December 19, 2007 / 10:59 AM / 12 years ago

FSA calls for tougher bank liquidity tests

LONDON (Reuters) - Banks need to carry out tougher tests to ensure they can withstand liquidity shocks, including testing possible strains from off-balance sheet vehicles like conduits, the regulator said on Wednesday.

Customers queue to enter a branch of Northern Rock in Kingston, Surrey, September 17, 2007. The Financial Services Authority said on Wednesday that banks and building societies need to achieve a higher level of resilience to funding stress, and advocated a "a belt and braces approach". REUTERS/Alessia Pierdomenico

In a long-awaited discussion paper reviewing the liquidity regime, the Financial Services Authority said banks also need to draw up better contingency plans and to update the regulator more frequently on their liquidity position.

Liquidity risk has been a major issue for all regulators since the start of the global credit crunch and a priority for the FSA, which is under fire for its role in the near-collapse of mortgage bank Northern Rock NRK.L.

In the aftermath of Northern Rock, the FSA had said it would re-examine some aspects of liquidity regulation — particularly stress-tests carried out by banks — and it had been expected to put forward some proposals by the end of 2007. The regulator has also said it wants international standards, to accommodate international banking groups, not national regimes.

In Wednesday’s document — a discussion paper ahead of more formal proposals next summer — the FSA gave little detail on its “belt-and-braces” approach to liquidity supervision.

But the regulator highlighted its areas of concern, including the tests carried out by banks to ensure they can survive both extreme and lengthy liquidity crises.

Northern Rock, for example, remained solvent after August’s crisis, but was unable to fund its lending after the summer’s liquidity crunch became both chronic and long-lasting. Its “stress tests”, along with those of all banks, were drawn up by the firm itself — but did not cover a crunch the lender’s management said they and others had been unable to predict.

TESTING TIMES

“Stress tests need to contemplate prolonged lack of access to sources of long-term funding ... which might be closed off to them for several months,” the FSA said in the paper. It added that short-term funding might also be unavailable, as happened in recent months. Diversification of funding sources also proved of limited use, it said.

The FSA said banks testing their models should consider customers’ behaviour and the effect on deposits as well as stresses from off balance sheet vehicles — the focus of uncertainty in the recent crisis — including legal and reputational strains from those vehicles.

Banks should also test their liquidity “insurance”, including what assets they hold as treasury and whether liquidity promises from other banks can really be called upon.

Liquidity — or lack of it — is typically the cause of bank failures and is one of the top risks for institutions on the sector, but bank rule books such as the Basel II supervision rules have focused instead on capital requirements.

Liquidity risk depends on deposits, how long they are tied in for and several factors, making it very tough to measure.

To tackle this complexity, liquidity rules have not so far been risk-adjusted, or altered to suit a bank’s model.

The current system is based on high-level rules requiring firms to maintain liquidity, test their position and develop contingency plans, as well as on quantitative requirements — referred to as the stock and mismatch regimes.

The stock regime requires banks to hold enough liquid assets to survive at least five days without tapping wholesale markets and to cover customer withdrawals equivalent to 5 percent of retail deposits, allowing authorities time to find a solution.

The mismatch regime aims to ensure banks have enough maturing and marketable assets to cover maturing liabilities.

Neither, however, proved enough for Northern Rock, and the FSA said it was also exploring an “early warning” system for future liquidity crises.

Reporting by Dan Lalor and Clara Ferreira-Marques; Editing by Paul Bolding/Richard Hubbard

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