Liquidity rules will test watchdog and banks

LONDON (Reuters) - The Financial Services Authority will update banks soon on its plans for tougher liquidity rules that may cause some banks to think twice about operating in the country.

The FSA is set to become the first regulator in a major financial centre to introduce a formal new regime of bank liquidity requirements in response to the financial crisis. The new rules are expected to cost the sector hundreds of millions of pounds.

From October, the watchdog will have the power to determine how much cash-equivalent assets each individual bank must hold, drawing on principles published in 2008 by the international Basel Committee on Banking Supervision.

The complexity of the new system, and uncertainty over its impact on the money markets, pose a challenge to the FSA and banks just as they start to emerge from the financial crisis.

"It's a gathering storm. The regulators are going to be struggling to get their systems ready," said Paul Beach, head of investment banking at Atos Consulting in London.

The government's experience of having to bail out banks during the crisis is behind the new rules, which will require bankers to do more to assess their liquidity risks and develop policies to deal with them, such as contingency plans if credit suddenly dries up.

This applies a lesson from Northern Rock, which had to be nationalised last year after collapsing due to a lack of liquidity rather than core capital, the focus of traditional regulatory schemes.

FOREIGN BANKS

The FSA has explicitly said the operations of foreign banks in Britain will also be subject to the rules, possibly in response to reports that the London unit of Lehman Brothers transferred chunks of cash back to New York days before it collapsed last September.

Banks will have to provide the FSA with a regular report -- even a daily one if asked for -- on their liquidity positions, although the reporting requirement has been pushed back to the first quarter of 2010 and some major details remain sketchy.

The lack of detail about the planned rules and how the FSA intends to implement them is making banks nervous.

"We don't know if there would be a minimum, across-the-board liquidity buffer floor, but expect that the liquidity buffer will be one that is more tailored to a particular bank's business," said Simon Hills, a director at the British Bankers' Association.

An FSA spokeswoman told Reuters that the regulator was due in a couple of weeks' time to publish an update on its liquidity policy, describing the next stages in introducing the rules and providing a timeline.

Banks will scrutinise the update for any signs that the FSA might slow the introduction of the rules further in order to ease their impact on the industry.

Atos estimated changes in banks' operations and internal systems to meet the new requirements would cost the banking sector 300-700 million pounds, while additional costs would stem from banks having to hold more lower-yielding, liquid assets.

Such costs could change flows of funds in the money markets; liquid assets such as government bonds could benefit, while complex derivatives could attract less interest.

LIQUID ASSETS

RBS bank calculates liquid assets have fallen from 30 percent of an average bank's balance sheet to under 1 percent in the past 40 years, and the new rules will send that up to 5-10 percent in two or three years, to levels last seen in the 1980s.

Credit Suisse analysts estimate the three big British domestic banks might eventually have to boost holdings in government bonds by around 200 billion pounds in total, causing a pre-provision drop in profit of 6 percent.

The FSA's rules could thus in effect create captive buyers for surging debt issuance by the government, which plans to sell a record 220 billion pounds of gilts in the coming year.

But some banks are thinking about contingency plans such as moving trading books outside Britain if the rules prove too tough, said Bob Penn, financial service lawyer at Allen & Overy.

"The question is how much liquid assets will they have to hold. The uncertainty is spooking the market," Penn said.

"The real concern is that banks may start to look more like insurers. They will have to hold a significant volume of low- risk assets."

Concern about driving bank business out of Britain could pressure the FSA into slowing introduction of the new rules, or at least synchronising them carefully with other jurisdictions.

Reforms to EU bank capital rules due to be proposed this autumn are set to cover liquidity requirements, but are unlikely to take effect before 2011. France and Germany, two rival banking centres, have not signalled they will move before then.

But some analysts think the FSA's desire to reduce risk in the banking system will trump any possible loss of business.

"The FSA has been so clear they are changing to becoming more interventionist, and if they soften the deadline, it won't help them in that change," said Beach at Atos Consulting.

(Editing by Andrew Torchia)