'Liquidity swaps' beneficial in moderation, City regulator says

Last year the Financial Services Authority (FSA) reported that so-called 'liquidity swaps' between banks and insurers were on the increase. It warned the practice "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".

However, following a consultation with industry last year the regulator has now issued guidance stating that 'liquidity swaps' practices have their benefits.

"Our consultation was issued in response to observing an increasing trend of banks looking to improve liquidity by entering into new types of collateral upgrade transactions: in particular those transactions where banks look to access the liquidity embedded within asset portfolios held by insurers, although there have also been a number of transactions between two bank counterparties," Paul Sharma, FSA director of policy, said in the new guidance (10-page / 139KB PDF).

"We recognise that these transactions enable the temporary transfer of liquid assets to firms that need them, whilst at the same time providing the lending firm with secured exposures (which can benefit its creditors including depositors and policy-holders) and potentially an enhanced yield. We see a role for these transactions on a sensible scale, provided the risks are properly identified and managed by both parties," he said.

'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 consultation document. 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.

Sharma said that the FSA still has "potential concerns" about trading "collateral upgrade transactions" and said that companies that load "balance sheets" with assets in this way could harm consumers.

The regulator is also worried about a lack of resilience in using borrowed assets to meet liquidity or funding arrangements in "a time of stress". It has also questioned whether "risk management frameworks" can cope with "the increased risk from extended maturities, significant size, and the use of potentially illiquid or less-liquid, poorer quality and difficult to value assets as collateral; and whether such transactions hinder the resolvability of firms".

Companies will be required to notify the FSA of "any proposed significant transactions" prior to the planned transaction date in order for the regulator to assess the risks "inherent" to the exchange, the FSA said.

The regulator said it expects to be notified of "any intra-group transaction; any transaction that relies on material amounts of own-issued and/or own-originated securities as collateral; and any transaction for which a firm proposes holding an amount of capital that is below that required to be held on a comparable asset (for example, some structured covered bonds that fall outside of the regulated covered bond regime)".

If risks only associate themselves to one of the two firsm involved in a transaction it is only the firm "exposed to the material risk" that is expected to inform the FSA.

Sharma said that the FSA may step in to prevent transactions occurring if they "pose unacceptable risks to ... financial stability and consumer protection".

In responding to the FSA's consultation on liquidity swaps guidance both the British Bankers' Association (BBA) and the Association of British Insurers (ABI) criticised the FSA's overly prescriptive approach to regulating the form of asset trading.

The BBA, which represents more than 200 banks that operate in the UK, said that firms should have to report liquidity swaps to the FSA after they are "executed" but that prior notification was "inappropriate".

"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," the BBA said.

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