On the management of liquidity risk

Some highlights from FSA's discussion paper 07/07, Review of the liquidity requirements for banks and building societies follow.

On the nature of liquidity risk:

Liquidity stresses are low-frequency, but extreme severity, events that are not well-understood ... liquidity risks can grow in severity very rapidly... liquidity risk appears to be that it is hard to predict.

On incentive structures:

Even if some banks mitigate their liquidity risk they face a competitive disadvantage if other banks do not and therefore have lower costs. As liquidity stresses are low-frequency, but extreme severity events, this disadvantage may endure for long periods of time. In a perfect market, these other banks would not be able to exploit this cost advantage, as depositors and other counterparties would be reluctant to do business with them because of their failure to mitigate liquidity risk. In practice, it is often difficult even for wholesale depositors or counterparties to assess from the outside the liquidity position of a bank, and almost impossible for a retail depositor or investor to do this...

On stress tests:

Stress tests should consider both ‘chronic’ and ‘shock’ plausible liquidity stresses.

• A ‘shock’ stress is an extreme, but short duration (e.g. a few days or weeks) stress.
  
• A ‘chronic’ stress is less severe but may continue for several months.
  

Recent events have been a ‘chronic’ stress – the wholesale deposits, corporate paper and certificates of deposits have not closed completely for a short period of time, rather they have remained open but for the last several months we have seen decreased volumes and significant maturity shortening.

The market-wide stress tests need to take account of plausible disruptions and closures of not only the unsecured funding markets, but also of the secured funding markets, and also of both at the same time.

On funding sources:

Recent events have stressed the importance of diversification of funding sources – by counterparty, by market and by product - as a liquidity risk management tool. However, assumptions as to how effective diversification across sources of funding will be during a liquidity stress should be cautious. In recent months, diversification across funding product types, e.g. wholesale deposits, corporate paper, certificates of deposit, secured finance such as repo, covered bond, securitisation etc, has only proved to be of limited use. Simultaneously, there has been a complete closure of the securitisation market, a near-complete closure of the covered bond market and decreased volumes and significant shortening of duration in available wholesale deposits, corporate paper or certificates of deposit funding. And this has all occurred simultaneously in the major currency zones – Euro, US$ and sterling.

On liquidity lines:

During the recent market-wide liquidity stress, banks that held liquidity lines proved extremely reluctant to call upon them. There appear to be two main reasons for this.

• First, there was a perception that if a bank was seen drawing down on a liquidity promise this might be seen as sign of weakness. The fear was that this would damage the bank’s reputation and so make it more difficult to raise liquidity from other sources, possibly more than negating the help to liquidity gained by the draw down.
  
• Second, at least for some liquidity promises, there appeared to be a strong commercial expectation between the bank and the counterparty that the promise would not be called. And this is perhaps linked to the first bullet point, as drawing down against such an expectation would heighten the risk of damage to a bank’s reputation.

On regulatory tolerance for liquidity risk:

We are also clear that we do not seek to operate a zero-failure regime.

Brace yourselves. New rules coming.