Feb 25 2008 Peter Elstob
Some national supervisors faced "considerable industry resistance" to their attempts to persuade banks and firms to carry out more rigorous and comprehensive stress testing in the lead-up to last summer's market turmoil. Liquidity experts at the Basel Committee on Banking Supervision said last week that market participants were also insufficiently prepared for the global financial shock that ensued.
Summarising (PDF) the key findings of its Working Group on Liquidity, the committee said that, in most cases, banks' stress testing, aimed at identifying potential weaknesses and vulnerabilities in firms' liquidity positions, had focused on "idiosyncratic or firm-specific shocks".
But the recent turmoil had demonstrated that stress tests should also capture the implications of wider disruptions, such as market-wide events and events that affect several markets or currencies simultaneously. The working group said that stress tests should also address "the combination of idiosyncratic and market-wide shocks which incorporate the behavioural responses of other affected banks".
A further weakness in banks' planning that the working group identified was insufficient integration between stress tests and contingency funding plans. They had, for example, been overly optimistic about the market liquidity of mortgage-backed products and asset-backed commercial paper, raising the question of which assets banks could rely on as consistent liquidity backstops. Banks' stress tests had also underestimated the risks of extending liquidity support to their conduits and off-balance-sheet vehicles.
The working group highlighted the diversity of national liquidity supervision regimes. "In some jurisdictions, different rules are implemented for large and small banks. For example, in some countries the regime embodies a more sophisticated approach for certain banks (where more flexibility is granted to the institution to use internal modelling methods), and a more prescriptive approach principally designed for smaller banks. In another style of regime, the larger banks are required to hold a large buffer of liquid assets compared to smaller banks, reflecting their systemic importance. One important differentiating factor across regimes is the extent to which supervisors prescribe detailed limits on liquidity risk and insurance that banks should hold."
Diversity problems
Simon Hills, of the British Bankers' Association, told Complinet that this diversity in liquidity regimes caused problems for BBA members that operated across international borders. The BBA therefore encouraged the Basel Committee to take forward work on the cross-border supervision of liquidity and crisis resolution.
John Tattersall, head of PricewaterhouseCoopers' financial services regulatory practice, told Complinet that the working group's findings served to highlight the difficulties in achieving a harmonised approach to the supervision of liquidity risk between supervisors, given the diversity of approaches that they currently took and their differing objectives.
"However, its analysis of recent changes in the market and their impact on the management of liquidity risk is valuable, and also gives an indication of the likely changes to the Basel 'Sound Practices for Managing Liquidity Risk in Banking Organisations' later this year, which institutions will ignore at their peril," Tattersall said.
The working group undertook to update the Basel Committee's February 2000 "Sound Practices for Managing Liquidity in Banking Organisations" (PDF) in the light of the liquidity crisis, focusing on:
The working group comprises the supervisory authorities of the 13 members of the Basel Committee (G10 plus Switzerland, Luxembourg and Spain), together with Australia, China, Hong Kong and Singapore.
