Liquidity Risk Regulations - Establishing the Foundation for Global Collaboration

Toronto/London - December 18, 2007 -

Central banks and other regulatory supervisors could ensure a safer financial climate by establishing more thorough requirements regarding capital and liquid assets as a basic way to ensure a safer financial climate. The recent co-ordinated effort to support the global money markets with the injection of $100 billion provides an indication that such an initiative may be considered. In particular, a more extensive endorsement of quantitative instruments for measuring liquidity risk would contribute to market stability

Those are the key conclusions of a White Paper published today by Algorithmics.

The paper notes that within the Basel II framework, liquidity risk appears under Pillar 2 - which means that banks are not subject to a formal capital requirement in connection with their exposure to liquidity risk. And although it is expressly mentioned within the Internal Capital Adequacy Assessment Process, no indication is provided regarding the quantitative methods to be used for measuring the amount of capital to be maintained in connection with liquidity risk exposure.

In addition, there is a lack of harmony amongst regulators and risk management experts regarding the optimal way to handle liquidity risk.

These two facts, among others, mean that regulatory requirements on liquidity risk are non-uniform across countries, which can only add to potential global volatility in the financial markets.

To illustrate the state of liquidity risk regulations globally, the researchers examined the current state of liquidity risk regulations in eight major jurisdictions: US, UK, Spain, Germany, Italy, Singapore, France and Japan, highlighting differences and similarities among varying approaches and assessing their relative effectiveness in controlling liquidity risk at the systemic level.

Dr. Mario Onorato, Director of Enterprise Value Based Management at Algorithmics, said, 'One of the most conspicuous differences is that some supervisors rely solely on qualitative requirements, while others also impose quantitative constraints, although none of the supervisors rely exclusively on a quantitative approach. Even those that do have quantitative constraints, use traditional cash flow maturity ladders or other simple indicators. Very little mention is made of probabilistic quantitative frameworks for liquidity risk management, such as those used for market or credit risk.'

The paper notes that the need for change is already being recognised. In its survey on EU banking structures published in October 2007, the European Central Bank pointed to the possibility of significant future revisions in EU supervisory regulations for liquidity risk. In addition, the Financial Stability Forum has suggested that there is a need to consider whether recent events call for some refinements of Basel II and a greater focus on liquidity risk.

Amongst other things, the underlying factors which Algorithmics' believes should be critical for an effective approach to liquidity risk management goals are:

Inherent systemic risk - Recognising that there is little an individual firm can do in the event of a global credit crunch, although for non-extreme circumstances, maintaining a prudential level of liquid assets is a basic way to reduce its liquidity risk.

Constraints on Central Bank influence - The responsibility for managing systemic liquidity risk and overall market stability lies with central banks. However, unilateral action by an individual central bank has only a limited ability to effectively impact financial markets in reaction to unexpected events and central banks must therefore concentrate on co-ordination and making unexpected adverse events as unlikely as possible.

Potential Volatility of Available Credit - This is an important liquidity risk indicator at the system level. From a central bank's point of view, an increase in potential volatility entails an increase in systemic liquidity risks and therefore requires improvement of tools and practices for market control and risk awareness. In recent years, the significant increase in the potential volatility of available credit arose from factors ultimately linked to financial innovation. The increase in liquidity risk was widely underestimated, both by market institutions and the central banks.

Dr. Onorato continued, 'As a result of this study of the existing regulatory regimes and the way the liquidity crisis developed in 2007, we are making two recommendations to improve liquidity risk management in the future.

'First, it appears that a more extensive endorsement of quantitative instruments for liquidity risk management, particularly stochastic scenario-based frameworks linked to evolving business strategies, would contribute to market stability by providing a more comprehensive awareness of risks, earlier detection of warning signals and better ability to detect connections between phenomena in different financial instruments and sections of the economy.

'Secondly, we believe that central banks and other supervisors could take the initiative in establishing more rigorous requirements for capital and liquid assets as a basic way to ensure a safer financial climate. For example, regulatory requirements in general may benefit from a stronger emphasis on the availability of adequate liquidity sources as protection against stress scenarios. It may also be consistent to expect that banks with a sounder liquidity structure, steadier funding sources, or greater business diversification, might be granted a lower capital requirement.

'We believe these could provide important first steps toward greater harmony among international regulatory entities and financial institutions as to what constitutes the most effective protection against liquidity events both locally and throughout the global economic environment.'

'Liquidity Risk: Comparing Regulations Across Jurisdictions and the Role of Central Banks', by Fabio Battaglia and Dr Mario Onorato www.algorithmics.com/EN/publications/whitepapers/1207/WhitePaper1207.cfm

Notes to Editors:

Algorithmics is the world's leading provider of enterprise risk solutions. Financial organizations from around the world use Algorithmics' software, analytics and advisory services to help them make risk-aware business decisions, maximize shareholder value, and meet regulatory requirements. Supported by a global team of risk experts based in all major financial centers, Algorithmics offers proven, award-winning solutions for market, credit and operational risk, as well as collateral and capital management. Algorithmics is a member of the Fitch Group.

Algo ALM provides a comprehensive assessment of earning sensitivity and future market valuation using a dynamically modeled balance sheet. Earnings and value are supported by a single, integrated and analytical framework with common scenarios, growth and reinvestment assumptions, as well as common cash flow generation and valuation models.

Balance sheet professionals can aggregate, measure, monitor and restructure the market and liquidity risk of the balance sheet according to their specific needs through Algo ALM. In addition to satisfying the liquidity risk and interest rate risk in the banking book requirements of Basel ll, Algo ALM supports:

  • a full range of assets, liabilities and off balance sheet instruments;
  • flexible facilities to chart accounts as well as group and consolidate transactions;
  • traditional ALM analytic tools and reports including static and dynamic interest rate and liquidity gap reports, beta and shift gap reports and duration and convexity reports;
  • advanced analytic tools including dynamic balance sheet income simulation, full liquidity and funding risk analysis, VaR and market value sensitivity analysis;
  • a patented scenario-based optimizer to assess the trade-off between earnings and values;
  • a comprehensive EaR framework, which includes the assessment of losses from credit events.

Fitch Group is the parent company of Fitch Ratings, a global rating agency dedicated to providing the world's credit markets with independent and prospective credit opinions, research and data. The Fitch Group also includes Derivative Fitch, an independent provider of a suite of ratings and comprehensive services for the credit derivatives market; Algorithmics, the world's leading provider of enterprise risk solutions; and Fitch Training, which offers high-quality analytical training for financial professionals. The Fitch Group is a majority-owned subsidiary of Fimalac, S.A., headquartered in Paris, France. For additional information, please visit www.fitchratings.com; www.algorithmics.com; www.fitchtraining.com; and www.fimalac.com.

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