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Wednesday, 24th April 2024 |
| Maturity mismatch- the new approach to liquidity management in Ireland |
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| The Financial Regulator has unveiled the new liquidity framework that will apply to Irish institutions from 2007. The new framework provides clear evidence of how dialogue between the financial services industry and the Financial Regulator can result in a solution agreeable to all parties, writes Debra Mc Carthy. |
‘Requirements for the Management of Liquidity Risk’, the regulatory document outlining the new liquidity framework, was published by the Financial Regulator in June this year. It has been a long time coming. In response to calls from the industry to review the liquidity rules in place in Ireland, the Financial Regulator issued a consultation paper in August 2004 outlining a maturity mismatch approach to liquidity management, to replace the current stock approach. In November 2005, the Financial Regulator approached Irish Bankers Federation (IBF) with a second draft. Over the subsequent six months, IBF has been in extensive dialogue with Financial Regulator regarding the new framework. This final paper is a culmination of this process.
Overview of the paper
The new liquidity framework is based on a maturity mismatch approach to liquidity management whereby institutions must analyse their cash flows under various headings and place them in pre-determined time-bands depending on when the cash is received or paid out. Assets are allocated to the relevant time-band according to their latest maturity and liabilities are allocated according the earliest possible date of obligation. There are seven time bands, ranging from sight to eight days, to over two years.
Within each time-band, the inflows are compared to the outflows and a ‘mismatch’ is recorded for each band. Liquidity limits apply to the first two time bands. In the first time-band (sight to eight days) the cash inflows plus liquid assets must be greater than or equal to 100 per cent of the cash outflows. In the second time-band (eight to 30 days), cash inflows, including any net positive cash flow carried forward from the first time-band must equal at least 90 per cent of cash outflows. Monitoring ratios will apply to the remainder of the time-bands.
The components of liquid assets have not changed substantially from the components of liquid assets under the existing stock approach. The most significant changed is that to be considered a liquid asset, the asset must be available to a credit institution within four business days. Eligibility as a liquid asset is further determined by satisfaction of the three overriding criteria set out in the paper: concentration of holdings, depth of market and risk of forced sale loss.
In addition to these quantitative requirements, the paper also introduces a number of qualitative requirements. These requirements range from the responsibilities placed on the board of directors for developing the institution’s strategy for the ongoing management of liquidity risk to the stress testing and scenario analysis to be conducted by each institution.
Comparison of consultation paper and final regulatory document
A number of significant changes have been made to the paper since the original consultation in August 2004 as a result of discussions between the industry and the Financial Regulator. The most notable changes include:
Permission to apply behavioural assumptions to retail and corporate deposits with and without a contractual maturity: In the original consultation paper, institutions were permitted to apply behavioural assumptions to certain cashflows, if these cashflows did not have a specific contractual date associated with them. These cashflows included overdraft facilities granted, credit card balances, undrawn committed facilities granted, non-government deposits, undrawn committed facilities received and certain derivative activities. The final draft of the paper has extended this feature such that institutions can also apply behavioural assumptions to retail and corporate deposits that do have a contractual date associated with them IBF had raised concerns regarding the possibility that the provisions, as they stood, could lead to banks moving away from fixed-term products.
The final paper also permits institutions to apply behavioural assumptions to mortgage-related products where the effective maturity date is different to the contractual maturity date due to prepayments. These behavioural assumptions are however subject to a haircut, the level of which has been agreed as a result of negotiations between the Financial Regulator and industry. A €1.5 million threshold is used to distinguish between retail and corporate deposits, increased from €1 million in the original consultation.
A concession from the limits of the first two time-bands for credit institutions which are subsidiaries of a large financial institution, where liquidity is managed on a centralised basis by the head office. This concession has been introduced in response to concerns raised by IBF regarding our international subsidiary members. The concession will be considered on an exceptional bilateral basis and only in circumstances where a sufficiently robust legally binding confirmation is forthcoming from the credit institution’s parent stating that the funds are available at all times to ensure the Irish credit institutions can meet the remainder of the liquidity requirements.
Introduction of the limit in the second timeband: Another significant change made to the paper is the introduction of the limit in the second timeband, such that banks’ inflows must be at least 90 per cent of its outflows within the 8-30 days timeband.
The introduction of this second limit was flagged as a possibility in the original consultation paper, but is nevertheless an unwelcome surprise in the final draft.
Increasing the scope of eligible liquid assets: A number of changes have been made to widen the scope of assets considered as eligible liquid assets. Under the original consultation paper, securities were listed as a category of liquid assets. This was, however, conditional on the security being issued by a Monetary Financial Institutions (MFI). Under the final paper, it is not a prerequisite that the security be issued by an MFI. The institution’s entire minimum reserve is also eligible. Furthermore, under the original Consultation Paper, only balances with the ECB and euro-zone national central banks were eligible as liquid assets. Under the final paper, balances with any OECD central bank are eligible as a liquid asset.
The new framework will be effective from July 2007. In the run up to the full launch, institutions will be subject to a six-month parallel run, beginning in January 2007. During the parallel run, the revised liquidity report will be prepared in parallel with the existing requirements. The 25 per cent stock requirement will be maintained during the parallel run. The maturity mismatch limits will replace the stock requirement on completion of the parallel run.
In terms of the practical implications of the paper, inter-bank lending policies are likely to change such that lending may become more short-term in nature. A similar occurrence was evident in London on introduction of the maturity mismatch approach in the UK, which saw the certificates of deposit market gain significant momentum in response to the changing environment.
The paper represents a major shift in the regulatory approach to liquidity management and with its introduction coordinated with the introduction of the Capital Requirements Directive, will pose a major challenge to banks. This being said, the new framework has come about in direct response to calls from the industry to review the liquidity rules and has benefited greatly from extensive interaction between the Financial Regulator and the industry. |
Debra Mc Carthy is an adviser in risk management and prudential supervision at the Irish Bankers Federation.
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| Article appeared in the September 2006 issue.
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