Are UK Regulators Missing the Boat?

This article draws on the convergence of both external and internal drivers behind strengthening liquidity and funding regimes within financial institutions. While noting the irony of timing (with regard to the economic cycle), it welcomes the increased scrutiny given the genesis of the ‘credit crunch’ in poor cash management.¹ However, it observes that the recent UK Financial Services Authority (FSA) Consultation Papers on Liquidity and Funding² do not address the critical issue of how funds are managed internally. It argues that banks can gain competitive advantage if their ‘internal funding frameworks’ are operated effectively.

It is common to seek to strengthen external regulation during a crisis, but this is a time when it is least needed and effective.³ Banks are all too keen to retrench to ultra-conservative lending practices during economic downturn, and do not need any encouragement or intervention to do so. It is this risk aversion in a falling market, as has been well documented, which exacerbates the impact of the ‘credit crunch’. The need for tighter supervision is at its greatest at the top of a bull market when lending and allocation decisions are looser.

By the same token, organisations are less likely to address internal processing inefficiencies when funds are flush and revenues growing, when in fact the cost and opportunity to implement such efficiency gains are at their most benign. A rising cost:income ratio is one of the first signs that the economic cycle for an institution has turned, by which time it is too late to instigate effective cost reduction strategies (large scale redundancy notwithstanding).

So, just as we are now witnessing a steady flow of supervisory proposals addressing the twin tenets of financial health and stability in the banking world – solvency and liquidity – we are also seeing banks fight rearguard actions to address shortfalls in their capital adequacy and liquidity assessment capabilities. All of this comes at a time of severe economic contraction and rock-bottom consumer and capital market confidence.

Liquidity and Funding

It is in the areas of liquidity and funding risk management (part of treasury risk management) where an external/internal dichotomy can be seen to be in play.

The management of liquidity risk, defined as the risk of being unable to raise funds to meet payment obligations as they fall due, and to fund increases in assets,⁴ and funding risk – the risk of being unable to borrow funds in the market – is the current focus of three separate consultation papers issued in the past six months by the UK regulator, the FSA.

The move towards prescriptive (rather than principles-based) regulation that characterises capital adequacy compliance under Basel 2 would appear also to be crystallised in these nascent rulebooks, as is the emphasis not just on searching reporting and disclosure requirements but on the mechanisms in place to compute that data. In adding the methods to produce, collate, aggregate and transform cash flow data, as well as the policies that govern these processes, into the remit of these new regimes, the regulator is setting an Individual Liquidity Adequacy Standard (ILAS) against which organisations are assessed (through an ILAA – Individual Liquidity Adequacy Assessment) which is analogous (in form at least) to the Capital Adequacy assessment of Pillar 2 of the Basel 2 Accord.

The prescribed mechanism to manage and mitigate liquidity and funding risk – including in the case of the latter, funding, the risks related to wholesale and retail liabilities, inadequate diversification and asset marketability, inter alia – is notable for its focus on, in the main, the type, tenor, source and availability of funding, exercised in normal and stressed market conditions.

With asset liability horror stories such as Bradford and Bingley building society and Northern Rock, episodes that catapulted the financial crisis into the public domain, it is perhaps not surprising that there is a strong emphasis on the extraneous considerations to funding. The use of that funding (i.e. the internal funding framework, including the price at which cash is internally transferred) within organisations, however is less resolutely scrutinised .

Internal Funding Framework

While the relevant consultation paper in question (CP 08/22) does touch on banks’ internal liquidity pricing, this remains peripheral. A consideration of the pricing of funding liquidity in the business decisions driving sales, i.e. asset accumulation, specifically across the ‘product pricing’, ‘approval process for new products’ and ‘performance measurement’ policies within organisations,⁵ albeit ‘explicitly and clearly’, it does not fully exploit the opportunity for firms to develop a comprehensive framework for internal funding.

Just as capital allocation decisions affecting front office business units need to account for the cost of that capital (in terms of return on regulatory and economic capital), so funding decisions exercised by corporate treasurers carry significant implications for sales and trading teams at the coal face.

It is crucial that the price at which cash is internally transferred within institutions reflects the true economic cost of cash (at each maturity band), thereby aligning commercial propensity to maximise profit with the correct maturity profile of associated funding. Any mismatch, or ‘haircut’, after taking into account the ‘repoability’ of each asset class in question, should be highlighted and acted upon as a matter of priority with the objective to reduce recourse to short term, passive funding as much as possible.

Joined-up thinking between controlling and front office departments needs to include the view from operations as well, where funding projection and cash management teams work to ensure the institution carries a flat cash position at the end of the trading cycle.⁶ The need for greater cohesion, perhaps even centralisation, to enforce greater collaboration between these groups becomes compelling given the impact of any disparity between perceived and actual views of the world on lost opportunity and direct interest rate costs.

It is vital that the internal funding framework is transparent to all trading groups, and is supported by effective processes and technology – for example timely data transfer between front and settlement systems, and from external correspondent/agent banks, that must be underpinned by cash flow information that is sourced from the general ledger.

With the cost of inter-bank lending still touching record highs, allied to the size (notwithstanding recent disposals) of the balance sheets of the major banks (that are in excess of US$1 trillion), a slip of a single basis point in funding efficiency can lead to millions being wiped off the bottom line.

Conclusion

As organisations size up the cost of compliance with the current regulatory soup being served up by the FSA, it may be worth them looking beyond the literal scope of the new supervisory fiat to consider the internal determinants of an efficient, cost effective funding regime. In this way they can move towards the heart of this proposition – to embed funding into the corporate DNA of financial institutions.

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