4 The financial crisis and liquidity reform

The global financial crisis from 2007 resulted in a major liquidity crisis in the banking sector, threatening the solvency of many banks in Europe and the United States.

The crisis had its roots in the collapse of the sub­prime mortgage market in the United States in 2007. This was caused by the earlier underwriting of a large volume of sub-prime mortgages and a rise in mortgage interest rates in the US. Many banks were exposed to this market, largely through their holdings in mortgage-backed securities (mortgage-backed securities are bonds supported by claims on the cash flows from mortgage loans through a process known as ‘securitisation’), which fell in value due to defaults on the underlying mortgages. In this environment banks became increasingly reluctant to lend to each other, given fears that they may be lending to those institutions with material exposures to the collapsed mortgage market. (Due to the complexities of the securitization and credit default swap markets, there was no way of knowing which institutions held the final exposures.). So many banks found it difficult to borrow. However, to compound the issue, significant volumes of the so-called liquid assets (e.g. highly rated bonds, particularly from securitization vehicles) that the banks were holding became unmarketable – and so could not be used to raise cash. Clearly, the liquidity regulations that financial services industry regulators had imposed on banks and other financial institutions were found to be failing during the financial crisis. With many banks unable to raise new funds or generate cash by selling their liquid assets, an insolvency crisis loomed and had to be resolve d by governments and their regulatory bodies. This took the form of both providing short-term loans to the banks and allowing financial institutions to swap – for up to three years – certain of their bond holdings for high quality, and marketable, treasury bills (i.e. short dated paper issued by the Government). In the UK, the Special Liquidity Scheme, organised by the Bank of England, ran from 2008 until 2011 bringing liquidity back for the banks and renewing market confidence.

The failure of the existing liquidity requirements for banks during the financial crisis prompted regulatory authorities to revise their thinking about their requirements for holding liquid assets. In the UK, the answer to this matter was produced by the then regulator, the Financial Services Authority (FSA).

Primarily as a result of the financial crisis, the FSA was disbanded in 2012. This resulted in the supervisory responsibilities for financial organisations in the UK being passed to the newly formed Prudential Regulation Authority (PRA), a subsidiary of the Bank of England. Other activities of the FSA were passed to another newly formed body, the Financial Conduct Authority (FCA).

In 2010, the FSA introduced the Individual Liquidity Adequacy Standards (ILAS) regime for banks and other UK lenders. The approach taken reflects many of the underlying principles of good liquidity management identified in this course. Under ILAS, each bank has to undertake a stressed assessment of their potential exposure to cash outflows over a short-term period. This involves estimating the risk of outflows arising from ten sources of liquidity risk defined by the FSA (see Box 2). Following review by the FSA, the process then defines the minimum volume of the buffer of liquid assets that the bank must always hold, which is confirmed by the FSA and monitored through regular reports by the bank to the FSA.

Because banks, even in normal business conditions, periodically have to draw on some of their liquidity to accommodate cash outflows, the implication is that banks have to hold an additional store of liquid assets over and above the permanent core buffer. The inevitable consequence was that many banks found that under the new regime they were required to hold larger volumes of liquid assets than was previously the case.