FSA calls for more liquidity controls

Reform of Britain's banking system began in earnest yesterday as regulators and politicians set in motion plans to forestall another financial crisis.

The latest news and views on the credit crisis

	The Northern Rock fiasco has focused attention on liquidity risk

Most significant was a long-awaited discussion paper from the Financial Services Authority on how banks and building societies can better manage their liquidity risk to prevent a repeat of the Northern Rock fiasco. The watchdog is calling for stronger stress testing, in particular of off-balance sheet vehicles such as conduits, and a "belt and braces" approach to internal controls.

Separately, the Chancellor Alistair Darling pledged to unveil proposed changes to the UK's tripartite system of regulation next month to "improve the position [of] banks that might get into difficulty". And German Chancellor Angela Merkel said European Union leaders would decide at a summit in March on measures "to boost transparency in financial markets and improve risk management".

News of the co-ordinated reforms came a day after the world's central banks flushed the money markets with an unprecedented $530bn (£265bn) of funds and the UK Treasury raised the taxpayer support for Northern Rock to £57bn.

Northern Rock has focused attention on liquidity risk after it turned to the Bank of England in September because it was unable to fund itself in the wholesale markets.

In yesterday's document, which comes ahead of more formal proposals next summer, the FSA stressed the reforms should ensure "a bank takes reasonable steps to withstand liquidity stress without needing to take actions - such as large-scale asset sales or access to emergency central bank lending - that might disrupt market confidence".

The key changes it is proposing are:

• To extend stress testing of a bank's cash flows to areas currently exempt such as off-balance sheet funding like conduits and structured investment vehicles;

• To increase the frequency with which a bank updates the FSA of its position from quarterly to once a month;

• To better match the maturity of its assets against its liabilities by securing, for example, more long-term funds to set against its mortgage commitments;

• To hold more highly liquid assets, such as gilts, that can be turned into cash quickly so the bank can last longer then the currently stipulated five days without tapping wholesale markets;

• To test whether liquidity promises from other banks can be reliably called upon in times of crisis.

Paul Sharma, head of risk review at the FSA, said: "There will be an element of dismantling the current regime and an element of revolution. The discussion paper will inform the debate."

To tackle the complexity of liquidity risk, the rules have previously been adjusted to suit a bank's model. However, the FSA will now consult on whether a one-size-fits-all approach would improve regulation. It is also exploring an "early warning" system for future liquidity crises.

Earlier in the day, the Prime Minister brushed aside suggestions that Britain's tripartite system of regulation needs to be completely overhauled, saying the current rules are "fundamentally the right framework". He also dismissed the idea of a rift with Bank of England Governor Mervyn King. "The Governor, the Chancellor and I are completely at one," he said. inside