The Financial Stability Board (FSB) has released a consultation report proposing a series of measures to bolster the ability of non-bank financial institutions to weather liquidity shocks.
The FSB’s recommendations respond to the liquidity strains experienced by non-bank market participants during the March 2020 market turmoil, the Archegos failure in 2021, and the commodities market turbulence in 2022.
The report identifies risk management and governance weaknesses as key factors contributing to inadequate liquidity preparedness among some non-bank entities.
The consultation report sets out eight policy recommendations focused on managing and mitigating the impact of spikes in margin and collateral calls in the NBFI sector. The proposals cover liquidity risk management and governance, stress testing and scenario design, and collateral management practices of non-bank financial institutions.
Eight Policy Recommendations:
1. Incorporate liquidity risk assessment from margin and collateral calls in liquidity risk management and governance frameworks.
2. Define appetite for liquidity risk arising from margin and collateral calls and establish contingency funding plans.
3. Review and update liquidity risk frameworks to ensure robustness under extreme but plausible stress scenarios.
4. Conduct liquidity stress tests to identify potential liquidity strains and calibrate adequate, diverse, and reliable sources of liquidity and collateral arrangements.
5. Ensure liquidity stress tests cover a range of extreme but plausible scenarios, including both backwards-looking and hypothetical.
6. Implement resilient and effective operational processes and collateral management practices.
7. Maintain sufficient cash and readily available, diverse liquid assets to meet margin and collateral calls.
8. Engage in transparent, regular interactions with counterparties and third-party service providers in collateralised transactions.
Example: How the rule will affect hedge funds.
Let’s explore the case of the fictional hedge fund “Alpha Investments”.
According to the report, “The increase in margin and collateral calls can impact market participants differently depending on the size of their positions and level of liquidity preparedness.” For Alpha Investments, let’s assume that the fund has taken on substantial leveraged positions in various markets.
During market stress, Alpha Investments experiences a sudden spike in margin and collateral calls from its counterparties. As noted in the report, “Whilst margin and collateral calls are a necessary protection against counterparty risk, they can also amplify the demand for liquidity by market participants if they are unexpected in times of stress and affect a large enough part of the market.”
If Alpha Investments has not adequately incorporated liquidity risk arising from margin and collateral calls into its risk management framework (Recommendation 1), defined its liquidity risk appetite, or established contingency funding plans (Recommendation 2), it may struggle to meet these increased demands for liquidity.
Suppose Alpha Investments needs to conduct robust stress testing (Recommendations 4 and 5) or maintain sufficient cash and diverse liquid assets (Recommendation 7). In that case, it may be forced to liquidate positions at unfavorable prices to raise the necessary funds, potentially aggravating market stress.
The FSB highlights, “The recommendations cover liquidity risk management and governance, stress testing and scenario design, and collateral management practices of non-bank market participants, focussing on liquidity risks arising from spikes in margin and collateral calls.” By adopting these recommendations, Alpha Investments would be better prepared to navigate periods of market turmoil and meet its liquidity obligations without contributing to systemic risk.
