By Wissam El-Zeenni, Product Manager, AxiomSL EMEA
25 June 2018
The financial crisis was, in effect, a crisis of liquidity: huge flaws in the financial system were exposed and so liquidity all but dried out. In the years following, regulators have sought to embed tests and requirements in the financial sector that enable them to foresee any repetition of those events.
One such directive from the EU is the Capital Requirements Directive IV (CRD IV), which has applied to member states since 2014. This directive is central to regulatory efforts to limit the risk of another financial crisis, as it seeks to regulate the amount of high-quality liquid assets (HQLA) held by banks, building societies and investment firms, enabling them to meet any unexpected, short-term obligations. Through CRD IV’s Liquidity Coverage Ratio (LCR), regulators test whether these financial institutions hold enough readily available assets to cover sudden net cash outflows over a 30-day stress period. While this is an EU directive, it derives from the first pillar (or ‘Pillar 1’) of the Basel Committee’s recommendations for liquidity risk management as stipulated in Basel III.
With this European directive in place, it is the responsibility of national regulators in member states to transpose these laws into their respective statute books. In the UK specifically, it is the Prudential Regulation Authority (PRA) that is responsible for the regulation and supervision of financial institutions, including the financial sector’s adherence to the LCR under its Pillar 1 regime. In recent months, the PRA published a Policy Statement which sets out the final rules for the UK’s cashflow mismatch risk framework (CFMR), following the outlining of its Pillar 2 objectives (the pillar of Basel II which seeks to provide regulators with enhanced supervisory tools) and a round of two consultation papers. This new framework aims to complement the PRA’s Pillar 1 regime by focusing on liquidity risks not fully captured under Pillar 1. The new framework, known as the PRA110, particularly intends to address a range of risk types, such as high quality liquid assets (HQLA) monetisation risk and foreign exchange (FX) mismatch risk.
This Policy Statement also set out the delay of the PRA110’s reporting template, which will now be in place from July 2019 rather than January 2019. This delay, however, should not be seen as a sign to put off PRA110 compliance, as these requirements widen the scope of reporting for many institutions and so will require thorough preparation. Moreover, the PRA110 sets out different reporting frequencies based on a firm’s assets: firms with total assets of €30 billion or above will be required to submit their PRA110 template weekly with a one-day remittance period, while smaller institutions will be expected to submit the template monthly with a fifteen-day remittance period.
Similarly, there are three key updates to the templates used for LCR compliance that will require due care and attention. Firstly, new rows have been added to align with the LCR so the template is now more granular. Secondly, new sections have been added to address the risks which Pillar 1 regime do not cover, such as HQLA monetisation and FX mismatch risk. And thirdly, 92 days of daily maturity bucketing granularity has been added. Overall, PRA110 takes the 30-day stress testing aspect of the LCR and almost turns it into an enhanced daily compliance metric.
Overall, with nearly 260 rows by 112 columns totalling up to around 29,000 data points, the PRA110 compliance effort is not to be underestimated. This extreme granularity is the utmost challenge presented by the regime, which raises the question of whether firms have the systems and processes in place that can handle the data collection and submission requirements, especially if the PRA begins to request them daily.
From a practical perspective, many banks are likely to struggle to meet the requirement if they have separate systems for regulatory compliance and internal risk management. The key is to align these two systems without disruption and with a single solution for end to end risk management and reporting, defined by its ease of use as well as a robust, flexible infrastructure that can adapt to any future updates as well.
While the PRA110 delay should not allow for complacency, it should certainly be seen as an opportunity. Institutions now need to ensure their PRA110 systems are all fully functional well in advance. For example, data will need to be reconciled with Pillar 1 metrics, and it will be critical for institutions to run the new and the old templates in parallel before the old template is phased out.
Furthermore, the entire process will need to be traceable and auditable to enable regulators to have full transparency over the data. This approach will also allow financial institutions to explain how their results are produced, where their data originated from, and how the data has transformed over the liquidity reporting process.
In many ways, PRA110 has all the hallmark features of a post-crisis regulation. It increases the quantity and complexity of data that has to be submitted to regulators. It is derived from a global initiative – the Basel rules – as well as a European directive before being transposed into UK law. It has even been delayed. But most importantly, it aims to prevent a repetition of the shortage of liquidity that defined the global financial crisis.
With this in mind, it seems possible that preparations for PRA110 could follow a similar path to other regulations, such as MiFID II, which required a very last minute rush for some industry participants to be compliant. But this does not have to be the case. In fact, despite the six-month delay to PRA110, the complexities of this regulation mean that the time to tackle the substantial challenges presented by this new regime is already here.
As featured in TabbFORUM.