Barbican Consulting Limited
Internal Liquidity Adequacy Assessment Process (ILAAP)
Summary
Firms must undertake an Internal Liquidity Adequacy Assessment Process (ILAAP). This is their assessment of the liquidity risk they face. The regulator evaluates this process and subsequently issues the Internal Liquidity Guidance (ILG). This is the level of liquid assets a firm is expected to maintain.
Introduction
Under CRD IV the regulator is required to apply the Liquidity Supervisory Review and Evaluation Process (L-SREP). Under this process a firm must undertake an Internal Liquidity Adequacy Assessment Process (ILAAP).
The ILAAP is the responsibility of the firm’s Board. It therefore requires Board approval. It should be consistent with the Board’s risk appetite and the way the firm measures and manages both its liquidity and funding risks. It also needs to be fully integrated into the culture and business of the firm. The ILAAP is therefore specific to the firm.
The ILAAP is used by the regulator to determine whether a firm has appropriately identified, measured and managed its liquidity risk. The regulator will then advise the firm on the amount of High Quality Liquid Assets (HQLA) it expects it to hold to meet short term liquidity requirements under the Liquidity Coverage Ratio (LCR). This is a Pilar 1 requirement.
In addition the longer term stable funding requirement is evaluated together with a qualitative assessment of the processes and management involved. If additional risks are identified a Pilar 2 add-on will be applied. The Internal Liquidity Guidance (ILG) that results is therefore the Pilar 1 and Pilar 2 amounts.
Firms are expected to maintain the ILG but are permitted to fall below it in times of stress. In such an event the firm is expected to have an appropriate contingency plan to rectify the situation.
Overall Liquidity Adequacy Rule (OLAR)
A firm must have adequate levels of liquid resources, prudent funding and appropriate controls and management. This should be clearly articulated in a risk appetite statement.
As part of this process a firm needs to define the duration of survival in stressed conditions. The stressed conditions need to be relevant and should include scenarios that are appropriate. They should include market wide events as well as macro-economic conditions.
Frequently we think about this process as ensuring that we meet the LCR. (The need to hold HQLA to meet an anticipated outflow over a time horizon like 30 days). This requirement could be met but nevertheless a firm could still fail OLAR. Why is this? This is because the LCR is a formulaic approach to the rules rather than a holistic assessment of all the risks present.
This means that as well as meeting the LCR a firm needs to show that it is truly on top of liquidity risk. What sort of things indicate this?
You would expect gap reports showing the cumulative daily inflows and outflows of cash to form part of the narrative.
Consideration should also be given to the sources of funding, their maturity and reliability. This should be accompanied by the appropriate limit structure.
Assets that are held for liquidity also need to be evaluated as to their composition and suitability. From time-to-time they need to be liquidated to demonstrate their worth. Stress testing is very much part of the process.
Stress testing
This needs to be severe, relevant and plausible. It should evaluate the effect on cash flows, liquid resources, profitability, solvency, encumbrance and the survival horizon. It should reflect what would happen daily and examine the liquidity risk drivers. They include:
The run-off of retail funding;
The reduction of secured and unsecured wholesale funding;
The correlation and concentration of funding;
Additional contingent off-balance sheet exposures;
Funding tenors;
The impact of a deterioration in the firm’s credit rating;
The ability to transfer liquidity across entities, sectors and countries;
Estimates of future balance sheet growth;
The impact on a firm’s reputation or franchise;
Marketable asset risk;
Non-marketable asset risk;
Internalisation risk.
An assessment should also be made of intraday liquidity risk.
“This is the risk that a firm is unable to meet its daily settlement obligations, for example, because of timing mismatches arising from direct and indirect membership of relevant payment or security settlement systems”.
Examples include incoming payments not received, credit lines withdrawn and a large client default. Suffice to say that firms need to ensure that they have adequate and immediate liquidity to cover this risk.
From this work the firm will be able to determine how much high quality liquidity it needs to hold as HQLA.
HQLA
HQLA are there to cover liquidity shortfalls. Notwithstanding the definition of Level 1 and Level 2 assets it is important for a firm to make its own assessment as to their appropriateness. For example, is there concentration risk? Are there any legal impediments to usage (for example is the asset pledged)? Would large scale liquidation cause market disruption or raise questions?
It is now up to the regulator to determine whether the work that has been undertaken by the firm meets requirements. This involves a Liquidity Supervisory Review & Evaluation Process (L-SREP).
Liquidity Supervisory Review & Evaluation Process (L-SREP)
This is the analysis undertaken by the regulator into the way a firm manages its liquidity risk. It involves an assessment of:
The strategy, processes and governance;
Liquidity risks faced and how the firm measures and deals with them;
The stress testing, its severity, relevance and bearing on identified risks;
The funding profile, concentration, currency and maturity;
The appropriateness, level and concentration of liquid resources;
The Common Reporting Liquidity Returns (COREP);
The culture and understanding of liquidity risk in the firm.
This leads to the Individual Liquidity Guidance (ILG).
Individual Liquidity Guidance (ILG)
This is the regulator’s assessment of the Liquid Asset Buffer (LAB) required by the firm. It includes whether the
quantity of HQLAs held is sufficient;
quality and composition of HQLAs held are appropriate;
operational arrangements to manage HQLA are appropriate;
firm’s funding profile is appropriate; and
firm should undertake any further qualitative arrangements to mitigate its liquidity risk.
Liquidity risks not captured by the LCR are captured by way of a “Pilar 2” add on. At the time of writing this is in a transitional phase. What happens if the ILG is not maintained?
In times of stress the firm may breach the ILG but if this happens the regulator must be informed and a plan to resolve the situation should ensue.
It is anticipated that under such conditions access to the Bank of England via the Discount Window Facility or other liquidity insurance facilities will occur before using up a large proportion of the liquid asset buffer.
Therefore, HQLA Assets pre-positioned at the Bank of England can count as HQLA. Other prepositioned assets do not count but may demonstrate effective contingency planning.
Shortfalls in the ILG lead to daily liquidity reporting. Firms should ensure they can undertake this before it is required.
Glossary
Overall Liquidity Adequacy Rule (OLAR): A firm must have adequate levels of liquid resources, prudent funding and appropriate controls and management.
Internalisation Risk: Where a client makes a short sale and then uses the proceeds to buy an asset. This can lead to timing mismatches in terms of cash inflows and outflows for the facilitating firm at the point where the trade is put-on and taken-off.
Individual Liquidity Guidance (ILG): This is the regulator’s assessment of the Liquid Asset Buffer required by the firm. It includes whether, the quantity of High Quality Liquid Assets (HQLAs) held is sufficient, the quality and composition of HQLAs held are appropriate, whether the operational arrangements to manage HQLA are appropriate, if the firm’s funding profile is appropriate and whether firm should undertake any further qualitative arrangements to mitigate its liquidity risk.
Liquidity Supervisory Review & Evaluation Process (L-SREP): This is the analysis undertaken by the regulator into the way a firm manages its liquidity risk. It involves an assessment of the strategy, processes and governance, the liquidity risks faced and how the firm measures and deals with them, the stress testing, its severity, relevance and bearing on identified risks, the funding profile, concentration, currency and maturity, the appropriateness, level and concentration of liquid resources, the Common Reporting Liquidity Returns (COREP) and the culture and understanding of liquidity risk in the firm.
Marketable asset risk: The risk that assets normally thought of as liquid cannot be liquidated in times of stress with as much ease as anticipated. Difficulty may arise in market access, haircuts, timelines, pricing, operational capacity or eligibility.
Non-marketable asset risk: The risk that assets that are monetised by structuring, for example, mortgage backed securities and covered bonds are difficult to liquidate in times of stress because counterparties are unavailable or adverse structural arrangements like collateral or financing of warehoused assets may arise.
Internal Liquidity Adequacy Assessment Process (ILAAP): This is the assessment an individual firm makes of the liquidity risk it faces. This is a board responsibility. It must identify and stress test all liquidity exposures and account for any liquidity risk not captured within this framework. For example structural funding ratios and concentration risks. The process determines the amount of high quality assets that need to be held to keep the firm within its risk appetite. The regulator evaluates this process and subsequently issues the Internal Liquidity Guidance (ILG). This is the level of liquid assets a firm is expected to maintain.
First Published by Barbican Consulting Limited 2017