PRU 5.1 13Liquidity risk systems and controls

The FSA recognises that a typical firm of a type described in PRU 5.1.4 R generally faces liquidity risk from a wider range of sources and of greater significance than a typical insurer. This section therefore explicitly applies some items of guidance to firms in PRU 5.1.4 R. Other parts of the guidance are also not relevant to many insurers. In particular, where the guidance refers to factors that a firm should consider in relation to a specific type of business, a firm that does not undertake such business does not need to carry out such consideration.

High level requirements in relation to carrying out stress testing and scenario analysis are set out in PRU 1.2. In particular, PRU 1.2.35 R requires a firm to carry out appropriate stress testing and scenario analysis. This section gives guidance in relation to these tests in the case of liquidity risk.

Firms with group liquidity management should refer to PRU 1.4.14 G to PRU 1.4.16 G.

PRU 1.2.26 R, PRU 1.2.27 R, PRU 1.2.31 R, PRU 1.2.33 R and PRU 1.2.35 R entail that, for the purposes of determining the adequacy of its overall financial resources, a firm must carry out appropriate stress testing and scenario analysis, including taking reasonable steps to identify an appropriate range of realistic adverse circumstances and events in which liquidity risk might occur or crystallise.

PRU 1.2.36 G and PRU 1.2.40 G to PRU 1.2.55 G give guidance on stress testing and scenario analysis, including on how to choose appropriate scenarios, but the precise scenarios that a firm chooses to use will depend on the nature of its activities. For the purposes of testing liquidity risk, however, a firm should normally consider scenarios based on varying degrees of stress and both firm-specific and market-wide difficulties. In developing any scenario of extreme market-wide stress that may pose systemic risk, it may be appropriate for a firm to make assumptions about the likelihood and nature of central bank intervention.

A firm should review frequently the assumptions used in stress testing scenarios to gain assurance that they continue to be appropriate.

In identifying the possible on and off balance sheet impact referred to in PRU 5.1.61E (1), a firm may take into account:

1. (1)

   possible changes in the market's perception of the firm and the effects that this might have on the firm's access to the markets, including:

   1. (a)

      (where the firm funds its holdings of assets in one currency with liabilities in another) access to foreign exchange markets, particularly in less frequently traded currencies;

   2. (b)

      access to secured funding, including by way of repo transactions; and

   3. (c)

      the extent to which the firm may rely on committed facilities made available to it;

2. (2)

   (if applicable) the possible effect of each scenario analysed on currencies whose exchange rates are currently pegged or fixed; and

3. (3)

   that:

   1. (a)

      general market turbulence may trigger a substantial increase in the extent to which persons exercise rights against the firm under off balance sheet instruments to which the firm is party;

   2. (b)

      access to OTC derivative and foreign exchange markets are sensitive to credit-ratings;

   3. (c)

      the scenario may involve the triggering of early amortisation in asset securitisation transactions with which the firm has a connection; and

   4. (d)

      its ability to securitise assets may be reduced.

For a firm described in PRU 5.1.4 R, management information would normally contain the following:

1. (1)

   a cash-flow or funding gap report;

2. (2)

   a funding maturity schedule;

3. (3)

   a list of large providers of funding; and

4. (4)

   a limit monitoring and exception report.

For a firm described in PRU 5.1.4 R, the additional information referred to in PRU 5.1.69 G may include:

1. (1)

   asset quality and trends;

2. (2)

   any changes in the firm's funding strategy;

3. (3)

   earnings projections; and

4. (4)

   the firm's reputation in the market and the condition of the market itself.

The FSA would normally expect a firm described in PRU 5.1.4 R to consider setting limits on:

1. (1)

   liability concentrations in relation to:

   1. (a)

      individual, or related groups of, liability providers;

   2. (b)

      instrument types;

   3. (c)

      maturities, including the amount of debt maturing in a particular period; and

   4. (d)

      retail and wholesale liabilities; and

2. (2)

   where appropriate, net leverage and gross leverage.

PRU 1.2.22 R states that a firm must at all times maintain overall financial resources adequate to ensure that there is no significant risk that its liabilities cannot be met as they fall due.PRU 1.2.3 R (2) states that for the purposes of determining the adequacy of its overall financial resources, a firm must estimate the financial resources it would need in each of the circumstances and events considered in carrying out its stress testing and scenario analysis in order to meet its liabilities as they fall due.

A firm should adequately document the contingency funding plan referred to in PRU 5.1.86 E.

The contingency funding plan of a firm described in PRU 5.1.4 R should cover the extent to which the actions in PRU 5.1.86E (1) include:

1. (1)

   selling, using as collateral in secured funding (including repo), or securitising, its assets;

2. (2)

   otherwise reducing its assets;

3. (3)

   modifying the structure of its liabilities or increasing its liabilities; and

4. (4)

   the use of committed facilities.

A firm's contingency funding plan should, where relevant, take account of the impact of stressed market conditions on:

1. (1)

   the behaviour of any credit-sensitive liabilities it has; and

2. (2)

   its ability to securitise assets.

The contingency funding plan should contain administrative policies and procedures that will enable the firm to manage the plan's implementation effectively, including:

1. (1)

   the responsibilities of senior management;

2. (2)

   names and contact details of members of the team responsible for implementing the contingency funding plan;

3. (3)

   where, geographically, team members will be assigned;

4. (4)

   who within the team is responsible for contact with head office (if appropriate), analysts, investors, external auditors, press, significant customers, regulators, lawyers and others; and

5. (5)

   mechanisms that enable senior management and the governing body to receive management information that is both relevant and timely.

PRU 1.2.37 R states that a firm must document its assessment of the adequacy of its liquidity financial resources, how it intends to deal with those risks, and details of the stress tests and scenario analyses carried out and the resulting financial resources estimated to be required. Accordingly, a firm should document both its stress testing and scenario analysis (see PRU 5.1.58 G) and its contingency funding plan (see PRU 5.1.85 G).