In October 2009, the FSA published its new liquidity policy designed to implement the “Principles for Sound Liquidity Management and Supervision” issued by the Basel Committee on Banking Supervision. In the words of an earlier consultation paper:

“… proposals are far-reaching and robust; many institutions will need to significantly reshape their business model over the next few years as a result”.

Liquidity policy is based on two overarching principles. Firstly, that firms should maintain adequate liquidity resources, both in normal and stressed times. Secondly, firms must be self-sufficient for liquidity purposes unless given express permission by the FSA.

For firms that are part of a group, the FSA may consent to deviation from the second ‘self sufficiency’ principle, through waivers that would allow group-wide and cross-border liquidity management.

Liquidity Adequacy Framework

The framework consists of systems and controls requirements together with Individual Liquidity Adequacy Standards (shown wtih double border):

Systems and Controls

Systems and controls requirements apply to UK banks, building societies and investment firms as well as UK branches of certain non-UK banks. Under the framework firms must:

• Establish a documented liquidity risk appetite, endorsed by their board and supported by policies, processes and systems approved by their board.
• Set risk limits / incorporates early warning indicators in their internal reporting systems to identify potential breaches to their risk tolerance.
• Price liquidity risk for transparency in product pricing, performance measurement and product approval purposes.
• Identify, measure, monitor and control liquidity risk in conformance to specific detailed risk management rules and guidance set out in the FSA Handbook.
• Stress test liquidity funding capability in firm-specific and market-wide scenarios, and in combination of both.
• Have contingency funding plans to address liquidity shortfalls in emergency situations.

Individual Liquidity Adequacy Standards (ILAS)

Individual Liquidity Adequacy Standards (ILAS) apply to firms mentioned above, with the exception of smaller investment firms i.e. Limited Licence, Limited Activity and Full Scope investment firms with total net assets of no more than £50m. The regime is based on assessing the adequacy of liquidity resources, both in normal times and for surviving varying liquidity stresses.

Central to ILAS is the holding of a liquid assets ring-fenced buffer, over and above normal day-to-day liquidity resources, to provide a backstop in the event of severe stress.

The assessment process is similar to the Internal Capital Adequacy Assessment Process (ICAAP) for capital adequacy:

• Individual Liquidity Adequacy Assessment (ILAA): ILAS Firms (BIPRU firms including investment firms that are ‘full scope’) are required to undertake their own assessment of the adequacy of their liquid assets buffer.
• Supervisory Liquidity Review Process (SLRP): Under which FSA supervisors will assess the firm’s ILAA. This process will also take into account other factors, such as the firm’s ARROW risk assessment, wider market developments and supervisory knowledge of the firm.
• Individual Liquidity Guidance (ILG): Given by the FSA, will include setting the minimum size of the firm’s liquid assets buffer to meet liabilities during periods of stress and advising an appropriate funding profile.

Firms must consider the impact of firm-specific and market-wide stresses, and a combination of both, in carrying out their ILAA. Assumptions and parameters for undertaking analysis under normal conditions and stress testing are prescribed in detail in the FSA Handbook, including identification and measurement of cash flows for specific sources of liquidity risk and including both on and off-balance sheet commitments.

There is a ‘Simplified ILAS’ intended for simple retail banks and building societies, ‘money box’ banks and small wholesale subsidiary banks that meet eligibility criteria. These firms are only required to submit an Individual Liquidity Systems Assessment (ILSA) to its assess compliance with systems and controls requirements.

Liquid Assets Buffer

Proposals are specific on the composition of the buffer - high quality debt securities issued by approved countries/international institutions or sight deposits with a central bank. Unlike capital adequacy, there is no prescribed minimum size.

Firms must maintain a level of liquidity resources that does not fall below the level indicated by the results of their ILAA or the Individual Liquidity Guidance (ILG) given by the FSA. The only indication of what may be required in practice is the fixed formula for ‘Simplified ILAS’. This is basically the firm’s peak cumulative wholesale net cash outflow over the next 3 months plus 10% to 20% of retail deposits added to 25% of undrawn credit facilities.