The paper draws some early lessons from recent market turbulence, suggests how future liquidity policy should develop, and sets out key issues for discussion with the banking industry and other stakeholders.
The FSA's preliminary conclusions are that a principles-based approach is right, but that the application of existing high-level standards needs to be toughened and some form of quantitative liquidity requirements remains necessary. The DP re-emphasises the primary responsibility of firms' boards and management for maintaining adequate liquidity and managing their liquidity risk. It also looks at the market failure and cost-benefit issues involved.
Acting managing director of wholesale markets, FSA, Thomas Huertas said: "Assuring adequate liquidity at all times is critical for a bank, and in this paper we recommend that banks take a belt and braces approach. The 'belt' is a comprehensive view of all the demands for funds that a bank could face as well as a plan to meet those demands. The 'braces' are a quantity of cash or assets that can be turned into cash at short notice even under stressed market conditions.
"This paper draws important lessons from how we saw banks and building societies coping with the recent market turbulence. We also analyse the liquidity risks inherent in some of the newer structures such as SIVs, and other off balance sheet or contingent arrangements. Nor is it a one-sided review – we also challenge our own existing policies, as well as firms' liquidity management.
"We already know, following the events of the late summer, that individual firms' stress testing and contingency funding plans need improvement, and our ongoing supervision is addressing this. Banks and building societies need to achieve a higher level of resilience to funding stress.
"But we also want to have a constructive and intelligent debate with the industry about how - in the longer term - liquidity requirements can best, and most cost-effectively, achieve our objectives of consumer protection and market confidence."
The DP delivers on a commitment in the Chancellor's statement of 11 October. The closing date for responses is 31 March 2008. The DP will be followed up with consultation on firmer proposals next summer.
The FSA intends to develop UK policy in line with international work being undertaken by the Basel Committee and the Committee of European Banking Supervisors (CEBS).
