Courtesy of Mete Feridun
When it comes to changing UK liquidity regulations, each round of revisions – such as the liquidity coverage ratio, net stable funding ratio, and the cash-flow mismatch risk framework – typically makes funding and liquidity risk management more complex and costly for firms. However, the Prudential Regulation Authority’s (PRA) recent consultation paper (CP27/19 Liquidity: The PRA’s approach to supervising liquidity and funding risks) is reversing this trend by giving regulated firms more flexibility in managing their liquidity and funding risks.
The proposed changes give firms more freedom to use the Bank of England’s (BoE) liquidity facilities to meet their funding needs. This has important implications because the PRA currently has a presumptive order of use between the BoE’s liquidity facilities and drawing down on a firm’s liquid asset buffer. Under the current order of use, the Discount Window Facility is available only as a “last resort” in the event of either a firm-specific or a market-wide liquidity stress event.
The PRA currently expects firms experiencing distress to initially draw on their holdings of high-quality liquid assets (HQLA) to meet outflows, thereby eroding a significant proportion of their liquidity buffer before they turn to central bank liquidity facilities. The presumption is that firms should meet their liquidity demands through the private market during most adverse scenarios. Now, the PRA is set change this assumption by allowing firms to draw on BoE liquidity facilities without first tapping into their stock of HQLA. Consequently, the BoE’s liquidity facilities would no longer be a last resort for firms under stress.
The proposed change would not alter the BoE’s role as lender of last resort. The PRA makes it clear that it does not intend to allow firms to rely on BoE liquidity facilities for their day-to-day liquidity management. Instead, the PRA seeks to encourage firms to exercise their own judgement when applying for the BoE’s liquidity facilities, taking into account their individual circumstances. The industry has long argued that they are best placed to evaluate the relative costs and benefits of different sources of liquidity, as well as the stability of these sources. The PRA’s proposal largely acknowledges this view and would give firms greater freedom and flexibility in managing their liquidity needs.
While the proposed changes are set to revise the regulatory approach with respect to the availability of the BoE’s liquidity facilities, firms should note that the PRA’s expectations and supervisory approach with respect to recovery planning would remain the same. This means that firms are expected to have in place credible liquidity and funding strategies. These strategies may or may not involve the use of foreign or domestic central bank liquidity facilities.
While the PRA’s proposed changes do not require firms to include the use of central bank liquidity facilities as a recovery option, firms that do are expected to (1) consider the circumstances when they would access these facilities and (2) have feasible recovery options in their liquidity contingency plans to enable them to restore their HQLA after firm-specific or market-wide stresses. Therefore, firms that include central bank liquidity facilities as an option in their recovery plans must consider actions they would take to repay the funds and detail these actions in their recovery plans. The PRA is not prescriptive in terms of setting a particular timeframe during which firms are expected to repay these funds. However, firms should have a full range of realistic and credible recovery actions which would enable them to repay any borrowed funds as quickly as possible. These actions should take into account both a firm’s individual circumstances and the market-wide liquidity conditions.
Even though firms will have additional flexibility in accessing emergency liquidity, the PRA will continue to require that firms consider the circumstances under which they would access the BoE’s liquidity facilities and test their operational ability to draw from these facilities. In particular, firms will be required to review their eligible and pre-positioned HQLA, and their drawing capacity against them. While the proposed changes are good news for the industry, management of liquidity and funding risks will remain a significant challenge.
Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.