Pillar 2 liquidity

Pillar 2 liquidity

The Pillar 2 liquidity framework focuses on liquidity risks not captured, or not fully captured, under Pillar 1 requirements (the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

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The Pillar 2 liquidity framework focuses on liquidity risks not captured, or not fully captured, under Pillar 1 requirements (the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

The UK PRA outlined the objectives of its Pillar 2 framework and proposed a Statement of Policy on three specific Pillar 2 risks (intraday liquidity, debt buyback and non-margined derivatives) in a consultation paper issued in May 2016.

The PRA has now issued a second consultation paper, which sets out a cashflow mismatch risk (CFMR) framework, to:

  • assess whether a bank would have sufficient cash from the monetisation of liquid assets and other inflows to cover outflows on a daily basis, under a defined stress scenario; and
  • monitor, with daily granularity, liquidity mismatches during longer lasting and more severe stress events.

The PRA proposes to assess CFMR on both a consolidated currency and single currency basis; to introduce a new liquidity reporting template (PRA110) to monitor CFMR; and to collect the new liquidity reporting template on a weekly basis with a one-day remittance period for large banks, and on a monthly basis with a fifteen-day remittance period for small banks.

The CFMR framework focuses on four sources of liquidity risk:

  1. ‘Low point risk’ - under the LCR banks need to hold sufficient high-quality liquid assets (HQLA) to cover their cumulative liquidity needs over 30 calendar days. But a bank might not hold sufficient HQLA to cover “peak” outflows on one or more days within this 30-day period. 
  2. HQLA monetisation risk – a bank may not be able to monetise sufficient non-cash HQLA to cover cumulative net outflows under the LCR stress on a daily basis, because of limitations to the speed with which cash can be raised in the repo market or through outright sales.
  3. ‘Cliff risk’ – a bank can ‘window-dress’ its LCR by pushing maturity mismatches just beyond the 30-day horizon.
  4. FX mismatch risks – banks typically assume that currencies are fungible given the depth of liquidity in the spot FX and FX swap markets, particularly in reserve currencies. However, a bank may not be able to access FX markets as normal in times of stress.

The PRA is also consulting on its proposed approach to other types of liquidity risk not captured under Pillar 1 requirements:

  • Prime brokerage and matched book risks. The two main liquidity risks within prime brokerage relate to franchise risk (where a prime broker may roll over funding transactions at a customer’s request even in circumstances where doing so might be detrimental to the bank’s liquidity position and leave the prime broker in a position where the customer transaction is not fully covered) and internalisation (where a prime broker can internally net opposite positions from two clients on the same asset, creating a risk if one client wishes to withdraw from its transaction). 
  • Initial margin on derivatives contracts, where during a period of stress counterparties may, for a number of reasons, increase a bank’s initial margin requirements. 
  • Securities financing margin liquidity risks.
  • Intragroup liquidity risk, which can arise where entities within the same group are strongly interconnected and reliant on each other, so intragroup support may become unavailable in stress; and where liquidity may not flow freely within a group because of legal, contractual, regulatory or operational limitations.
  • Liquidity systems and controls risks. 

The PRA will set out proposals on calibration in a third consultation paper in early 2018. The implementation of the new Pillar 2 methodologies is envisaged to commence shortly thereafter.

Although UK-specific, this approach to Pillar 2 liquidity guidance may be followed by the ECB and by other national authorities.

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