Modernising the Liquidity Policy Framework: What firms need to know

• The events of March 2023, when Silicon Valley Bank and Credit Suisse experienced significant liquidity outflows within just a few days, demonstrated how advances in digital banking can accelerate deposit outflows and crystallise liquidity risk at a pace not anticipated when the existing framework was designed (in the case of SVB, a deposit outflow of 85% over 2 days, compared with Northern Rock having an outflow rate of 20% in 4 days in 2007). The Basel Committee's report to G20 Finance Ministers noted that the scale and speed of outflows far exceeded LCR assumptions, and that some banks lacked the operational capacity to monetise securities quickly in private markets or with central banks, impacting their ability to meet outflows. The PRA considers that the existing liquidity framework does not sufficiently address these risks, providing strong justification for its modernisation.
• The CP contemplates primarily operational changes, rather than material increases to available liquidity. The PRA is NOT proposing to solve for the challenges of rapid movements of liquidity and the risk of runs by requiring banks to self insure against remote risks by holding significant amounts of high quality liquid assets (HQLA), but rather to demonstrate that operationally and practically they have realistically and sensibly modelled the challenges to which their particular business models may make them subject in a sudden and severe stress, can demonstrate that they have operationalised the mobilisation/monetisation of assets in stressed situations and are able efficiently to use the various central bank facilities made available by the Bank of England in the Sterling Monetary Framework and have taken steps to identify and manage any frictions which might impede their management of liquidity.

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• CP5/26 is relevant to PRA-authorised UK banks, building societies, PRA-designated UK investment firms, as well as their qualifying parent undertakings (including financial holding companies, mixed financial holding companies, and credit institution and investment firm subsidiaries regardless of their location). It is also relevant to counterparties who have entered into financial contracts with such entities and which are governed by third-country law.   It is not directly relevant to large asset managers or non-bank  financial institutions which are not subject to PRA prudential supervision, but it will be of interest to them, in as much as it clearly demonstrates that the Bank of England is keen that the tools it uses as part of its market operations should not be seen to be there only in the event of crisis and with stigma attached to usage, but as being more generally available to firms as part of their own tool kits for managing liquidity.  It is not relevant to credit unions.

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The PRA proposes to take a phased approach to implementation, with Phase 1 applying to its proposal to cease requiring reporting of the monetisation section of the PRA110, and Proposals 3 and 4 on central bank facilities and pre-positioned collateral with central banks, with immediate effect from when the rules are made. Phase 2 would apply all other proposed requirements 12 months from the date the final rules are made.

• Firms will be required to assess the composition (and not just the amount) of their liquidity resources: The PRA proposes to revise the Overall Liquidity Adequacy Rule (OLAR) to explicitly clarify that firms must maintain an adequate composition of liquidity resources — as well as the amount — at all times, to ensure there is no significant risk that liabilities cannot be met as they fall due. Firms' assessments of composition would be expected to inform their judgement on the appropriate balance between cash and non-cash assets, as well as the broader balance of liquid assets that could be monetised in private markets and/or using central bank facilities to meet liquidity outflows during periods of financial market stress.
• Firms will be required to design a new 7-day stress scenario: The PRA proposes to introduce a new requirement for firms to design a stress scenario, relevant to their business model, with sudden and severe liquidity outflows that peak during the initial days of a stress — with the focus expected to be on the first week. The parameters of the scenario are for each firm to design to reflect the nature, complexity, and size of its business. The proposed PRA expectations for the stress scenario are set out in more detail at paragraphs 2.19Aff in the updated Supervisory Statement 24/15 (SS24/15) – “The PRA’s approach to supervising liquidity and funding risks”.
• Firms must identify and address frictions to monetisation — including unrealised losses on assets: As part of internal stress testing, firms may be required to assess the frictions associated with monetising assets and sources of outflows, considering risks that could delay or limit the ability to meet outflows and identifying contingent alternatives. This assessment should cover both private market monetisation and use of central bank facilities, and any frictions internal to firms (such as delays due to internal governance processes). Critically, this assessment should also cover whether the accounting treatment of unrealised losses on liquid assets could affect firms’ abilities and willingness to monetise their liquid assets rapidly — including the impact of monetising assets on their capital ratios.
• "Marketable asset risk" will be replaced by "monetisation risk": The existing Internal Liquidity Adequacy Assessment (ILAA) rule 11.5 requires firms to make appropriate assumptions around the major sources of risk in stress-testing scenarios on "marketable asset risk" — which narrowly focuses on risks to their ability to liquidate or monetise assets via sale or repo. The PRA proposes to replace this with the broader concept of "monetisation risk", with more detailed supervisory expectations on what firms need to consider in evaluating their ability to monetise assets, including market access, accounting treatment, and use of central bank facilities. An illustrative template will be provided in SS24/15 to assist firms in presenting the assessment proportionately to their liquid asset portfolio.
• Firms will no longer need to report “monetisation actions” from the PRA110 template: In light of the proposed changes outlined above, the PRA proposes to amend the Regulatory Reporting Part of the PRA Rulebook to remove the requirement for a firm to report monetisation assumptions from the PRA110 reporting template. The PRA would not change the PRA110 reporting template itself at this point but proposes that firms would not be expected to complete the section for the monetisation assumptions from the point the final rules are published.

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• The exemption for sovereign bonds and other Level 1 Assets from annual monetisation testing will be removed: Currently, the Article 8(4) Liquidity Coverage Ratio (CRR) requirement for firms to monetise, at least annually, a representative sample of their liquid asset holdings 4 does not apply to Level 1 Assets (other than certain high-quality covered bonds). This means that Level 1 Assets such as eligible sovereign bonds are currently exempt from this testing. The PRA proposes to remove this exemption entirely, aligning with Basel’s approach to monetisation testing under the international standard LCR. This is particularly important given the Bank of England's transition to a demand-driven, repo-led framework for supplying reserves, which means firms are likely to need to use central bank facilities to access these reserves in periods of stress. Firms will need to be operationally prepared to monetise eligible assets, including sovereign bonds, to do so.

• Central bank facilities are being formally integrated into the liquidity framework and operational readiness is key: The PRA proposes to clarify that firms may include drawings from central bank facilities, where regularly available and offered at published terms, as part of OLAR and internal stress testing. However, emergency liquidity assistance from central banks may not be included for the purpose of OLAR. Critically, where a firm includes central bank facilities in OLAR or stress testing, the PRA will require that it must be operationally ready to use those facilities  - including ensuring that it meets the eligibility criteria and has taken operational steps to prepare to use the facilities. This may include signing up to the Sterling Monetary Framework operational structure, pre-positioning eligible collateral, and conducting test or live use of the facilities.

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• Firms must monitor and disclose their central bank drawing capacity: The PRA proposes to amend ILAA rule 7 of the PRA Rulebook on collateral management to require firms to assess and monitor the adequacy and amount of central bank drawing capacity in relation to pre-positioned collateral (after any relevant haircuts), and to present this information in their Internal Liquidity Adequacy Assessment Process (ILAAP) document across all legal entities with drawing capacity with central banks, taking into account the currency. This explicitly includes access to and collateral available for foreign central bank facilities. Firms may also be required to calculate the amount of liquidity resources that would be available if they drew in full against all pre-positioned central bank collateral under a proposed amendment to ILAA rule 11.3C of the PRA Rulebook. This would provide both firms and supervisors with a complete picture of additional liquidity headroom available for further unexpected shocks in a period of severe stress.
• Firms’ assessments of pre-positioned collateral would need to be reported to and approved by firms’ management bodies: This proposal intends to support operational readiness, including ensuring firms’ governance structures and processes enable expedited escalation channels in periods of stress.
• Firms will be expected to estimate the amount of additional unencumbered and non-prepositioned assets which may be eligible as central bank collateral: The position on unencumbered and non-prepositioned assets remains unchanged: In preparing this information, firms will need to consider potential friction to the mobilisation of these assets, such as legal restrictions or operational barriers from third party funders. However, whilst the PRA recognises that unencumbered, non-pre-positioned assets would build firms’ operational preparation for wider recovery and resolution scenarios, it intends to maintain its current position that these assets cannot be considered as part of the OLAR, and therefore cannot be counted to meet outflows in firms’ internal stress testing.

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• The PRA proposes to make other, small clarificatory amendments to the PRA Rulebook: To ensure consistency with proposals 1-3 on liquidity resource composition and monetisation risk, the PRA proposes to clarify in ILAA rule 3.1 of the PRA Rulebook that firms are expected to have in place robust strategies, policies, processes and systems to ensure they maintain an appropriate composition of liquidity buffers, and as appropriate, of pre-positioned collateral with central banks, as well as adequate levels of liquidity buffers.
• Updates to the PRA’s supervisory expectations: The PRA proposes to clarify in its supervisory expectations that firms should take any potential limitations to monetisation of liquidity resources into account when setting their liquidity risk appetite. It will also embed clear governance expectations for the preparation of the ILAAP document, review of liquidity resources under OLAR and operational readiness to monetise assets, including use of central bank facilities. In addition, the PRA proposes to clarify expectations for effective senior Asset and Liability Management (ALM) committees by drawing on key aspects of good practice observed, reinforcing the importance of strong governance over liquidity risk management in the ILAAP.
• Updated expectations for liquidity contingency plans (LCPs): To ensure consistency with Proposals 1-3, the PRA also proposes to update expectations for LCPs. The PRA considers it important that there is a clear link to risks emerging from stress testing and the ILAAP are appropriately reflected in LCPs.
• Removal of EU references and the streamlining of SS24/15: The PRA proposes to replace redundant references to Commission Delegated Regulation (EU) 2015/61 (which is the EU’s LCR delegated Act) with the relevant parts of the PRA Rulebook, and to remove references to other EU supervisory documents, incorporating relevant key elements into the PRA's supervisory expectations where necessary — in particular, clarifying expectations for funding plans in SS24/15. The PRA also proposes to streamline SS24/15 more broadly, consolidating guidance on monetisation risk, distinguishing HQLA eligibility guidance from broader monetisation risk management guidance, and updating Section 5 to focus on the Sterling Monetary Framework and regularly available facilities

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