Address by Director of Policy & Risk, Gerry Cross, to the Liquidity and Funding Conference

'Liquidity, funding and regulation'

Good morning. It is a great pleasure to be here this morning to talk about liquidity and funding risk and regulation. I want to talk a little about market liquidity and the possible impact of recent regulatory reforms. Then I want to welcome the fact that we are now arriving at the end of a long journey in finalising one of the key pieces of post-crisis regulatory reforms, the Net Stable Funding Ratio. And then I will say a few words about liquidity risk in investment firms.

Market Liquidity

The issue of market liquidity has been the subject of considerable attention in recent times from public authorities, research institutions, academics and market participants. .

The introduction of new rules, such as the leverage ratio, higher risk-weighted capital requirements, restrictions on proprietary trading and increased margin requirements is argued to have impacted market liquidity.

At the same, there are other drivers of developments in market liquidity such as post-crisis deleveraging, advances in technology and the conduct of monetary policy in major currency areas.

While it is difficult to quantify the forces that may be impacting market liquidity in recent times^[1], the first question is whether or not market liquidity, considered in all its dimensions, is changing, and if so how. What are the key aspects that we should monitor and consider?

A recent PwC^[2] study commissioned by the Global Financial Markets Association and the Institute of International Finance is one amongst a number of recent reports supporting the proposition that certain instruments portray signs of reduced market liquidity in one or other of its aspects. 

Other studies emphasise a different perspective.  For example, the UK FCA and French AMF have conducted studies of liquidity in their national bond markets, finding no evidence of a sustained decrease in market liquidity over the relevant period.

This leaves us with a somewhat inconclusive picture of market liquidity conditions.

This is hardly surprising, given how notoriously difficult liquidity is to measure, and indeed the multifaceted nature of any good understanding of market liquidity.

Depending on the measure one chooses to use, the results may differ.

For example, bid-ask spreads have not significantly changed, though the price impact of large trades appears to have increased.

Average trade sizes have fallen and it now appears to take longer to execute large trades than before.

Further complicating the issue, it is difficult to separate out the impact of structural factors, such as dealer de-leveraging and the move towards greater electronic trading, from the cyclical factors such as the extraordinary monetary policy which has now been in place for several years across many key global jurisdictions.

As previously stated, an inconclusive picture.

The question of prevailing levels of first-order market liquidity, as evidenced for example by spread levels, is only part of the picture. Another aspect is the resilience or fragility of that liquidity in times of stress.

And here again the picture is not straightforward, because there are different types of resilience and fragility and different modes of stress. Stress can take the form of a shock to pricing arising from new information. What we can call non-systemic stress events. But it can also take the form of a systemic event, such as we saw in 2008, when the dislocation of prices and fundamental values is of such penetration and scope that significant feedback loops develop giving rise to major losses in value.

A number of recent reports reach the, still tentative, view that while levels of current liquidity appear to be undiminished, depth in a range of cases has decreased and fragility in the face of idiosyncratic events may have increased. Useful reading in this regard is the January 2016 report of the BIS Committee on the Global Financial System, on Fixed Income Market Liquidity.

However, as that report also points out, it is important to think of resilience in its wider sense. It is important that we have markets that work effectively and well in both good times and bad times. And in particular that they are resilient to periods of significantly heightened risk and dislocation.

Another noteworthy report is a recent study by the Bank of England on the resilience of fixed income market liquidity^[3]. The key finding of this study was that the ‘normal’ level of liquidity in markets that are less reliant on core intermediaries appears to have increased, but this may have been at the expense of resilience in some cases.  Conversely, the study found that the ‘normal’ level of liquidity in markets which are strongly reliant on core intermediaries appears to have reduced, but this is in conjunction with a likely increase in the resilience of those markets via a strengthening of the resilience of the core intermediaries themselves.

This finding encapsulates the key issue in this debate – market liquidity must be assessed in terms of both current and materially changed conditions. To do otherwise is to miss the point as any reduction in market liquidity, which is not yet proven, must be offset against any corresponding improvement in the resilience of market liquidity, particularly in times of stress.

An argument frequently put forward by those who believe market liquidity has diminished is that regulation, particularly the bank capital and leverage frameworks, is driving the reduction.

It is of course important that with the passage of time we assess as fully as possible the impact and any unintended consequences of the regulatory reforms.

However, this comes back to my argument that the liquidity debate needs to be well differentiated. We need to consider not just levels of liquidity in current circumstances but also resilience and that both in current and materially changed scenarios.

While it remains an open question, it seems not unlikely that the post-crisis regulatory reform programme will be found to be having some impact on market liquidity. Not unlikely and not surprising, the mispricing of liquidity risk was one of the failures that led to the financial crisis. Regulation designed to address this failure, amongst others, should not be negatively judged on the basis of divergences from immediate pre-crisis benchmarks.

However it is important that we continue to work to understand the changes that are occurring and their drivers as well as possible.

We should be cautious not to rush to judgements. As pointed out by the IMF and the BIS^[4], it is too early to yet determine the structural impact of new regulation on market liquidity given that markets are still adapting and are in a state of transition.

Overall the Central Bank’s view, as articulated in our response to the Commission’s call for evidence on the cumulative impact of financial regulation, is that we need to continue to work to understand well the cumulative impact of recent regulation. We believe that this is a long-term rather than a short-term project – though of course where clear weaknesses are identified these should be addressed. On the whole we think that it is simply too early to judge fully the effects of post-crisis regulation and we must avoid any erosion of the hard won benefits that have delivered significant stability improvements.

Net Stable Funding Ratio

In this context, let me turn now to a particular piece of regulation directly relevant to the funding of banks – the Net Stable Funding Ratio (NSFR) which is now, coming to the end of its long post-crisis development period.

In December 2010, the Basel Committee announced the introduction of the NSFR which is to become a minimum standard on 1 January 2018 as a response to the inappropriate funding structures observed during the crisis. The lack of appropriately stable financing structures led to bank failures and costly interventions, contributing to the contraction in credit from banks to the economy. The NSFR requires that banks maintain a stable funding profile in relation to the composition of their assets and off-balance-sheet activities.

Under the CRR the EBA was mandated to report to the European Commission on the appropriateness of introducing a stable funding requirement (“SFR”) for European institutions and this report was published in December 2015.

The EBA report concluded that the stable funding ratio objectives are not achieved by existing requirements and recommended the introduction of a SFR for banks following the calibration and definition adopted in Basel, except for some limited aspects where the findings suggest merit in reflecting some European specificities in the details.  

Most banks in Europe are found to be prepared for the NSFR. In a sample of 279 banks in December 2014 (representing 75% of total assets in the EU), 70% of banks are already compliant and only 14% of the banks in the sample have NSFRs below 90%^[5].

Other studies have also concluded that the NSFR will not result in significant distortions.

In May 2016, the Commission launched a targeted consultation on further considerations for the implementation of the NSFR as part of its overall CRR/CRD IV review^[6]. A legislative proposal is expected to be submitted by the Commission by the end of this year.

A couple of weeks ago, EBA provided its advice to the Commission on the latter's enquiry about the benefits, taking account of proportionality, of a "core funding ratio". In its response EBA noted that the concept of a core funding ratio cannot do the job of the NSFR. This is because it does not take account of the makeup of the assets side of the balance sheet and therefore does not effectively address the risks, it does not create a level playing field, it is a non-risk sensitive measure, and it could hinder effective macro-prudential oversight.

And let us make no mistake about this, as the Commission targeted consultation notes, central to the unfolding of the 2008-9 financial crisis was the extent to which new debt was created by a banking system which had managed to largely slip the constraints of appropriate funding requirements. Key to the proliferation of new debt and a finally disastrous credit spiral were levels of maturity transformation that were massively unsustainable. The NSFR is specifically designed to address this aspect. It is a key part of the overall regulatory reform package. Its introduction now in accordance with the long-articulated timelines will be an important milestone.

Liquidity risk in investment funds

Another prominent debate centres on the question of whether there may be a potential threat to financial stability arising from liquidity mismatch in investment funds.

We are all familiar with the main debates around market liquidity (as I have discussed a few moments ago), market-based finance, and the growing size of the asset management industry since the crisis.

Clearly, an important risk to consider is that structural and cyclical pressures could interact with diminished liquidity in markets, as already discussed, resulting in rapid asset re-pricing and a liquidity shock in certain markets, e.g. corporate bonds. There are concerns about risks being potentially amplified and transmitted elsewhere in the system given the large increase in assets under management in investment funds which are open-ended and investing in less liquid assets as part of a search for yield.

This is an important discussion.

However, given the lack of a conclusive output from the research on liquidity, there is a need for us to move beyond conjunctural factors in the markets and assess the structural challenges and risks which asset management activities may pose to financial stability.

Liquidity mismatch in investment funds is a key element of this structural assessment.

Liquidity mismatch is addressed within the current European framework. It is often forgotten that the core of the European UCITS regime is the legal obligation to maintain the liquidity of these open funds which are obliged to provide redemption facilities every two weeks and usually provide daily liquidity. UCITS are also subject to eligible asset, pre-investment due diligence, risk management and temporary borrowing requirements. 

The regime established under the AIFMD for hedge funds and other ‘alternative’ investment funds is quite different. Instead of being required to maintain liquidity, they are required to have a liquidity profile consistent with their investment strategy and must make reports to regulators about the liquidity of their assets in pre-defined but self-allocated time-to-sell buckets.

Additionally, decisions made at the design phase of an investment fund have a large impact on the degree to which liquidity mismatch is present, the most important being whether or not to offer daily dealing to investors. Though anecdotally the Central Bank of Ireland hears the pressure from investors for daily dealing is substantial.

Funds also have a range of liquidity management tools available, both for day-to-day liquidity management and also for exceptional circumstances. Such exceptional tools were deployed recently in the UK by several real estate funds - though instances of their use are relatively rare.

Such tools help to mitigate the risk inherent in liquidity mismatch from a micro-prudential perspective and their efficacy in this regard has been proven previously.

However, these tools do not entirely remove the risk from a macro-prudential perspective and remain largely untested in that regard. Further analysis around the usefulness of the current framework and tools from a systemic risk perspective is necessary, including an assessment of whether or not the framework may need to be strengthened in certain areas.

Without wishing to pre-judge the outcome of any such further work, I would like to suggest three areas where the current framework could be improved.

Firstly, the availability and use of liquidity management tools could be more harmonised across the EU. The current range of tools available differs between Member States, as does guidance and the protocols governing their use. More harmonisation could be beneficial.

Secondly, we need to assess the benefits of adding new tools to the current set. Stress testing is perhaps the most widely known example of a new tool in investment fund liquidity management.

Currently, there is a lack of consensus as to how stress testing for the asset management sector should be applied.

We have been doing some work in the Central Bank of Ireland in relation to investment fund stress testing. There are a number of points I would make based on our internal deliberations.

Investment fund stress tests are quite different from bank stress tests since the concept of failure is not the same. Bank stress tests have a central focus on whether there is enough loss-absorbing capital. If not, recapitalisation or even resolution of some kind may follow. Investment fund stress events involve the risk that the liquidity expectations of investors are not fulfilled. Depending upon the circumstances, this may, or may not, have consequences for market liquidity more widely including systemically. 

It is not clear that the pass-fail approach of some bank stress tests would be the most appropriate one in this context.

Right now, it seems desirable that individual fund managers should have a central role in advancing investment fund stress testing. It seems to us very important at this point to build-up the capacity of funds to conduct stress tests of a high quality, while also seeking to align the approaches as much as possible. We need to create strong foundations for high quality stress testing across the sector.

Fund managers are already required to conduct liquidity stress tests on a regular basis under EU legislation with supervisors having the possibility to review the outcome of these tests. Working on this basis, supervisors should continue to develop strongly their own capacities in this area.

This will require a challenging mix of capabilities: reviewing investor disclosures regarding the redemption promise, understanding the nature of the investor base, inspection of the liquidity management processes, periodic assessment of fund governance, and a strong data analytic capability to measure the risks associated with a wide range of idiosyncratic and common redemption scenarios.

Over time, the sophistication of investment fund stress tests can be increased. In the short-run, we should aim for developing a foundation common framework which can be enhanced going forward.

Developing a system-wide liquidity stress test similar to solvency stress testing will not be straightforward. It will need to be developed over time. Such stress testing, to be successful, needs to take account of the characteristics of individual fund portfolios, investor profile and investment mandate requirements, liquidity management practices in funds, and the potential presence of countercyclical buyers in the market.

Thirdly, it is worth mentioning data as this is crucial to the wider risk assessment as well the conduct of any fund stress testing.

It is fair to say that the availability of data on the asset management sector for financial stability purposes lags behind sectors such as banking and insurance.

This is not entirely unexpected given the historical focus of regulators has been on investor protection and market integrity. But it will need to change going forward.

Data is the key to progressing regulators’ abilities to detect and mitigate potential financial stability threats posed by investment funds

There is a need to review the methods and formats of the data defined as collectable in the immediate wake of the crisis to ensure that it is fit for purpose and are being collected at an appropriate cost for industry and supervisors.

The goal needs to be real-time or near-real-time analysis of cyclical changes in risk.

Additionally, cross-border data analytics frameworks are needed given the international nature of the investment fund industry.

Taken together, these three elements would significantly strengthen the resilience framework for funds in Europe.

Given the importance of all of this and the work still to be done, European and international progress on the issue of investment fund liquidity risk is welcome and is why the Central Bank of Ireland has engaged in the major projects underway.

Globally, a key output of course is the FSB’s consultation paper released on 22 June relation to structural vulnerabilities from the asset management activities.

This is an important, comprehensive and thoughtful document and I would encourage all market participants to read it.

Global leadership is needed in this area and the FSB is providing that.

It is also welcome that many of the FSB’s recommendations are likely to be passed to IOSCO to operationalise.

IOSCO is well placed, in my view, to take the recommendations forward to implementation given the particular expertise of its members and its history of producing Principles for industry best practice.

In Europe too we continue to develop our thinking on the topic. The ESRB has led the way on this. And I am happy to say that the Central Bank of Ireland has played a leading role in this work to date.

This ESRB work, coupled with the existing legislative framework for funds in Europe, provides an ideal base from which to implement global reforms as outlined by the FSB as well as regional proposals which are tailored to the European market.

Thank you

Acknowledgements: I would like to thank Cian Murphy, Lorraine McDonald and Vincent O’Sullivan for their inputs into this speech. 

--------------------------------------------------------------------------------

^[1] Committee on the Global Financial System, Fixed income market liquidity, January 2016.

^[2] PwC, Global Financial Markets Liquidity Study, 2015 August.

^[3] Anderson N, Webber L, Noss J, Beale D, Crowley-Reidy L., “The Resilience of Financial Market Liquidity”, Bank of England Financial Stability Paper, 2015 Oct; 34.

^[4] Committee on the Global Financial System, Fixed Income Market Liquidity, Bank for International Settlements 2016 Jan; 55.

^[5] EBA, Report On Net Stable Funding Requirements under Article 510 of the CRR, December 2016