SEC Chair Christopher Cox has praised the decision by the Basel Committee on Banking Supervision to update its guidance on liquidity risk management at financial institutions. In a letter to Basel Chair Nout Wellink, he also described how the SEC staff evaluates liquidity risk management at the financial institutions the Commission regulates under its consolidated supervised entity regime. Mr. Cox further assured the Basel chief that, when broker-dealer holding companies and their affiliates elect to be subject to group-wide SEC supervision, they must compute on a monthly basis their group-wide capital in accordance with the Basel standards. Specifically regarding Bear Stearns, the SEC chair assured Basel that Bear Stearns' registered broker-dealers were comfortably in compliance with the SEC's net capital requirements, and, in addition, that the firm’s capital exceeded relevant supervisory standards at the holding company level.
The job of liquidity risk management is to ensure a financial institution’s ability to fund increases in assets and meet obligations as they come due. The market turmoil that began in mid-2007 highlighted the crucial importance of market liquidity to the banking sector. The contraction of liquidity in certain structured securities product, as well as an increased probability of off-balance sheet commitments coming onto banks’ balance sheets, led to severe funding liquidity strains for some bank, which required central bank intervention in some cases.
With the increasing securitization of assets and the explosive growth of complex derivatives, the Basel Committee decided to update its guidance for managing liquidity risk, with proposed new standards expected in July. Mr. Wellink recently emphasized the need to enhance the overall governance of liquidity risk management, integrating it more closely with other risk management disciplines. Also, liquidity stress testing practices must be enhanced, including the capture of off-balance sheet contingent exposures. And Basel is focused on the importance of firms having in place rigorous contingency funding plans that reflect the possibility of major funding sources drying up for long periods of time.
In his letter to the committee, Chairman Cox explained how liquidity risk management functions under the SEC’s consolidated supervised entity regime. The holding company must periodically provide the Commission with extensive information regarding its capital and risk exposures, including market and credit risk exposures, as well as an analysis of its liquidity risk.
With respect to computing capital at the holding company level, CSEs are expected to maintain an overall Basel capital ratio at the consolidated holding company level of not less than the Federal Reserve Bank's 10 per cent well-capitalized standard for bank holding companies. CSEs provide monthly Basel capital computations to the SEC. The CSE rules also provide that an early warning notice must be filed with the SEC in the event that certain minimum thresholds, including the 10 per cent capital ratio, are breached or are likely to be breached.
The SEC considers liquidity risk management to be of critical importance to broker-dealer holding companies, said Chairman Cox. Due to the importance of liquidity to the firms, CSEs have adopted funding procedures designed to ensure that the holding company has sufficient stand-alone liquidity and sufficient financial resources to meet its expected cash outflows in a stressed liquidity environment where access to unsecured funding is not available for a period of at least one year.
In evaluating the liquidity risk management processes at a CSE, the SEC staff considers not only capital but also the assets supported by the capital. Applying such a liquidity standard alongside a capital standard is critical to the effective supervision of a CSE. To assess the adequacy of liquid assets, the SEC staff takes a scenario-based approach. The CSEs have developed a set of scenarios for use internally in assessing liquidity. A key assumption underlying the scenario analysis is that during a liquidity stress event, the holding company would not receive additional unsecured funding but would need to retire maturing unsecured obligations.
Further, firms generally assume that during a liquidity crisis, assets would not be sold to generate cash. Another premise of this liquidity planning is that any assets held in a regulated entity are unavailable for use outside of the entity to deal with weakness elsewhere in the holding company structure, based on the assumption that during the stress event, including a tightening of market liquidity, regulators in the US and relevant foreign jurisdictions would not permit a withdrawal of capital. There are also considerations as to the degree a firm relies on overnight and other short-term funding versus long-term funding.