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Click here for the Financial Services Authority and Liquidity Risk   Click here for the Financial Services Authority and Liquidity Risk


Treasury & Capital Markets

The Financial Services Authority & Liquidity Risk

Introduction

While we focus on global markets this article is focused on the United Kingdom and its unitary regulator the Financial Services Authority (FSA).

The FSA published a detailed response to the liquidity crisis in their policy paper entitled Strengthening Liquidity Standards (Policy statement 09/16) issued in October 2009. We thought you would like to know how we assess the paper and what we feel could be its impact. Risk Reward will prepare its review of the next Liquidity Paper, currently in consultation, later this year (2010).

The Issues Identified

The FSA in the UK is not a central bank, instead it is a regulator of financial institutions dealing with both consumer matters and more general supervisory issues. They have identified the following failures of liquidity risk management and are suggesting new mitigation approaches to deal with them. That they are bound to fail and will exacerbate the next set of problems is one of the reasons why we have written his article at this time.

Issue 1: Liquid Asset Buffers

The FSA state that the first issue related to banks maintaining inadequate quality and quantity of liquid asset buffers, leading to firms' inability to liquidate them in a stress event.

The mitigation (chapter 8) is a new tough definition of liquid assets and risk-based buffer. They are requiring a stock of high-quality government bonds, central bank reserves and bonds issued by multi-lateral development banks to be held.

The new requirements are based on an initial two-week firm-specific and market-wide stress with the wider market-wide stress continuing out to three months. The cash flows need to cover the two week period and then an assessment of the additional buffer requirements will be made.

There is a problem here that should be obvious to everyone, not least of whom is the FSA. What we are to expect is that banks will hold the government securities of their home issuer. What happened when we had the 1999 problems in Russia? At the time when Russia defaulted the value of Russian bonds collapsed and a large number of banks failed. Given that the governments that are issuing the highest quality assets are exactly the governments which are the most indebted and have the greatest likelihood of failure, this concentration is extremely dangerous. To make the issue crystal clear, at exactly the time that the bank will need to realise these assets they will themselves become illiquid. Indeed if the FSA was really considering the risk assessment appropriately and the market correlations they would have required the banks to hold physical commodities, not government securities.

Click here for the Financial Services Authority and Liquidity Risk Article

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