Strengthening or weakening liquidity standards?

The UK financial services regulator, the Financial Services Authority (FSA) has been consulting with banks and financial market participants on its response to the so-called liquidity crisis.

Boasting the memorable title of CP08/22:Strengthening Liquidity Standards, the FSA consultation paper talks about "high-level" requirements for banks to maintain "adequate" liquidity at all times without relying on other parts of the group.

The consultation paper also mentions the need for adequate systems and controls for liquidity management; quantitative standards for liquidity; standards around quality and quantity of liquid assets and the requirement for a liquidity buffer of "high quality unencumbered assets"; as well as data pertaining to a "firm-specific" and "market-wide view" of liquidity risk.

It sounds reminiscent of Basel II in that the consultation paper talks about qualitative and quantitative standards. I would not be surprised if the FSA's consultation paper gives rise to a cottage industry of conferences, vendor solutions and consultants, all eager to plug their FSA- friendly liquidity risk management expertise.

While the FSA proposes that it will conduct a supervisory liquidity review of each firm, alarm bells start ringing when one reads that the FSA is still pursuing a "high-level" principles-based approach to regulation.

In light of recent market events, which clearly demonstrate that the banks themselves and the regulators got it so horribly wrong, one has to question whether a wholly principles-based approach to regulation works. The FSA also mentions that responsibility for liquidity risk lies with the banks themselves, not the central banks or regulators, but haven't we seen the devastating consequences of what happens when banks are left to their own devices?

Some risk management consultants I have spoken to have also expressed misgivings about the consultation paper (CP08/24) that the FSA published on stress and scenario testing back in December 2008.

The FSA proposes to introduce a "reverse-stress test" requirement for banks, building societies, investment firms and insurers, requiring firms to consider "the scenarios most likely to cause their current business model to become "unviable".

Sounds great in theory, but as one risk management consultant pointed out to me, the banking industry and the FSA are not "up to speed" on scenario planning, unlike the oil and aerospace industries which have 40 years of experience. So what chances do we have of the banks and the FSA, who are part of the problem, getting it right?

The consultant said the current risk management strategies banks use such as Value at Risk (VaR) were no good at predicting extreme events. Using the example of a plastic ruler being bent, the consultant said while mathematics could calculate how much the ruler would bend, it could not predict at which point it would snap. "[The collapse of] Lehman Brothers was like the ruler snapping," he said. Yet, standard risk models failed to predict the point at which Lehman's would snap, let alone the consequences that ensued.

While placing more emphasis on stress testing and scenario planning in terms of contemplating a myriad of "what if" scenarios may help firms better anticipate the unexpected, the consultant said that the problem with the FSA's approach is that it was taking the standard risk models (how much the ruler is bending) and applying them to something that only matters when the ruler snaps.