1 Strengthening Liquidity Risk Management and Supervision – an international challenge Financial Regulation Conference, London 3 July 2009 Nigel Jenkinson Adviser to the Governor SERV

2 Developing a global framework “The BCBS and national authorities should develop and agree by 2010 a global framework for promoting strong liquidity buffers at financial institutions, including cross-border institutions.” G20 London Summit

3 Containing System-wide risks – five objectives for consideration Objective 1: Prudent liquidity risk management by individual banks (Institutional) Objective 2: Tougher standards on banks whose distress has largest system-wide impact (System-spillover) Objective 3: Tougher overall standards if system-wide risks are rising (Countercyclical system-wide) Objective 4: Consistent application internationally (International) Objective 5: Central bank facilities should underpin prudent liquidity risk management (Central bank)

4 Objective 1: Institutional “Liquidity regulation should encourage prudent liquidity risk management by individual banks. Defences should be robust to both the crystallisation of firm specific and market- wide stress.” Basel Sound Principles (September 08) Measurement and calibration (metrics, stress tests, CFPs) Links to other risks and defences (eg solvency and capital) Usable defences (avoiding adverse spillovers) Form of regulatory intervention (liquidity cushions, insurance, capital?) Desired level of resilience?

5 Banks economised on cushions of highest quality assets Sterling liquid assets relative to total asset holdings of UK banking sector(a) Source: Bank calculations. (a) 2009 data are as of end-March (b) Cash + Bank of England balances + money at call + eligible bills + UK gilts. (c) Proxied by: Bank of England balances + money at call + eligible bills. (d) Cash + Bank of England balances + eligible bills. US banks holdings of Treasury Bonds Source: FDIC Statistics on Depository Institutions.

6 Objective 2: System-spillover “Liquidity regulation should provide a disincentive for banks to increase liquidity risk. The disincentive should take into account the impact of liquidity risk distress at the bank on the overall financial system.”

7 Network of large exposures between UK banks Network of large exposures(a) between UK banks(b)(c) Source: FSA returns. (a) A large exposure is one that exceeds 10% of a lending bank's eligible capital during a period. Eligible capital is defined as Tier 1 plus Tier 2 capital, minus regulatory deductions. (b) Each node represents a bank in the United Kingdom. The size of each node is scaled in proportion to the sum of (1) the total value of exposures to a bank, and (2) the total value of exposures of the bank to others in the network. The thickness of a line is proportionate to the value of a single bilateral exposure. (c) Based on 2008 Q1 data.

8 Objective 2: System-spillover “Liquidity regulation should provide a disincentive for banks to increase liquidity risk. The disincentive should take into account the impact of liquidity risk distress at the bank on the overall financial system.” Tougher standards for large banks very active in interbank markets and as market-makers in capital markets than for small banks on system periphery Measurement and calibration (correlated tail risks, ‘Co-risk’ measures) Spillovers depend on system-wide risks

9 Objective 3: Countercyclical system-wide “Liquidity regulation should guard against the crystallisation of system-wide liquidity risk. Disincentives to contain liquidity risk should increase as system-wide liquidity risk rises.” Measures and calibration (interactions between banks and financial network) Endogeneity of market liquidity and impact on funding liquidity Market liquidity most vulnerable when it seems highest (Borio)

10 Decomposition of sterling-denominated high-yield corporate bond spreads Sources: Bloomberg, Merrill Lynch, Thomsom Datastream and Bank Calculations. (a) Webber, L and Churm, R (2007), 'Decomposing corporate bond spreads', Bank of England Quarterly Bulletin, Vol 47, No. 4, pages (b) Option-adjusted spreads over government bond yields. Vulnerability of banks to sudden reversal in market liquidity Financial market liquidity(a) Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch, Thomson Datastream and Bank calculations. (a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity measures, normalised on the period The series shown is an exponentially weighted moving average. The indicator is more reliable after 1997 as it is based on a greater number of underlying measures.

11 Indicators of system-wide liquidity risk Important area for future research: Some ideas: Banking system-wide maturity mismatch with non-banks Leverage indicators Pressures for central bank refinancing Market measures of illiquidity premia

12 Proxies for system-wide funding liquidity risk Chart 7: Illiquidity premia in sterling and US dollar-denominated corporate bond spreads(a)(b) Sources: Bloomberg, Merrill Lynch, Thomsom Datastream and Bank Calculations. (a) Webber, L and Churm, R (2007), 'Decomposing corporate bond spreads', Bank of England Quarterly Bulletin, Vol 47, No. 4, pages (b) Option-adjusted spreads over government bond yields. (c) Average of sterling and dollar IG/HY illiquidity premia, weighted by market value of bonds outstanding. UK banks' leverage ratio(a)(b) Source: Thomson Datastream, published accounts and Bank calculations. (a) Gross leverage measured by total assets divided by shareholders equity minus minority interests. (b) Due to the mergers and acquisitions of banks, the chart includes data for the bank peer group as used in ' A new peer group to analyse large UK-owned banks resilience over time', Financial Stability Review, Box 7, December 2004, page 68.

13 Objective 4: International “Regulatory standards should be applied consistently internationally, to prevent regulatory arbitrage and leakage.” Regulation developed and implemented nationally Similar high level objectives But many differences of application: –Some reflect structural differences (eg, Deposit insurance, Insolvency/Crisis resolution regimes, Central Bank frameworks) –Other do not Common metrics, benchmarks and standards Extending ‘system-wide’ approaches to take account of international ‘system’ is very challenging!

14 Objective 5: Central bank “The design and operation of central bank facilities should underpin incentives for banks to manage liquidity risk prudently, in the long-run interests not only of the banking system but of the wider economy.” No buffer proof against all events Central banks provide valuable liquidity insurance But may encourage excess risk-taking (moral hazard) Design facilities to limit moral hazard But cannot fully offset through lending terms ex-post Need for regulation to correct incentives ex ante Clear principles for public safety nets

15 Public safety nets Central bank liquidity insurance Market maker of last resort Capital provider of last resort General principles: –Avoid incentivising imprudent behaviour –Clear and time-consistent –Well-defined exit strategy (See Paul Tucker ‘The repertoire of official sector interventions in the financial system: last resort lending, market-making, and capital’ May 2009 and Bank of England Financial Stability Report June 2009)

16 Issues for further research and analysis Measuring (system-wide) liquidity risk Interconnection between market and funding liquidity Optimal form of regulatory intervention Desired level of resilience Role and design of central bank insurance Promoting international consistency given differences in drivers