FSA Chair Seeks Global Standards on Managing Liquidity Risk

In a major address to the Basel Committee on Banking Supervision, FSA Chair Callum McCarthy called for a uniform international policy on liquidity risk to provide clarity to global financial institutions and other market participants. The senior official’s remarks come as the FSA begins a broad review of its current regime for managing liquidity risk. The Basel II Accord has improved the measurement of capital adequacy, he noted, particularly in its treatment of off balance sheet vehicles. But he urged the Basel Committee to speed up its consideration of liquidity risk since, in his view, it was liquidity problems that started the present market turmoil.
Liquidity risk is the risk that a firm, although solvent in balance sheet terms, does not have enough cash to meet its payment obligations in full as they fall due. The corollary is that liquidity risk management means mitigating the risk that a financial institution is not able to do this. Managing liquidity risk is a significant issue not only for banks, but also for securities firms since they are typically active in the same money and debt securities markets as banks.

The FSA chair said all this with full knowledge of how difficult managing liquidity risk can be, involving judgments about the stresses which have to be withstood rather than the more statistical analyses which underpin capital. Grappling with liquidity risk also depends on understanding the attitude of the relevant central bank or banks as the ultimate providers of liquidity towards the eligible collateral they will accept, when policy manifestly differs between central banks and is not necessarily clear to market participants in advance.

While the FSA has begun a review aimed at changing its current liquidity risk management regime, the official emphasized that there must be more effective international action. The informal cross-border links between central banks and regulators must be strengthened.
That said, the FSA will move forward with its own initiative on managing liquidity risk. At a recent appearance before a Treasury Select Committee, the FSA committed to examine: the extent to which its framework for assessing risk within firms should place further importance on liquidity issues; the interrelationship between the UK's and other countries' liquidity risk management regimes; and the strengthening of stress-testing within firms.

Being a principles-based regulator, the FSA approaches liquidity risk from the high level principle that a firm must maintain adequate financial resources (Principle 4). Also coming into play is Principle 3, which states that a firm must implement effective risk management systems. Taken together, these two Principles mean that, in the first instance, it is the financial institutions themselves, not the regulators, that are responsible for the effective management of liquidity risk.