The new EU regulator and liquidity risk

The de Larosière Group published a report on EU financial supervision yesterday. 

The report covers lots of stuff about liquidity risk, regulation and supervision, including the rejection of any need for a single European regulator (ECB won’t like that one) and the strengthening of the current key authorities: CEBS, CEIOPS and CESR. These will be re-named the European Banking Authority, the European Insurance Authority and the European Securities Authority, and given new powers including:

• representation of EU interests with any discussions with non-EU countries.
• licensing and regulation of any pan-European institutions, such as credit rating agencies and post-trade infrastructures;
• interpretation authority for any EU legislation with a legal mandate as the final decision-making authority;
• a role as mediator in any disputes between national supervisors;
• an ability to challenge national supervisors’ performance; and
• a coordination role during any future crises.

There is also lots of discussion about liquidity risk and it is clear that there is still no definition of how to get liquidity risk management right.

For example, the liquidity section of the report, as discussed on page 18, states that:

“Measuring and limiting liquidity risk is crucial, but cannot be achieved merely through quantitative criteria … therefore the assets of the banking system should be examined in terms not only of their levels, but also of their quality (counterparty risk, transparency of complex instruments...) and of their maturity transformation risk (e.g. dependence on short term funding … (and) the Basel committee should in the future concentrate more on liquidity risk management.  Even though this is a very difficult task, it should come forward with a set of norms to complement the existing qualitative criteria (these norms should cover the need to maintain, given the nature of the risk portfolio, an appropriate mix of long term funding and liquid assets).”

This leads to a logical conclusion and recommendation on page 19:

“Recommendation 1: The Group sees the need for a fundamental review of the Basel II rules. The Basel Committee of Banking Supervisors should therefore be invited to urgently amend the rules with a view to:

• gradually increase minimum capital requirements;
• reduce pro-cyclicality (boom-bust cycles), by e.g. encouraging dynamic provisioning or capital buffers;
• introduce stricter rules for off-balance sheet items;
• tighten norms on liquidity management; and
• strengthen the rules for bank's internal control and risk management, notably by reinforcing the 'fit and proper' criteria for management and board members

“Furthermore, it is essential that rules are complemented by more reliance on judgement.

“Recommendation 2: In the EU a common definition of regulatory capital should be adopted clarifying whether, and if so which, hybrid instruments should be considered as tier 1 capital. This definition should be confirmed by the Basel Committee.”

There's also an amusing "disclaimer" which states that "the Members of the Group support all the recommendations.
However, they do not necessarily agree on all the detailed points made
in the report."

I bet!

The full report can be downloaded.

This is all timely as we have a debate on 10th March at the Capital Markets Chamber, the specialist group of the FSClub, as to whether the FSA’s liquidity regime is going to set the new global standard.

The debate focsuses upon this month's FSA Financial Risk Outlook, which says that: “when the crisis struck, the assumption that the markets for these [credit] instruments would remain liquid was proven wrong ... New, more effective regulations, supervisory processes, reporting requirements and internal risk management approaches are required.”

Andrew Howieson, formerly the Managing Director of Tabb Group Europe, will be debating this with Scott Eaton, who has been working with the National Bank of Australia and was previously Global Head of Principal Trading at ABN AMRO. The evening will be chaired by PJ Di Gimarrino, Chairman of the Capital Markets Chamber and CEO of JWG-IT.

Register to attend as a member or non-member if you want to come, and a big thank you to PJ for giving me the heads-up on this subject and report.