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Regulator's liquidity swaps guidance criticised by banks and insurers

Banks and insurers have defended a form of asset trading the UK's financial services regulator has previously said could threaten stability in the financial markets.18 Oct 2011

Earlier this year the Financial Services Authority (FSA) reported that so-called 'liquidity swaps' between banks and insurers were on the increase and "could have the effect of increasing inter-connectedness between the insurance and banking sectors and, in turn, create a transmission mechanism by which systemic risk across the financial system may be exacerbated".

'Liquidity swaps' refer to a process where insurers exchange "high-credit quality, liquid assets such as gilts" with "illiquid or less liquid assets, such as asset-backed securities" held by banks, according to the FSA's consultation. Assets that are 'liquid' can be more easily and more quickly turned into cash than other assets. Banks have been urged to free up some assets to lend money to businesses during the recession.

The regulator issued draft guidance (23-page / 207KB PDF) on the 'swaps' and consulted on its recommendations. The FSA said firms considering liquidity swaps should only be allowed to complete certain types of asset transactions. It also laid down rules on the kind of checks and risk assessments that should take place and said mandatory 'break clauses' should be included in liquidity swap agreements to enable the transactions to be "unilaterally terminated" if they become "uneconomic" as a result of a change in regulations. The FSA also said that potential transactions must be reported to it before they are carried through with.

The British Bankers' Association (BBA), which represents more than 200 banks that operate in the UK, said that making break clauses obligatory in liquidity swaps would be "completely inappropriate".

"We believe that mandatory break clauses would create undue commercial uncertainty and will make it difficult to price a transaction properly," the BBA said in response to the FSA's consultation seen by Out-Law.com.

"Further, break clauses contingent on legislation will most likely take effect on the date of implementation of the regulation; this could result in many transactions being unwound at the same time, adversely impacting on market stability. We recommend that, as with other transactions, counterparties to liquidity swaps should be left to make their own commercial arrangements for regulatory uncertainty. We would welcome the FSA in its guidance to encourage counterparties to agree in good faith to renegotiate their commercial arrangements in the event of regulatory implementation," the BBA said.

The BBA said that firms should have to report liquidity swaps to the FSA after they are "executed" but that prior notification was "inappropriate".

"We believe the requirement for all liquidity swaps to be reported to the FSA prior to the execution of the transaction is inappropriate" and would disadvantage regulated businesses, the BBA said in its response to the FSA's consultation seen by Out-Law.com.

"In particular, seeking permission for each transaction prior to execution is too severely restrictive and practically difficult. For example, this kind of reporting system would prevent the ability of the liquidity seller to take advantage of favourable short‐term market conditions, places significant pricing risk on banks and places the liquidity seller at a competitive disadvantage to other non‐FSA‐regulated counterparties," it said.

The BBA also said that "introducing overly onerous requirements for liquidity swaps" would just mean that organisations would "enter into other types of transactions" instead.

The Association of British Insurers (ABI) also raised concerns with "serious weaknesses" in the FSA's approach. It said that the guidance was "overly prescriptive" and that a "principles-based" approach would be more appropriate to "allow each proposed transaction to be judged on its own merits".

ABI also refuted concerns raised by the FSA that insurers that exchange liquid assets for less liquid ones may not be able to release funds when needed.

"While liquidity swaps arrangements will reduce the liquidity of the assets covered by the transaction it should be recognised that insurers will only use surplus liquidity (determined after taking into account expected stressed liquidity requirements) to fund such transactions," ABI said in its consultation submission (Click through to September 2011 for 7-page / 141KB PDF).

"These transactions need not, therefore, increase insurers’ liquidity risk," it said.

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