An assessment of UK banking liquidity regulation and supervision

This thesis assesses UK banking liquidity regulation and supervision and the Basel liquidity requirements, and models banks' liquidity risk. The study reveals that the FSA's risk-assessment framework before 2008 was too general without specifically considering banks' liquidity risk (as well as its failures on Northern Rock). The study also lists the limitations of the FSA's banking liquidity regimes before 2008. The thesis reviews whether the FSA's new liquidity regimes after 2008 would have coped with UK banks' liquidity risks if they have been applied properly. The fundamental changes in the FSA's liquidity supervision reflect three considerations. First, it introduces a systemic control requirement by measuring individual fifirm's liquidity risk with a market-wide stress or combination of idiosyncratic and market-wide stresses. Second, it emphasizes the monitoring of business model risks and the capability of senior managers. Third, it allows both internal and external managers to access more information by increasing the liquidity reporting frequencies. The thesis also comments on the Basel Liquidity Principles of 2008 and the two Liquidity Standards. The Principles of 2008 represents a substantial revision of the Principles of 2000 and reflect the lessons of the fifinancial market turmoil since 2007. The study argues that the implementation of the sound principles by banks and supervisors should be fexible, but also need to be consistent to make sure they understand banks' liquidity positions quite well. The study also explains the composition of the Basel liquidity ratios as well as the side effect of Basel liquidity standards; for example, it will reshape interbank deposit markets and bond markets as a result of the increase in demand for `liquid assets' and `stable funding'. This thesis uses quantitative balance sheet liquidity analysis, based upon modified versions of the BCBS (2010b) and Moody's (2001) models, to estimate eight UK banks' short and long-term liquidity positions from 2005 to 2010 respectively. The study shows that only Barclays Bank remained liquid on a short-term basis throughout the sample period (2005-2010); while the HSBC Bank also proved liquid on a short-term basis, although not in 2008 and 2010. On a long-term basis, RBS has remained liquid since 2008 after receiving government support; while Santander UK also proved liquid, except in 2009. The other banks,especially Natwest, are shown to have faced challenging conditions, on both a short-term and long-term basis, over the sample period. This thesis also uses the Exposure-Based Cash-Flow-at-Risk (CFaR) model to forecast UK banks' liquidity risk. Based on annual data over the period 1997 to 2010, the study predicts that by the end of 2011, the (102) UK banks' average CFaR at the 95% confidence level will be -£5.76 billion, Barclays Bank's (Barclays') CFaR will be -£0.34 billion, the Royal Bank of Scotland's (RBS's) CFaR will be -£40.29 billion, HSBC Bank's (HSBC's) CFaR will be £0.67 billion, Lloyds TSB Bank's (Lloyds TSB's) CFaR will be -£4.90 billion, National Westminister Bank's (Natwest's) CFaR will be -£10.38 billion, and Nationwide Building Society's (Nationwide's) CFaR will be -£0.72 billion. Moreover, it is clear that Lloyds TSB and Natwest are associated with the largest risk, according to the biggest percentage difference between downside cash flow and expected cash flow (3600% and 816% respectively). Since I summarize a bank's liquidity risk exposure in a single number (CFaR), which is the maximum shortfall given the targeted probability level, it can be directly compared to the bank's risk tolerance and used to guide corporate risk management decisions. Finally, this thesis estimates the long-term United Kingdom economic impact of the Basel III capital and liquidity requirements. Using quarterly data over the period 1997:q1 to 2010:q2, the study employs a non-linear-in-factor probit model to show increases in bank capital and liquidity would reduce the probability of a bank crisis significantly. The study estimates the long-run cost of the Basel III requirements with a Vector Error Correction Model (VECM), which shows holding higher capital and liquidity would reduce output by a small amount but increase bank profitability in the long run. The maximum temporary net benefit and permanent net benefit is shown to be 1.284% and 35.484% of pre-crisis GDP respectively when the tangible common equity ratio stays at 10%. Assuming all UK banks also meet the Basel III long-term liquidity requirements, the temporary net benefit and permanent net benefit will be 0.347% and 14.318% of pre-crisis GDP respectively. Therefore, the results suggest that, in terms of the impact on output, there is considerable room to further tighten capital and liquidity requirements, while still providing positive effects for the United Kingdom economy.