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European banking regulators focus on liquidity stress testing
European banking regulators focus on liquidity...
In recent weeks, the European Central Bank (ECB) has been made it clear that the 2016 Internal Liquidity Adequacy Assessment Process (ILAAP) responses did not meet their expectations. There have been significant efforts from regulators to harmonise and improve the transparency of ICAAPs and capital management processes and it is reasonable to expect that harmonisation of liquidity stress tests will be high on the agenda of the ECB throughout 2017.
Following the financial crisis, liquidity risk management was highlighted as a critical requirement for safeguarding the stability of banks and the wider economy.
The Basel Committee on Banking Supervision acted to issue Principles for sound liquidity risk management and supervision in 2008 and market participants rapidly developed liquidity risk management frameworks in order to navigate volatile and fragmented markets. Local regulators front-ran EU-wide regulation, not least as demonstrated in the UK with Individual Liquidity Adequacy Standards and by German and Dutch regulators with similar regimes. The most tangible effect of this has been the holding of higher values of liquid asset buffers to protect against stressed outflows of short term liabilities.
The Internal Liquidity Adequacy Assessment Process (ILAAP)
In recent years, there have been significant efforts from regulators to harmonize and improve the transparency of ICAAPs and capital management processes through public stress tests and it is reasonable to expect that harmonization of liquidity stress tests will be high on the agenda of the ECB throughout 2017.
This is the first full year that Eurozone banks have had to comply with the Liquidity Coverage Ratio and the associated requirements for conducting and documenting the Internal Liquidity Adequacy Assessment Processes.
As part of the Single Supervisory Mechanism (SSM), the first full review of these documents has been completed by the ECB, serving as the first in depth, cross-jurisdictional analysis of firm’s liquidity risk management frameworks. The ECB has clearly signaled that ILAAPs are not currently meeting the expectations of the SSM, which mirrors initial feedback issued by the ECB in January 2016. Armin Leistenschneider from the ECB recently said that “stress tests should be considered as an essential tool for banks as part of their own risk management” and that “this year was a trial – next year, we will become more interested”.
Key issues for firms include:
- The significant challenge of calibrating stress tests to remain relevant in rapidly evolving market environments. With the onset of the financial crisis almost a decade ago, over-reliance on outflows and market behavior of this period is not always appropriate.
- Firms have made significant steps in quantifying risk appetite and consequently holding higher-levels and more risk sensitive buffers. However, we continue to see challenge as to whether the Board always fully understands the nature and scale of the stress test that is ultimately driving this.
- Intraday liquidity management and effective Early Warning Indicators both require good quality data to allow the business to input into risk management decisions.
Impact of non-compliance
Central banks and regulators have taken steps to ease liquidity in financial markets over recent years. However, we have also seen that regulators have been prepared to be intrusive or punitive in their supervision of firms where they are considered not to have sufficient liquidity risk management processes. This can limit business opportunities and create significant drag on earnings.
Looking ahead to 2017
The ECB has made it clear that the 2016 ILAAPs did not meet their expectations. We therefore believe that banks should be working now to ensure that they have liquidity risk strategies that are proportionate to their business, compliant with regulatory requirements and critically provide value to the firm in mitigating future stresses and informing investment decisions. Firms need to address these weaknesses for 2017 or run the risk of additional scalars and/or add-ons.
