Regulating Liquidity Risks Within "Institutional Protection Schemes"

Abstract

During an early phase of the financial crisis (2007), many financial institutions—in spite of adequate capital levels—faced heavy difficulties because they didn't manage their liquidity profile in a prudent manner. Suddenly the crisis reminded the respective sector on the importance of liquidity to the proper functioning of financial markets. In front of the times of crisis, asset markets were broad and deep, funding was readily available at low cost. The quick change in market conditions showed how fast liquidity can dry up, and that illiquidity can endure for an extended period of time. The banks faced severe stress, which required actions by central banks to—one the one hand—keep alive both the functioning of capital and money markets and—on the other hand— support individual banks or banking groups, which lost their most important funding sources. The impact of a liquidity crisis broadly differs among jurisdiction, markets and concrete market participants. Empirically banks, which were very reliant on interbank funding and closely connected to other financial institutions, suffered during the crisis more than e.g. banks with a business model in favour of funding by retail deposits and holding sufficient Liquidity buffers. Especially in Austria and Germany, there is a phenomenon rising of so called "Institutional Protection Schemes" (in the following: "IPS"). The establishment of an IPS means the foundation of a "contractual or statutory liability arrangement which protects those institutions and in particular ensures their liquidity and solvency to avoid bankruptcy where necessary" (Article 113 para 7 CRR). Currently it seems that a huge part of Austrian banks (about 800 institutions in total) will apply for a membership in an IPS. Given that banks within the same IPS are strongly connected and the role of an IPS is to ensure the ongoing solvency and liquidity of its member institutions, such banking networks may create special needs for liquidity risk management and supervision. This paper deals with the question whether IPS' are sufficiently regulated by CRR and CRD IV, focusing on the topic liquidity and liquidity risk. As mentioned, the basic notion of Basel III focuses on banking groups, not on banking networks and by no means on IPS. This raises the question whether the scope and content of the European regulations regarding liquidity risk deals with networks of banks, especially IPS, in an appropriate manner.

1. Introduction

"Liquidity is the lifeblood of financial institutions"
(Harris, 2013: p. 179)

"Liquidity [...] it is merely the oil greasing the wheels of the financial system, so that they function frictionless and costless. Nevertheless, smooth periods do not last for ever."
(Nikolaou, 2009: p. 43)

The financial crisis unveiled specific weaknesses of the functioning of financial markets and the risk management of its most crucial participants—financial intermediaries, mainly credit institutions. Especially the drying up of unsecured interbank lending markets disclosed the strong mutual dependence and interconnectedness of financial institutions, having the consequence of contagion risk and potential domino-effects in global markets.

Although a lot of banks have sufficiently implemented preparations in order to avoid to get hit by a severe crisis scenario, most banks predominantly build up capital buffers and underestimated the probably central risk of the heart of banking—liquidity risk. When liquidity is cheap (low interest/lending rates) banks create incentives to search for higher yield, decreasing their costly liquidity buffers and consequently increasing the entire systemic risks. Cheap funding sources do have the effect that liquidity risks get underestimated and therefore not priced, which has the effect of further risk-concealing of assets and funding sources. Particularly interbank lending is a major source of funding, and thus funding risk.

In order to avoid future crisis, global actors and standard-setters, such as the (former) G20 and Banking Committee of Banking Supervision (BCBS), decided to strengthen financial regulators. This package of new standards, named "Basel III", was also introduced by the European legislator via a respective regulation (CRR) and a directive (CRD IV). One of the most crucial regulation issues in CRR and CRD IV is the topic of liquidity and liquidity risk.

Usually, global standards in banking regulation addresses banking groups, meaning a structure of a (controlling) parent entity and subordinated entities (subsidiaries). Also Basel III focuses on the regulation of banking groups.

However, especially in Austria, Germany and Spain, the majority of credit institutions are not part of a banking group. Those banks often are part of a so called decentralized sector, meaning that plenty of smaller banks are holding participations in one bigger (central)-institution (non-technically a subsidiary of many parents). The idea of such structures is to maintain autonomous and independent on solo-bank level to the greatest possible extent.

Generally CRR and CRD IV consider such models of banking networks, concretely (and most important) in the type of an Institutional Protection Scheme (IPS). According to the CRR an IPS is a "contractual or statutory liability arrangement which protects those institutions and in particular ensures their liquidity and solvency to avoid bankruptcy where necessary." (Art 113 para 7 CRR), established by a broad number of institutions with a predominantly homogeneous business profile. IPS' seems attractive to smaller banks because they may stay independent to a large extent and thus, additionally, gain big privileges in banking regulation.

The paper deals with the question whether IPS' are sufficiently regulated by CRR and CRD IV, focusing on the topic liquidity and liquidity risk. As mentioned, the basic notion of Basel III focuses on banking groups, not on banking networks and by no means on IPS.¹ This raises the question whether the scope and content of the European regulations regarding liquidity risk deals with networks of banks, especially IPS, in an appropriate manner. Note that the issue of the regulation of decentralized sectors and of IPS' is highly political. However, this paper does not elaborate an analysis of the ongoing political debate and lobbying concerns.

Thus, the paper on hand explains the approach of the European legislator of "Regulating Liquidity Risks within 'Institutional Protection Schemes'". From a structural perspective, this paper provides an overview about the basic notion of the Basel-Accord and its European implementation. In order to better understand the issue of liquidity regulation, this paper also grants an analysis of the specific categories of liquidity and liquidity risk. Central elements of the paper are the definition and further explanation of the specific structure and connected regulatory privileges concerning Institutional Protection Schemes and the mapping of the main issues of European liquidity regulation, including pillar I (CRR), pillar II (CRD IV) and systemic liquidity regulation opportunities, as well as supervisory powers referring to liquidity regulation and systemic risk.

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Footnotes

* The paper on hand is not an official statement by the Austrian FMA. It purely reflects the personal opinion of the author.

1. The BCBS do not even know the terminus "IPS". The establishment of IPS therefore is in fact a European idea.

Originally published by Scientific Research Publishing Inc., September 2014.

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