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CEBS Produces Advisory Paper on Liquidity Cost Benefit Allocation to Support New Risk Requirements

In order to assist the European financial services community in its attempts to improve liquidity risk management, the Committee of European Banking Supervisors (CEBS) has published a new consultation paper on how to go about producing an effective allocation mechanism for liquidity costs, benefits and risks, CP36. The recommendations are aimed at providing firms with a framework upon which to build internal pricing mechanisms to price liquidity risk and to align liquidity risk management culture across their organisation via suitable incentives, which are likely to include significant data gathering and technology requirements.

The European level regulator expects its individual regulator members to transpose the guidelines in CP36 into their national regulations and apply them by 30 March 2011 at the latest, although it recommends the implementation should be phased and applied with “sufficient flexibility”. The guidelines are not specific on technology implementations but the requirement to accurately capture the cost of liquidity risk and to track whether individuals are in compliance with liquidity risk requirements will involve a degree of investment to this end.

“The objective of these guidelines is to provide high level guidance to institutions on the elements to be considered when creating or reviewing adequate liquidity cost benefit allocation mechanisms. These guidelines target a liquidity cost concept that includes not only direct funding costs but also associated indirect costs such as liquidity contingency support,” states CP36.

According to CEBS, the starting point for developing a liquidity cost benefit allocation mechanism is an institution’s fund transfer pricing (FTP) system, which are used to price lending or to calculate the correct net interest income component of profitability for business units, products, and customers. These FTP systems have primarily been management accounting systems used for the purposes of budgeting, profit planning and asset and liability management, however, CEBS suggests that these should be altered to take into account liquidity risk.

“The prices derived from the proposed liquidity cost benefit allocation mechanism although market based are likely to have a wider information content than traditional management accounting figures,” notes the CEBS paper, thus highlighted the scale of the data challenge.

The regulator stresses the importance of transparency and consistency in the pricing process (much the same as for other areas) and that “all relevant management levels” should have access to the data. This suggests that a centralised data repository of this data should be maintained for regular access by downstream users in order to foster a “comprehensive approach”, as the CP36 states. It also discusses the need for an “appropriate level of granularity” of this internal pricing data across a wide range of data sets: “all significant parts of assets, liabilities and off-balance sheet items regarding liquidity”. A significant task indeed.

In designing the allocation mechanism a number of factors should be taken into account, according to CEBS. “The mechanism should be designed to ensure that the end users in the institution can understand the output and know how to use it to facilitate decisions that will ultimately impact the financial situation of the institution. The internal prices should percolate down to decision makers at transaction level to ensure maximum impact. There should be a good dialogue between business lines and the area responsible for calculating the internal prices. The business lines should understand the rationality of the internal prices and the treasury function needs to understand the rationale and funding implications of the deals transacted,” it states.

In drawing together CP36, CEBS examined the current liquidity cost benefit allocation practices at a number of European banks and found that these “differed considerably in scope and detail”. For example, the frequency at which prices were changes as a result of this data varied from “daily to weekly and monthly” and there was no single agreed methodology for calculating internal prices.

These recommendations will go some way to providing more clarity on what the regulatory community is expecting from the industry in a practical sense around internal liquidity risk management. However, given that a number of countries including the UK have already gone ahead with their own liquidity risk regimes, global firms may struggle initially to meet the slightly different requirements of the national regulators under whose jurisdictions they fall.

The draft guidelines contained in CP36 are now open for public consultation, which closes on 10 June 2010, and a public hearing will be held on 14 April 2010 at CEBS’s premises in London.

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