Liquidity standards - The FSA is on the war path

It seems that the UK financial services regulator, the Financial Services Authority (FSA) much maligned by the media and the public in the wake of banking failures under its watch, is eager to restore its credibility by wielding the heavy hand of regulation in the form of its onerous requirements for strengthening standards around liquidity risk.

The FSA is the first regulator to issue a consultation paper (CP 08/22) on strengthening liquidity standards and has set the rather ambitious deadline of October this year for banks, investment banks and building societies to comply with its new liquidity risk standards, which does not leave firms much time for planning, selecting solutions, building interfaces, testing and firm-wide education, says Selwyn Blair-Ford, senior domain expert, UK & Ireland, Financial Reporting Services, FRS Global, particularly given that the FSA is not expected to finalize the new rules until April.

Reading between the lines of the Consultation Paper (CP 08/22), one can see that the FSA is eager to come down hard on those banks with business models characterised by unsustainable lending practices and a reliance on wholesale funding or funding from foreign subsidiaries rather than retail deposits.

One of the key tenets under the new liquidity risk standards is that banks will need to maintain "adequate" liquidity at all times without relying on other parts of the group. Blair-Ford says this requirement will "break up" the centralised treasury management model that most banks operate under and will require liquidity to be held locally, which is an expensive undertaking. This appears to be specifically aimed at preventing what happened in the case of Lehman Brothers, where the illiquid US operation reportedly "sucked" all the liquidity out of its European offices.

As a result of the FSA's new requirements around managing liquidity risk the FSA anticipates that "...many institutions will need to significantly reshape their business model over the next few years as a result. Current agreements and practices will have to be reviewed and the status quo may no longer be acceptable. In line with our objectives, our regime will continue to put the responsibility of adopting a sound approach to liquidity risk management on firms and their senior management".

"There is an arms race to see who is the toughest [regulator]," says Blair-Ford of FRS Global. He anticipates that the cost of complying with the new liquidity risk standards will make banking less profitable, not exactly what the beleaguered banking sector wants to hear, but then it seems the FSA wants to change the face of banking, at least when it comes to stemming the systemic implications of liquidity risk, and if it has to claim a few scalps along the way or force further bank consolidation then so be it.

In its consultation paper, the FSA estimates that IT, reporting and training costs for the new liquidity risk standards will cost firms between £150 million to £200 million, however industry feedback suggests that the FSA has underestimated the "true" costs to the industry.

Regardless, the FSA makes no apologies for its ambitious implementation time frame or what it terms "tough prudential standards", and while it may be tempting to think that the regulator will at worst fine firms for non-compliance with the new liquidity risk standards, according to FRS Global, the penalties are likely to be more severe and could take the form of bank directors (bank chairmen, executive and non-executive board members) being "disbarred".

It appears that the FSA is on the war path eager to make amends for the unwanted media and public attention it has received for falling asleep at the wheel and it will be interesting to see which firm or firms are first in the firing line. Could it be a US bank? After all, many think this is largely a US banking problem that spread to other markets, and it seems the FSA is keen to extend its regulatory tentacles beyond UK shores.