Liquidity management has become an increasingly important factor for financial institutions following the 2008 financial crisis. To institute new controls, regulators have focused on a bank’s liquid assets and standards for measuring liquidity levels have been focused around cashflow mismatch risk (CFMR) and liquidity coverage ratios (LCR) implemented throughout various regulatory acts and guidelines. The newest wave of regulations and standards has caused significant changes in the process for liquidity management. The UK Prudential Regulation Authority’s (PRA) July 2017 consultation paper is one of the most recent publications addressing this topic. Its proposed guidelines are currently open for comment until October 13.
CFMR for Daily Liquidity Management
CFMR has been a main focus for financial institutions in the UK. In its most recent consultation paper released in July 2017, the UK’s PRAdiscusses CFMR for liquidity management in more detail. The July 2017 paper titled, “Pillar 2 Liquidity – CP13/17” focuses on CFMR as one aspect of three Pillar 2 risks identified in its 2016 paper, “Pillar 2 Liquidity – CP21/16.” The 2016 paper introduces developments around risks for intraday liquidity, debt buyback and non-margined derivatives.
CFMR is a measurement that focuses on daily liquidity management. It assesses a firm’s daily liquid assets and seeks to monitor the daily granularity and liquidity mismatches. In the PRA’s July 2017 consultation paper, it lays out the methodology for calculating CFMR which takes into account daily profiles of inflows, outflows and liquid assets. CFMR specifically focuses on the following: low point risk which ensures adequate daily liquidity throughout a full measurement period, HQLA monetization risk which details the monetization of assets, cliff risk which can lengthen the timeframe for asset liquidity and FX mismatch risk which considers asset liquidity in terms of international liquidation.
The PRA is also proposing that CFMR require additional reporting requirements. This reporting would be submitted with a new liquidity reporting template associated with PRA110.
LCR for Short-Term Liquidity Management
LCR is an important part of the liquidity guidelines outlined by Basel. The LCR ratio is also commonly being used around the globe for worldwide liquidity management and controls. The LCR examines liquidity controls over a short-term period of approximately 30 days. It currently applies to banking institutions based on the levels of assets on their balance sheet.
To determine the LCR, banks identify the amount of highly liquid assets on their balance sheet. They then measure that against the projected net cash outflows versus inflows over a 30-day period. Banks must have 100% coverage of projected outflows from their highly liquid assets to comply with LCR requirements.
Various regulating agencies have incorporated new standards for LCR including the U.S. Federal Reserve. The PRA’s July 2017 consultation is one of the latest industry releases on the topic of LCR. It proposes required reporting for banking LCR which provides transparency and accountability for 30-day liquidity management.
Effects on Market Liquidity Management
Liquidity measures such as CFMR and LCR have increasingly been used across the globe to better manage liquidity and provide for greater transparency. LCR has been the market leading measurement guiding analysis of liquidity across the market with its determination of 30-day liquidity credibility. Government agencies across the globe including the U.S. Federal Reserve and the UK’s PRA have been leading advocates for this analysis. Recently the UK’s PRA also introduced CFMR which analyzes banks’ liquidity coverage on a daily basis, requiring that they have sufficient liquidity to cover daily transaction activity.
Overall, the increased regulation around liquidity management has increased the level of transparency and accountability required by financial institutions. It has also significantly increased the amount of reporting documentation and testing required by banks. The increased focus on liquidity has also caused banks to be more conservative in the types of assets they have available for collateral which has influenced a number of market activities for which they are specifically involved including securities finance. The current trend in the market supports increased levels of liquidity oversight similar to the introduction of CFMR by the PRA. In general, broader accountability and transparency around liquidity management is expected to continue.