are aggregated and then deposited with a credit institution, and certain wholesale firms predominantly funded by a parent, may also apply simplified ILAS standards, provided they meet certain conditions.
Simplified firms will need to prepare a policy statement on how they will split their retail deposits into two categories: (i) lower quality retail deposits, to which a stress of 20% would be applied, and (ii) the most stable retail deposits, to which a 10% stress would be applied. This will be reviewed by the FSA as part of the waiver process for firms applying to use the simplified ILAS regime.
Firms that qualify for the simplified ILAS regime will have three years within which to build up their liquid assets buffer (see below) from the beginning of the relevant period.
Composition of Liquid Assets Buffer (BIPRU 12.7)
All ILAS BIPRU firms will be required to maintain a stock of high-quality government bonds, central bank reserves and bonds issued by multilateral development banks. However, the FSA will make limited allowance when setting ILG on a whole-firm basis where a local supervisor sets a regulatory requirement to hold a liquidity buffer in local currency.
The new liquidity standards are based on an initial two-week firm-specific and market-wide stress, with the wider market-wide stress continuing on for three months. Beyond the initial two weeks, the actual size of the buffer will vary depending on the FSA's view of the quality of risk management within the firm. Firms will be required to generate liquidity from the liquidity buffers through sale or repo, and access all relevant central bank emergency facilities to which they have access, on a regular basis. The aim of the turnover requirement and the requirement to access emergency central bank facilities on a regular basis is to reduce any associated stigma.
Group-wide Management of Liquidity (BIPRU 12.8)
EEA and non-EEA branches may apply for a whole-firm liquidity modification to modify the self-sufficiency requirement, provided certain conditions are met. This replaces the GLC regime, where the task of liquidity supervision is delegated to the home supervisor once its liquidity regime is deemed equivalent. The whole-firm liquidity modification will also allow a branch to rely on other parts of its group to satisfy the systems and controls requirements.
UK solo entities may modify the self-sufficiency requirement by applying for an intra-group liquidity modification, which can result in the overall liquidity adequacy rule being applied at a UK group level and/or to permit an ILAS firm or the ILAS Group to place a degree of reliance on a foreign parent in order to satisfy the overall liquidity adequacy rule. Firms granted the intra-group liquidity modification will also have the option of relying on other parts of its group to satisfy the FSA's Senior Management Arrangements, Systems and Controls (SYSC) requirements, subject to the group having adequate regard to the liquidity position of the applicant firm.
Quantitative Requirements Transitions Dates
The effective date for the BIPRU 12 quantitative requirements for ILAS BIPRU firms ranges from 1 June 2010 to 1 November 2010, depending on the different class of ILAS BIPRU firm (BIPRU 12.2 and BIPRU 12.5 to 12.9), and on 1 November 2010 for non-ILAS BIPRU firms (BIPRU 12.2 and 12.8). Firms qualifying for the transitional period will remain subject to their current quantitative liquidity requirements during the transitional period that applies to them.
Additionally, the overall liquidity adequacy rule (BIPRU 12.2.1R), will take effect at the end of the transitional period. Thus, during the transitional period, the adequate financial resources rule (GENPRU 1.2.26R) should be followed. Applications for modifications should be submitted within the modification submission deadline prescribed for each class of firm.
Liquidity Reporting (SUP 16.12)
The FSA's quantitative reporting requirements will apply to all ILAS firms, at a frequency varied according to whether the firm is a standard or low-frequency reporting firm, and whether it has been granted a modification. Low-frequency reporting firms are those falling within the scope of the standardised buffer ratio regime or which have balance sheets of less than £1bn.
Firms which fall outside of the scope of the ILAS requirement (ie limited licence and limited activity BIPRU investment firms, as well as certain other firms) will not be subject to the quantitative reporting requirements but will instead submit a systems and controls questionnaire (FSA055) on an annual basis.
Firms will be required to submit FSA047 and FSA048, on a default basis, as a consolidated currency report. The FSA will assess firms' cross-currency liquidity risk exposures as part of firms' ILAAs and will agree with them which additional currencies they should report, if any.
Firms must report on three levels of consolidation, though the precise structure of a firm's consolidation level of reporting will depend on whether it has been granted a modification and whether the FSA is the lead regulator. The three levels of consolidation are:
- on a solo basis;
- as a Defined Liquidity Group (DLG) where they have a modification (either as a UK DLG, whose only members are ILAS firms, or as a non-UK DLG, which is any other type of DLG as it relates to the firm or the UK DLG created by the modification); and
- as a DLG by default. A DLG by default includes group entities where material support is provided between the firm and entity. In practice, the scope of the DLG by default will be agreed initially between firms and the FSA.
In the absence of a whole-firm liquidity modification, the default position for a branch is to report all the data items on a solo basis, based on UK branch operations. A branch that has been granted a whole-firm liquidity modification must report FSA047 and 048 on a whole-firm basis, quarterly at most. There will be no branch-level reporting and no currency reporting.
All firms with a balance sheet threshold of under £1bn will automatically fall within the category of low-frequency reporting firms. Low-frequency reporters will be required to report on a weekly basis, as opposed to on a daily basis, during stressed times.
Liquidity Reporting Transition Dates
During the relevant transitional period firms should continue to refer to their current liquidity requirements instead of the BIPRU 12 quantitative requirements and submit regulatory reports as required by their current regulatory reporting requirements. From the end of the relevant transitional period, firms must report under the new regulatory reporting regime.
ILAS BIPRU firms authorised in the period up to 30 November 2009 will be required to submit data items FSA047, FSA048 and FSA052 from 1 June 2010, though the precise deadline differs for the different classes of ILAS BIPRU firms.
ILAS BIPRU firms authorised on or after 1 December 2009 will be required to submit data items FSA047 and FSA048 within the framework of the extended Liquidity Risk Profile reporting project until 30 May 2010. From 1 June 2010, these firms are required to submit data items FSA047, FSA048 and FSA052.
All ILAS BIPRU firms, whether authorised before, on or after 1 December 2009, will be required to submit data items FSA050, FSA051, FSA053 and FSA054 from 1 November 2010.
The first data item non-ILAS BIPRU firms (exempt full-scope BIPRU investment firms, limited licence and, limited activity BIPRU investment firms) will be required to submit will be the FSA055 systems and controls questionnaire for the year to 31 December 2010. In the case of mismatch banks, these firms will be required to submit FSA010 in the period from 1 October 2010 until they are issued with their ILG (i.e. they will be required to submit both the 'old' and 'new' reports in this period).
Transition Dates for Overseas Firms
UK branches of overseas banks with a GLC, where the day-to-day supervision is transferred to the home state regulator, will not be required to apply any of the new BIPRU requirements until 1 November 2010.
Overseas banks that calculate their liquidity resources in accordance with Chapter LM of IPRU (BANK), will not be required to apply the requirements under BIPRU 12.2 and BIPRU 12.5 to 12.9 until 1 November 2010.
During the transitional period to 1 November 2010, when applying BIPRU 12.3 and BIPRU 12.4, these firms should replace any references to the overall liquidity adequacy rule with the overall financial adequacy rule.
Thus, many overseas firms will not be required to follow the new overall liquidity adequacy rule until 1 November 2010.
However, from 1 November 2010, until the earlier of the date on which the overseas firms receive their ILG from the FSA, and 30 November 2011, overseas firms which are standard ILAS BIPRU firms must ensure they maintain liquidity resources which are no less in amount than the higher of (i) the amount assessed as adequate in their ILAA; and (ii) the amount that they would have maintained during that period had they calculated their liquidity resources solely in accordance with Chapter LM of IPRU (BANK) in the form in which it appeared on 30 September 2010 or 31 October 2010 (as relevant).
Click here for commentary from Jacqui Hatfield, head of Reed Smith's UK Financial Services Regulatory Group