promontory.com InFocus January 31, 2014 Enhanced Expectations for Managing Liquidity Risk By Yoko Otani, Mark Levonian, and Stacy Coleman U.S. and international regulators are moving forward with initiatives that will require financial institutions to reconsider how they manage liquidity risk. U.S. regulators, in particular, have moved aggressively to implement new rules and to tighten supervisory expectations in ways that will compel banking companies to address fundamental aspects of liquidity risk management, including stress testing, integration with capital planning, and data collection. Yoko Otani Managing Director The Office of the Comptroller of the Currency s Jan. 16 proposal on heightened expectations for large banks covers the most recent element of the emerging regulatory regime for liquidity risk management. 1 The proposal sets forth new standards for large banks in the design and implementation of overall risk governance frameworks that must explicitly incorporate liquidity risk. Mark Levonian Managing Director and Global Head for Enterprise Economics and Risk Analysis Stacy Coleman Director Another element is the liquidity coverage ratio put forth last fall by the OCC, the Federal Reserve System, and the Federal Deposit Insurance Corp. a ratio that is more stringent in various respects than that finalized in January 2013 by the Basel Committee on Banking Supervision. 2 The proposed U.S. LCR places greater limitations on high-quality liquid assets than the Basel III LCR, and uses more conservative assumptions about cash outflows and asset and liability inflows. The proposal leaves unanswered some key questions, and hammering out the final rule is likely to take well into this year. In addition to requiring compliance by most large banking companies in the United States, the proposal would also apply to the U.S. subsidiaries of many foreign banking organizations and nonbank financial companies designated by the Financial Stability Oversight Council for Federal Reserve supervision. The LCR requirements should not be viewed as a narrow compliance exercise, but as a piece of the evolving regulatory agenda designed to promote stronger bank resilience with liquidity a key consideration. The emphasis on liquidity has reached beyond institutions explicitly covered by the U.S. LCR proposal, and is resulting in tighter monitoring of asset and liability profiles and liquidity risk management practices throughout the financial sector. The Federal Reserve s liquidity monitoring reports (FR 2052a and b 3 ) are already requiring firms, including some organizations not subject to the LCR requirements, to collect and report detailed quantitative information on selected assets, liabilities, funding activities, and contingent liabilities. Banks can expect further guidance from U.S. regulators on other important matters related to liquidity risk management, including the U.S. implementation of the net stable funding ratio and the leverage 1 See http://www.occ.gov/news-issuances/news-releases/2014/nr-occ-2014-4a.pdf 2 http://www.bis.org/publ/bcbs238.pdf and http://www.bis.org/publ/bcbs188.pdf 3 http://www.federalreserve.gov/reportforms/formsreview/fr2052a_fr2052b_20130925_omb.pdf Washington, D.C. Atlanta Brussels Denver Dubai Hong Kong London Milan New York Paris San Francisco Singapore Sydney Tokyo Toronto
ratio under the Basel III framework, monitoring tools for intraday liquidity management, and additional reporting and qualitative and quantitative disclosure standards. 4 Firms are likely to feel the pressure of enhanced expectations for liquidity risk management in three areas: liquidity stress testing; integration of capital and liquidity stress testing and planning; and the timely collection of accurate and granular data and information. Firms will be able to better develop an effective strategy to address these expectations by taking a holistic approach that requires interpreting how enhanced regulatory expectations will affect various disciplines throughout the firm, establishing appropriate governance and controls, and planning targeted information-technology upgrades. Firms that proactively develop liquidity risk management programs linked to enterprise risk management will benefit from information and reporting that more clearly illuminate key business and risk drivers. These firms will be better prepared to address emerging risk issues, business opportunities, and regulatory expectations as they continue to evolve. Liquidity Stress Testing U.S. regulators have moved forward with requirements for liquidity stress testing that are likely to place increasing demands on banks. The Federal Reserve in 2012 proposed enhanced liquidity standards that included requirements for liquidity stress tests and contingency funding plans, along with requirements for corporate governance and independent review. 5 The proposed standards built on a March 2010 interagency policy statement that included expectations for cash-flow projections, liquidity stress tests, and contingency funding plans, along with other components of strong liquidity risk management programs. 6 Though these are not new concepts or practices, regulatory expectations are clearly moving in the direction of more in-depth quantitative analysis and enhanced approaches to stress testing and incorporation of the results into the firm s risk and business practices. The Federal Reserve in late 2012 initiated the Comprehensive Liquidity Analysis and Reviews for the very largest U.S. banking organizations in an undertaking similar to the Comprehensive Capital Analysis and Review. The CLAR requirements are having a trickle-down impact on supervisory reviews of firms, and enhanced expectations for stress testing are an element of the review of recovery and resolution plans. As banks prepare for rigorous liquidity stress testing, regulators will continue to raise the bar. Firms should expect heightened supervisory expectations to include: Granular data and detailed analysis to support assumptions based on a company s business model, product mix, and customer characteristics Incorporation of secondary or systemic impacts as a result of actions a firm may take More focus on intraday liquidity needs and associated risks 4 The Basel committee on Jan. 12 released proposed revisions to the NSFR, proposed amendments to the leverage ratio, and final requirements for LCR-related disclosures. See http://www.bis.org/press/p140112b.htm; http://www.bis.org/press/p140112a.htm; and http://www.bis.org/publ/bcbs272.htm. 5 http://www.gpo.gov/fdsys/pkg/fr-2012-01-05/pdf/2011-33364.pdf 6 http://www.federalreserve.gov/boarddocs/srletters/2010/sr1006a1.pdf Promontory Sightlines InFocus January 31, 2014 2
Strong governance practices in the use of applicable data and information, including the development of key modeling assumptions that are subject to approval by senior management and the board of directors Integrating Capital and Liquidity Stress Testing and Planning Although supervisors and the financial industry conceptually agree that capital and liquidity stress testing and planning should be integrated, the modeling and other practical challenges have been substantial. Notwithstanding the challenges, supervisory interest in the topic is clear, and regulators have signaled they intend to make such expectations explicit. The Basel committee in October issued a working paper on liquidity stress testing that said separate assessments of capital and liquidity risks do not take proper account of their interaction, potentially resulting in an understated view of the company s overall risk. 7 Federal Reserve Board Governor Daniel Tarullo and other officials have articulated concerns regarding liquidity-related systemic risk, particularly with regard to short-term wholesale funding strategies, 8 with implications for linkages between liquidity and capital risk planning. Capital and liquidity are linked both conceptually and empirically, and stresses on either can lead to a damaging spiral in a crisis: Banks with impaired capital face higher funding costs and decreased access to funding sources, and higher funding costs deplete capital. 9 Integrated capital and liquidity planning and analysis will better inform ongoing business planning and strategy, including new-product assessment, portfolio rebalancing, contingency and crisis planning, and organic or acquisition-driven growth. By aligning scenarios and core assumptions such as economic variables and interest rate projections, banks can achieve some consistency across stress tests, notwithstanding the technical difficulties of explicitly linking liquidity and capital stress testing. Banks can also rationalize the data-collection process for these disciplines, reducing duplicative efforts, improving quality and governance, and easing IT burden and cost. Managing Risk Data and Information Regulators continue to push banking organizations to improve how they collect and use risk data and information, including for risk measurement and reporting purposes. 10 Dodd-Frank Act compliance has also added to data-collection demands, while the Basel Committee s LCR disclosures and the Financial Stability Board s phased introduction of the common data template could significantly increase data reporting burdens especially for global systemically important banks and other large internationally active banks. The data is frequently similar, even when gathered and used for different purposes. Data requirements may overlap but not fully align, and differing uses will influence the design of data and systems. 7 https://www.bis.org/publ/bcbs_wp24.pdf 8 http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.pdf and http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.pdf 9 http://www.promontory.com/news.aspx?id=2952 10 http://www.bis.org/publ/bcbs239.pdf; see also http://www.promontory.com/news.aspx?id=3031 Promontory Sightlines InFocus January 31, 2014 3
For example, calculating the proposed LCR is likely to present data and information challenges for many firms, including: Collecting and aggregating granular data for a wide variety of assets and liabilities, and by counterparties or currencies Generating historic time-series data for inflows and outflows associated with many types of assets and liabilities Accessing and using information relating to the contractual terms of assets and liabilities and to the transferability across jurisdictions that some LCR calculations require Identifying and excluding intracompany transactions, including transactions between subsidiaries Ensuring consistency in the data and information used for the LCR calculation with those used for other risk management and business reporting purposes. The Intensifying Focus on Liquidity Risk Management Promontory Sightlines InFocus January 31, 2014 4
Banks will face many of these same challenges in complying with the reporting requirements of the Federal Reserve s new FR 2052, which builds on existing liquidity reporting but adds new requirements and covers additional organizations. The challenge is for firms to address data requirements within an integrated strategic framework and architecture. Critical liquidity data and information are frequently spread throughout multiple IT platforms and may not be defined consistently, making it difficult to compile or aggregate data. Many constituencies throughout the company may have an interest in the data, but it is often unclear who owns the data and should manage it for risk purposes. Employees with the technical knowledge to access systems frequently lack a substantive understanding of the data and information that they are compiling. Conclusion Addressing evolving requirements in liquidity risk management will be challenging and will compete with other demands for firm resources. However, by addressing specific requirements through a cohesive approach to managing risk, firms will be better positioned to deploy the necessary resources and realize strategic benefits in addition to meeting regulatory expectations. About the Authors Yoko Otani is a managing director at Promontory and advises clients on risk and compliance matters, including asset-liability and liquidity risk management issues, and helps integrate strategic and regulatory objectives. Mark Levonian is Promontory s global head for enterprise economics and risk analysis, and assists clients with quantitative strategy and compliance matters, including risk quantification, model validation, stress testing, liquidity standards, and capital planning. Stacy Coleman is a director at Promontory, and assists clients on a variety of regulatory and supervisory issues, drawing on her expertise in policy analysis, development, and implementation. Damon Palmer and Eric Schwartz contributed to this article. Promontory Sightlines InFocus January 31, 2014 5
Contact Promontory For more information, please call or email your usual Promontory contact, or: Stacy Coleman Director, Washington, D.C. scoleman@promontory.com +1 202 384 1196 Kathy Dick Managing Director, Washington, D.C. kdick@promontory.com +1 202 384 1092 Erik Larson Managing Director and Global Head for Quantitative Methodologies and Analytics, Washington, D.C. elarson@promontory.com +1 202 384 1200 Mark Levonian Managing Director and Global Head for Enterprise Economics and Risk Analysis, Washington, D.C. mlevonian@promontory.com +1 202 370 0422 Yoko Otani Managing Director, New York yotani@promontory.com +1 212 542 6744 Bill Rutledge Managing Director, New York wrutledge@promontory.com +1 212 365 6984 Eric Schwartz Director, Washington, D.C. eschwartz@promontory.com +1 202 384 1090 To subscribe to Promontory s publications, please visit promontory.com/subscribe.aspx Follow Promontory on Twitter @PromontoryFG Promontory Sightlines InFocus January 31, 2014 6
Global Offices Atlanta Midtown Proscenium Center 1170 Peachtree Street, Suite 1200 Atlanta, GA 30309 +1 404 885 5741 Brussels Promontory Financial Group Brussels Branch Square de Meeûs 35 1000 Brussels, Belgium +32 2 893 97 61 Denver 1999 Broadway, Suite 1800 Denver, CO 80202 +1 720 612 5000 Dubai Promontory Financial Group, LLC Emaar Square Building 4, Office 204 Sheikh Zayed Road P.O. Box 53854 Dubai, UAE +971 4 445 15 55 Hong Kong Promontory Financial Group China Ltd Level 10, Central Building 1-3 Pedder Street Central, Hong Kong SAR, China +852 3975 2901 London Promontory Financial Group UK Ltd 2nd Floor, 30 Old Broad Street London, UK EC2N 1HT +44 20 7997 3400 Milan Promontory Financial Group Italy S.r.l. Via Alessandro Manzoni, 3 20121 Milan, Italy +39 02 7262 2100 New York 280 Park Avenue, 40th Floor West New York, NY 10017 +1 212 365 6565 Paris Promontory Financial Group France SAS 28 Boulevard Haussmann 75009 Paris, France +33 1 44 79 17 20 San Francisco Spear Tower, Suite 4100 1 Market Plaza San Francisco, CA 94105 +1 415 986 4660 Singapore Promontory Financial Group Australasia, LLP 260 Orchard Road #19-01 The Heeren Singapore 238855 +65 6410 0900 Sydney Promontory Australasia Sydney Pty Ltd Level 32, 1 Market Street Sydney, NSW 2000, Australia +61 2 9275 8833 Tokyo Promontory Financial Group Global Services Japan, LLC Teikoku Hotel Tower 9F 1-1-1, Uchisaiwaicho Chiyoda-ku, Tokyo 100-0011, Japan +81 3 3519 1400 Toronto Promontory Financial Group Canada ULC TD Centre, P.O. Box 326 77 King Street West, Suite 3720 Toronto, Ontario M5K 1K7, Canada +1 416 863 8500 Washington, D.C. 801 17th Street, NW, Suite 1100 Washington, DC 20006 +1 202 384 1200 Promontory is a leading strategy, risk management, and regulatory compliance consulting firm for the financial services industry. Promontory s professionals have deep and varied expertise gained through decades of experience as senior leaders of regulatory bodies and financial institutions. Promontory assists clients in meeting regulatory requirements and in enhancing governance, risk management, strategic plans, and compliance programs. Promontory Financial Group, LLC 801 17th Street, NW, Suite 1100, Washington, DC 20006 Telephone +1 202 384 1200 Fax +1 202 783 2924 promontory.com 2014 Promontory Financial Group, LLC. All Rights Reserved. Promontory Sightlines InFocus January 31, 2014 7