The Hedge Fund Redemption

Alternative Intelligence Quotient The Hedge Fund Redemption Alex Potts of Conyers Dill & Pearman in Bermuda shines a light on whether hedge funds can make redemption payments in kind. 34 ISSUE July 2009

The Financial Services Authority s Overhaul of Liquidity Regulation William Yonge, Proskauer Rose LLP, London William Yonge is a partner in Proskauer Rose LLP s London office where he specialises in issues of financial services regulation and advises on the structuring, establishment and marketing of a range of investment vehicles including hedge funds, private equity funds, funds of funds, UCITS and UK authorised funds. Background to the overhaul The current liquidity crisis, in its initial manifestation also known as the Credit Crunch, is often regarded as a wholly exceptional, even a once-in-a generation event. While the intensity and duration of the current crisis does make it remarkable, the fact is liquidity crises occur more regularly than widely assumed. Previous UK liquidity crises include the Secondary Banks Crisis (early 1970s), the Small Banks Crisis (early 1990s) and the failure of Barings Bank (1995). Non-UK liquidity crises include the collapse of Drexel Burnham Lambert (1990), the Asian Crisis and Yamaichi (1997), the Russian Crisis (1998), Long Term Capital Management Crisis (1998) and the Argentine Crisis (2001). Alternative Intelligence Quotient Issue 31, July 2009 Notwithstanding this history of liquidity crises, regulators and supervisors, in their prosecution of prudential regulation in recent years, concentrated their efforts on implementation of the Basel II capital adequacy requirement, first published in June 2004. Lord Turner, Chairman of the UK Financial Services Authority (FSA), acknowledges this was mistaken, since it followed that insufficient attention was paid both to growing risks in trading books and liquidity risks which proved fundamental to the crisis. In Lord Turner s view, This failure to spot emerging issues was rooted in the paucity of macro-prudential, systemic- and system-wide analysis. The FSA itself is currently fighting a turf battle of its own in order to preserve its role as supervisor of banks in the UK, with the Bank of England enthusiastic to take that role back. Since before the FSA s creation, the Bank of England has been responsible for guarding against systemic risk, and there is high level debate as to whether the status quo should continue or whether the FSA should have a joint role alongside the Bank in monitoring and dealing with systemic risk. The regulators and supervisors must shoulder their share of the blame for the crisis alongside the banking sector. Regulators, led by the FSA in particular, are broadly contrite and understand the need for thoughtful and robust change in their approach to regulation and systemic risk in order to avert, or at least mitigate, the next potential liquidity crisis. It is not yet clear whether the banks will move as quickly to put their own houses in order. Liquidity risk and regulation a cause of the crisis The regulators and supervisors must shoulder their share of the blame for the crisis alongside the banking sector. In October 2008, the Chancellor of the Exchequer asked Lord Turner to review the causes of the financial crisis, and to make recommendations on the changes and the regulatory and supervisory approach needed to 35

create a more robust banking system for the future. In March 2009, Lord Turner published his review. In considering the causes of the crisis, under the characteristically frank and transparent title, What went wrong?, Lord Turner identifies and describes the spectrum of causes, one of which was liquidity risk and regulation in the context of the growth of shadow banking. To elaborate, a main function of the banking system is maturity transformation, ie, holding longer term assets than liabilities and thus enabling the non-bank sector to hold shorter term assets than liabilities. This function delivers major social and economic value, since maturity transformation absorbs the risks arising from uncertainties in the cashflows of households and corporates. This results in a term structure of interest rates more favourable to longterm capital investment than would be the case if banks did not perform maturity transformation. Historically, one would expect regulated banks with central bank access to undertake most maturity transformation. However, a striking development of the recent past has been the growing proportion of maturity transformation in the shadow banking sector, in particular, structured investment vehicles (SIVs) and conduits, investment banks and, particularly in the US, mutual funds. Maturity transformation creates risk. Put simply, if everybody wanted their money back on the contractual date, no bank could repay them all. To manage this risk, a complex and interrelated set of risk management devices has been developed liquidity policies to measure and limit the extent of maturity transformation, insurance via committed lines from other banks and lender of last resort facilities provided by central banks. Lord Turner considers it highly likely that the aggregate maturity transformation being performed by the financial system in total increased substantially over the last two decades. Furthermore, both banks and near-banks developed an increasing reliance on liquidity through marketability, believing it safe to hold long-term to maturity assets funded by short-term liabilities, on the assumption that the assets could be sold rapidly in the then prevailing liquid markets if needed. This assumption was valid for individual firms in non-crisis conditions, but quickly became invalid in mid-2007 as many firms attempted simultaneous liquidation of positions. Lord Turner concludes that appropriate management of liquidity risk is essential and must reflect its inherently system-wide character. Liquidity risks must be contained in individual banks and at the systemic level. After years of focus on capital regulation, in particular, implementation of Basel II, Lord Turner calls for liquidity regulation and supervision to be recognised as of equal importance to capital regulation. Remedial action by regulators and supervisors Long before Lord Turner s review began, the FSA, prompted by the credit crunch, issued its Discussion Paper 07/7 Review of the liquidity requirements for banks and building societies (December 2007), in which the FSA considered the lessons of the then ongoing market turbulence and set out initial proposals for liquidity reform. Broadly, the FSA planned to continue with its current highlevel standards and principles-based approach to liquidity risk, but proposed to strengthen the application of existing high-level standards and quantitative liquidity requirements. In January 2008, the Tripartite Authorities (comprising the Bank of England, HM Treasury and the FSA) identified liquidity risk management as a key area for action. In December 2008, the FSA published its Consultation Paper 08/22 Strengthening Liquidity Standards, setting out its view on the future of liquidity regulation in the UK and amounting to a thorough overhaul of UK liquidity regulation for all FSAregulated firms subject to BIPRU rules (ie, banks, building societies and other investment firms). In formulating its proposals, the FSA had the benefit of feedback to its 2007 Discussion Paper, the lessons learned from the difficulties experienced by several financial institutions and the FSA s overseas counterparts during 2008, and recently agreed international standards for liquidity. On the international front, the Basel Committee on Banking Supervision (BCBS) set up a working group in early 2007 to review national guidance on liquidity and its inconsistency across borders. In September 2008, the BCBS published its updated Principles for Sound Liquidity and Risk Management and Supervision. The BCBS has established a Liquidity Working Group, one focus of which is liquidity risk supervision for cross-border banks and information sharing. The Committee of European Banking Supervisors (CEBS) also set up a liquidity working group in early 2007, to provide advice to the European Commission on 36

liquidity. CEBS published its Advice on Liquidity and 30 Recommendations in September 2008 and continues its work on the topic. Rationale for the FSA s proposed new liquidity policy The FSA addresses head-on its view of the economic rationale for strong liquidity regulation by reference to a paper written by Professor David Llewellyn entitled, The Economic Rationale for Financial Regulation (FSA Occasional Paper Series 1, April 1999). It is generally accepted that financial regulation should contain three core objectives: sustaining systemic stability; maintaining the safety and soundness of financial institutions; and protecting the consumer. The purpose of regulation should be limited to correcting identified market imperfections and failures. The role of liquidity regulation is to provide a common set of standards for firms, and is particularly justified as the social cost of the failure of financial institutions often exceeds the private costs and the social costs are not fully (if at all) incorporated into decision-making processes by firms. Professor Llewellyn highlights a range of systematic issues of which the following are germane to liquidity regulation: the pivotal position of banks in the financial system, especially in clearing and payments; potential systemic dangers resulting from bank runs; nature of bank (debt) contracts on both sides of the balance sheet; and adverse selection and moral hazard associated with safety-net arrangements (lender-of-last resort and deposit insurance). Turning to the FSA s own views, the following policy considerations have underpinned and informed the FSA s policy development process on liquidity and it is worthwhile considering those before examining the FSA s proposed new liquidity regime. Role of liquidity regulation in addressing moral hazard A key objective of liquidity regulation is to reduce the risk of moral hazard. This is the risk of firms undertaking imprudent liquidity risk management and holding lower levels of liquidity due to the expectation that central banks will provide support in the event of a market-wide stress and, for firms whose failure might have systemic consequences, a firm-specific stress. Co-ordination of liquidity policy and central bank frameworks There are links between central bank policies and the views of liquidity risk held by regulated firms and their supervisors. In order to ensure a proper understanding of firms liquidity risk profiles across markets and currencies, and to take appropriate remedial action where necessary, supervisors must take into consideration the prevailing central bank frameworks in the key countries where a firm is active. Strong and effective co-ordination at the policy level is necessary to provide firms with a clear basis on which to plan and manage their liquidity risks. Liquidity depends on confidence and reputation A firm will remain liquid as long as creditors have confidence in it and believe other creditors also have confidence. A sudden loss of confidence, whether rational or irrational, will result in liquidity difficulties. The FSA considers the objective of its liquidity regulation to be that firms can survive long enough to allow for one of the following actions to take place: the market decides that the perceived lack of confidence is unfounded; the firm adapts its funding structure to the change in business environment; the firm downsizes and restructures its business; the firm is taken over; or public authorities intervene. A mere buffer of liquid assets is not sufficient The FSA believes that each firm should know its gross liquidity risk and would expect firms to stress test their balance sheets against specified stress test scenarios and, where any weaknesses are identified, to limit or restrict the impact of the stress. Merely requiring firms to hold a buffer of liquid assets designed to protect against liquidity stress is no longer considered sufficient by the FSA. Legal entities matter The events of 2008 demonstrated that, during a severe liquidity crisis, it is the individual position of the various legal entities within a group that matters most. Supervisors, therefore, have to be satisfied Alternative Intelligence Quotient Issue 31, July 2009 37

with the liquidity position of the locally-incorporated entity or local branch. Firms underestimate extreme liquidity events Experience shows that firms tend to underestimate the potential extremity of liquidity stresses in their testing. Regulation has to address this potential shortcoming in firms liquidity risk management approach. The new regime, therefore, explicitly addresses the high-level scenarios that firms will need to consider in their stress testing and contingency funding plans (CFPs). Extreme liquidity events happen relatively often As noted above, extreme liquidity events regularly occur in the global financial markets. It is, therefore, necessary for the new regime to prepare for the next crisis and ensure that firms resilience to liquidity stresses remains high, even during businessas-usual periods. Internal models and methodologies are necessary, but not sufficient Internal models are a useful reference point for monitoring and measuring liquidity risk. However, they have a limited role to play in liquidity regulation and are only one of many tools a firm should apply. The new regime recognises this and relies strongly on supervisory judgment. Supervisors must set limits for the firms they regulate according to their risk appetite. The international competitiveness of UK firms is dependent on strong liquidity regulation The FSA takes the view that high standards of liquidity risk management will significantly increase the overall resilience of UK firms to liquidity crises and should reap substantial long-term benefits for the competitiveness of the UK financial services sector as a whole. Potential contractual barriers to effective action The Tripartite Authorities have identified potential contractual barriers that may hinder effective action by them. The FSA will, therefore, be requiring firms to take into account the effect of contract clauses such as negative pledges and adverse termination clauses by assessing the level and durability of funding required. Key aspects of FSA s new liquidity policy The five key aspects of the FSA s proposed new liquidity policy are: Adequate liquidity resources and self sufficiency: all FSA-regulated firms must have adequate liquidity and must not rely on other parts of their group to survive liquidity stresses without prior permission from the FSA. Systems and controls requirements: a new systems and controls framework that sets out the main systems and controls requirements for liquidity risk management, with an increased focus on stress testing and CFPs. Individual Liquidity Adequacy Standards (ILAS): a new domestic quantitative framework for liquidity management for many firms, which places a greater emphasis on firms ability to assess liquidity risks and develop policies to tackle them, and is based on firms being able to survive liquidity stresses of differing duration and magnitude. Under the ILAS regime, firms will carry out an individual liquidity adequacy assessment. The FSA will then review the results of this assessment and issue to the firm individual liquidity guidance based on what it believes is an appropriate liquidity profile and level of liquidity resource for that particular firm. Group-wide and cross-border management of liquidity: a new framework for allowing firms to deviate from self-sufficiency by way of waivers and modifications where appropriate. Reporting: a new reporting framework for liquidity which will enable the FSA to collect granular, standardised liquidity information at an appropriate frequency to enable it to form firm-specific, sector- and market-wide views on liquidity risk exposures. The proposed liquidity regime in detail High level standards, adequate liquidity and self sufficiency drive the new regime The foundation of the new regime is existing high-level standards in contradistinction to a set of complex rules. This is in keeping with the 38

FSA s established principles-based approach to regulation. The FSA s threshold condition four states: The resources of the person concerned must, in the opinion of the FSA, be adequate in relation to the regulated activities that he seeks to carry on, or carries on. Resources are defined to include capital and liquidity. In addition, various FSA Principles for Businesses are relevant. Principle four provides a firm must maintain adequate financial resources ; principle two a firm must conduct its business with due skill, care and diligence and principle three, a firm must take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems. Rules will, of course, be required, but in support of those highlevel standards, not the other way around. The FSA considers that it is the firms themselves (and not the regulator, central bank or government) that are responsible in the first instance for effective management of liquidity risk and their maintenance of adequate liquidity. The FSA will require firms to maintain liquidity resources and limit liquidity risk; liquidity resources must be adequate at all times both as to amount and quality, to ensure the firms can continue to meet their liabilities as they fall due in normal and in stressed times. Every firm must be self-sufficient for all liquidity purposes unless prior permission from the FSA allows otherwise. This means the firm is prohibited from relying on its parent or other related entities for liquidity purposes without the FSA s express permission. For example, in the case of a UK branch, the whole bank must ensure that its UK branch has adequate liquidity resources in the UK, under the day-to-day control of the senior management of the UK branch. The FSA considers that the experiences over 2008 demonstrate that, for the purposes of sound liquidity risk management, reliance on the parent or wider group can be counterproductive, damage the interests of consumers and the soundness and stability of the financial services markets in the country where the firm is based or incorporated. General systems and controls requirements The existing FSA rules and guidance on systems and controls for liquidity are to be replaced. The new requirements include overarching requirements to have in place sound, effective and complete processes, strategies and systems to identify, measure, monitor and control liquidity risk and liquidity resources. These requirements are backed up by guidance which indicates measures that tend to show that the firm is complying with them. These include having a robust framework for cashflow projections, compliance with the firm s liquidity risk tolerance, having early warning indicators of potential liquidity problems and systems for providing information to senior management and the board. The FSA expects to review this area rigorously. Stress tests and contingency funding plans The FSA is strengthening its requirements for firms to carry out stress testing. Specific new FSA rules will be introduced, supported by evidential provisions relating to the frequency of testing and the facts to be considered. There is also a new requirement for firms to have in place an appropriate CFP approved by the board. Responsibility and oversight The FSA places ultimate responsibility for the firm s liquidity risk with its board of directors. The board will be required to establish the firm s liquidity risk tolerance, which must be appropriate to its business strategy and reflect the firm s financial condition and funding capacity. The firm s senior management must then review the firm s liquidity position continuously and report appropriately to the board. The way the board discharges this responsibility will be reviewed rigorously by the FSA. Individual liquidity adequacy standards In order to tailor the current quantitative regimes (which are based on a one-size-fits-all calculation) to the particular circumstances of each firm, the FSA proposes the use of ILAS, a framework similar to the Individual Capital Adequacy Assessment Process (ICAAP) used by the FSA to set individual capital requirements for banks and other investment firms generally. These ILAS requirements will apply to all banks, building societies and full scope firms that are subject to BIPRU rules except as described below. The concept is that a firm must have sufficient liquidity resources to be able to withstand the liquidity stresses specified in the FSA rules. The stresses are: a stress specific to the firm itself, a market-wide stress and a combination of these two. The firm-specific stress is that for a two week period the market and/or retail depositors perceive the firm to be unable to meet its liabilities as they fall due, and that this is followed by a Alternative Intelligence Quotient Issue 31, July 2009 39

longer-term stress equivalent to a multi-notch credit rating downgrade that results in liabilities linked to the firm s credit crystallising. The market-wide stress is an unforeseen short-term, market-wide dislocation that gradually evolves into a long-term, market-wide liquidity stress involving widespread concerns about the solvency of financial sector firms and uncertainty about the value of financial assets leading to illiquidity in many financial markets. The firm must carry out an Individual Liquidity Adequacy Assessment annually to consider the effects of the stresses on its liquidity position, the FSA will then review that assessment and issue individual liquidity guidance to the firm (for example, the minimum level of liquid assets the FSA will expect the firm to hold). The FSA is consulting on a simpler regime for banks, building societies and full scope investment firms with comparatively simple business models. This is likely to involve a standardised buffer ratio for simpler mortgage banks and building societies and a phased introduction of, and supervisory reviews for, smaller wholesale-only and full scope BIPRU investment firms. Self-sufficiency of legal entities The FSA believes that a more rigorous approach is necessary in regulating the liquidity of UK branches of foreign firms and legal entities forming part of a wider group. At present, some UK branches of overseas firms rely on a global liquidity concession, under which many aspects of liquidity regulation of the branch are performed by the home state regulator. The starting point of the new regime will be that, in the absence of waiver or modification, a firm or UK branch of a foreign entity will need to be self sufficient in terms of liquidity adequacy. Before granting any waiver or modification, the FSA will need to be satisfied as to the effectiveness of the home state regulator s regime of liquidity regulation, in particular, that it complies with the Basel Committee s principles for liquidity regulation and does not favour domestic or other creditors to the detriment of UK creditors. Liquidity reporting a new framework In its Consultation Paper 08/22, the FSA included pre-consultation material on a proposed new framework for liquidity reporting. Given the multifaceted and fast-moving nature of liquidity risk, the FSA considers granular, frequent and standardised reporting, and its ability properly to analyse the data received to be key to the success of any liquidity regime. Its proposals will require a wider change in approach regarding: amount of data the proposed risk-based approach will result in an increase in the amount of data collected; whole-of-market view on liquidity by whole-of-market FSA means the market as it is relevant to the balance sheet of the firms covered by the regime, pointing out that this is not limited to Sterling markets; and crisis vs. business-as-usual (BAU) requirements are based on the data and frequency the FSA now knows it would need in a crisis, as well as to assess firms liquidity positions under BAU conditions. Therefore, the FSA proposes a new Liquidity Reporting, Business Intelligence (BI) and Systems framework to replace the existing liquidity reports. Quantitative reporting will be an integral part of the new liquidity regime, but will apply in full only to ILAS firms. For the remaining firms, which will only be subject to systems and control requirements, the FSA will introduce a simple, questionnaire-based report. The proposed data items and reporting frequency are designed to achieve the following aims: collect objective, granular liquidity information on a standardised basis and with sufficient frequency to allow the FSA to respond quickly to changes in firm-specific or market-wide liquidity risk factors, without sending adverse signals to the market; monitor firms compliance with the new liquidity regime; run its own firm-specific and market-wide stress tests; collect fir m behavioural data in a standardised format; conduct peer comparison and sector analyses; form a market-wide view on liquidity risk; collect data that is useful for monetary and financial stability analysis and can be employed for this purpose by the FSA and external stakeholders including the Bank of England; and produce BI reports and, where appropriate, liquidity risk outlook documents which will be useful to internal and external stakeholders. 40

In April 2009, the FSA published its Consultation Paper 09/13, Strengthening liquidity standards 2: Liquidity reporting. The FSA sets out its proposals for a new liquidity reporting regime, having taken on board the comments made to its pre-consultation, making certain adjustments which should make the overall approach less onerous than those outlined in the pre-consultation. One key lesson of the crisis was the need to monitor liquidity at a market-wide and sectoral level alongside firm-specific assessments. To achieve this, the FSA proposes to collect quantitative liquidity data that is granular, frequent, standardised and based on firms contractual commitments and exposures, allowing the FSA to conduct internal stress testing and what if analyses, peer comparisons and also to develop a common language for liquidity across the financial services sector and, possibly, internationally. The FSA acknowledges that the new requirements will be more costly to implement than the current requirements. The requirement for separate currency reporting and for sole and group reporting for some firms will result in multiple submissions of the same return to meet each of the different requirements, adding to the complexity of reporting. Scope of the new reporting regime The quantitative reporting requirements will apply to all ILAS firms to a frequency and granularity varied according to whether the firm is a standard ILAS or a simplified ILAS firm. ILAS firms are banks, building societies, full scope BIPRU investment firms and branches of EEA and non-eea banks. Limited licence and limited activity investment firms will fall outside the scope of the ILAS requirement and will be subject to the systems and controls requirements; so they will not be subject to the proposed quantitative reporting requirements. The table below shows FSA proposed data items, their purpose, respective frequencies, scope and submission deadlines. DATA ITEM DESCRIPTION SCOPE FREQUENCY SUBMISSION DEADLINES Alternative Intelligence Quotient Issue 31, July 2009 FSA047: EMR Daily Flows Collects daily flows out to three months to analyse survival periods and spot potential liquidity squeezes early. Standard ILAS Weekly; Daily in firmspecific and/or market liquidity crises. BAU: End-of-day Monday for the week ending the previous Sunday; Crisis: End of the following business day (23.59GMT) for the previous business day. FSA048: Enhanced Mismatch Report (EMR) Standard Based on lessons learned during the recent market turbulences; aims to capture the ILAS risk drivers and contractual flows across the full maturity spectrum; can also be used to collect behavioural information from firms on a standardised basis. Standard ILAS BIPRU firms on the full regime Weekly; Daily in firmspecific and/or market liquidity crises. BAU: End-of day (23.59GMT) Monday for the week ending the previous Sunday; Crisis: End of the following business day (23.59GMT) for the previous business day. FSA049: EMR Simplified Similar to the standard EMR; firms will not have to provide daily flows. Simplified ILAS BIPRU firms, as outlined in BIPRU 12.6 ; Daily in firmspecific and/or market liquidity crises. BAU: Three business days after month end; Crisis: End of the following business day (23.59GMT) for the previous business day. FSA050: Marketable Assets Provides more granular analysis of firms marketable asset holdings. All ILAS month end. 41

DATA ITEM DESCRIPTION SCOPE FREQUENCY SUBMISSION DEADLINES FSA051: Funding Concentration FSA052: Pricing Data FSA053: Retail and Corporate Funding FSA054: Currency Analysis FSA055: Systems & Controls Questionnaire Captures firms borrowings from unsecured wholesale funders (excluding primary issuance), by counterparty class to identify concentrations on a firm- and market-wide basis. Collects daily transaction prices and transacted volumes for wholesale unsecured liabilities by product, tenor (where appropriate) and currency; gives insight into system-wide financial stability. Captures firms retail and corporate funding profiles and the stickiness of various retail deposits; shows changing retail funding profiles. Provides an analysis of the foreign exchange (FX) exposures on firms balance sheets. Monitor firms compliance with our Systems and Controls requirements, as outlined in BIPRU 12.3 & 12.4. All ILAS All ILAS All ILAS All ILAS BIPRU firms Non ILAS Weekly Quarterly Annual month end. End-of-day Monday for the week ending the previous Sunday for standard ILAS ; month end for firms on the simplified regime. quarter end. quarter end. Five business days after year end. Source: FSA Consultation Paper 09/13, Strengthening liquidity standards 2: Liquidity reporting, p 17. On frequency, the FSA proposes that, with regard to key liquidity data items FSA 047 (Daily Flows), FSA 048 (Enhanced Mismatch Report) and FSA 049 (EMR-simplified), firms will have to report them weekly (monthly for FSA 049) under BAU conditions and daily in crisis times, and will have to satisfy FSA that they can report these items daily. The reporting frequency of these data items switches to daily if there is a firm-specific or market liquidity crisis in relation to the firm or group in question. The new reports will replace the following existing liquidity reports in their entirety: FSA010, FSA012 and FSA013. FSA011 will be almost entirely deleted. In addition, the FSA is sympathetic to industry comment that FSA044 should be discontinued. On deadlines, as outlined in the table above, under BAU conditions, firms will be asked to submit weekly data items by end-of-day Monday (23.59 GMT) for the previous week. This applies to FSA047, FSA048 and FSA052 (Pricing Data). Firms that are part of the simplified regime will have to submit their monthly Enhanced Mismatch Report or EMR three business days after the end of the month in question. The same will apply to monthly and quarterly data items such as FSA050 (Marketable Assets), FSA051 (Funding concentration), FSA053 (Retail and Corporate Funding) and FSA054 (Currency Analysis), for ILAS firms that are subject to the full regime, as well as those that are subject to the simplified regime. In crisis times, firms will be expected to report FSA047, FSA048 and FSA049 daily, and the FSA proposes a submission deadline at the end of the business day immediately following the business day to which the data relates (ie, 23.59 GMT on 2 March for 1 March data). However, supervisors will still expect to receive on specific request key data relevant to the firm specific or market crisis in question at the end of the day for that same day during crisis times. 42

Legal entity basis for reporting Branches will, by default, be required to report on a solo basis; the FSA may require a branch to report on a whole-firm basis or may switch off the liquidity requirements entirely, depending on the facts. Firms will need to report on a solo basis, as well as on a UK consolidation group and/or Defined Liquidity Group basis. The concept of a Defined Liquidity Group was introduced in CP09/13 and the DLG will comprise entities which provide liquidity support to the firm. Reporting for smaller firms The FSA proposes a simplified reporting regime for simpler ILAS firms that meet the following criteria: the firm has no foreign currency exposures in assets or liabilities; wholesale funding is no more than 30% of total funding; and the majority of assets are mortgages secured on residential property. Currently, these criteria will be satisfied primarily by simpler building societies and mortgage banks. For example, under BAU conditions, they will need to submit FSA049 monthly rather than weekly, but still daily in times of crisis and to submit FSA052 monthly rather than weekly. They will not have to complete FSA047 and FSA048. A summary of the data items that such firms should submit is in the table below. DATA ITEM DESCRIPTION FREQUENCY SUBMISSION DEADLINES FSA049: EMR Simplified FSA050: Marketable Assets FSA051: Funding Concentration Similar to the standard EMR; aims to capture the ILAS risk drivers. Captures contractual flows across the full maturity spectrum; can also be used to collect behavioural information from firms on a standardised basis. Firms will not have to provide daily flows. Provides more granular analysis of firms marketable asset holdings. Captures firms borrowings from unsecured wholesale funders (excluding primary issuance), by counterparty class to identify concentrations on a firm- and market-wide basis. during BAU times; Daily in firm-specific and/or market liquidity crises. BAU: Three business days after month end; Crisis: End of the following business day (23.59GMT) for the previous business day. month end. month end. Alternative Intelligence Quotient Issue 31, July 2009 FSA052: Pricing Data Collects daily transaction prices and transacted volumes for wholesale unsecured liabilities by product, tenor (where appropriate) and currency; gives insight into system-wide financial stability. Weekly month end. FSA053: Retail and Corporate Funding Captures firms retail and corporate funding profiles and the stickiness of various retail deposits; shows changing retail funding profiles. Quarterly quarter end. FSA054: Currency Analysis Provides an analysis of the foreign currency exposures on firms balance sheets. month end. Source: FSA Consultation Paper 09/13, Strengthening liquidity standards 2: Liquidity reporting, p 26. 43

The FSA plans to publish its final rules in Q3 2009. The start date for reporting key data items FSA047, FSA048, FSA049 and FSA052 will be Q1 2010. The remaining reporting requirements will be phased in, with the timetable likely to be dependent on the category of the firm and a tighter timetable applicable to high impact firms. The FSA anticipates that its new liquidity regime will result in the following changes for firms: enhanced liquidity risk management capabilities, including greater use of stress testing and improvements to CFPs; less reliance on short-term wholesale funding, including wholesale funding from foreign counterparties; greater incentives for firms to attract a higher proportion of retail time deposits; a higher amount and quality of stocks and liquid assets, including a greater proportion of those assets held in the form of government debt; and a check on unsustainable expansion of bank lending during favourable economic times. been baring its teeth as a credible enforcer in recent years, the scene at least appears set for such action. William Yonge Proskauer Rose LLP, London Tel: 44 207 016 3600 wyonge@proskauer.com William would like to thank his colleague Nicholas Vasquez for his assistance in researching this article. The FSA considers the new The proposed new liquidity regime regime will reduce the probability of banks failing is rooted in an understanding of, and the associated costs of and reflection on, past mistakes, is such events to shareholders, thoughtful, robust and attempts to depositors, bondholders be proportionate; it will require and, in the event of bailout, taxpayers. It could reshaping of business models and also reduce the frequency significant costs in the coming years. of systemic financial crises that, historically, have had large negative impacts on GDP in a range of countries. The proposed new liquidity regime is rooted in an understanding of, and reflection on, past mistakes, is thoughtful, robust and attempts to be proportionate; it will require reshaping of business models and significant costs in the coming years. The FSA is continuing its policy of principles based or outcomes-focused regulation and laying ultimate responsibility for sound liquidity management at the door of senior management of the firms it regulates. In order for that policy to work effectively, the FSA must call individual senior managers to account where there have been failures and, in the enforcement context where the FSA has 44