Wednesday, September 23, 2015

Regulators Focus on Liquidity Risk Management

Author: David Schwartz J.D. CPA

Since the liquidity freeze during the financial crisis, liquidity risk management has been a concern to regulators thorughout the financial industry.  Last week, the the SEC proposed new rules addressing liquidity management in open end funds and the Financial Industry Regulatory Authority issued guidance regarding effective liquidity management at broker-dealers.  

SEC Proposal

The SEC proposal, if adopted, would require mutual funds and ETFs would to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. In addition, the proposed rules would allow registered investment companies to use “swing pricing,” a process of adjusting the net asset value of a fund’s shares to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity.  

In addition to codifying the 15 percent limit on illiquid assets already included in current Commission guidelines, the proposed rules would require a fund’s liquidity risk management program to contain multiple elements, including:

  1. classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact;
  2. assessment, periodic review and management of a fund’s liquidity risk; 
  3. establishment of a fund’s three-day liquid asset minimum; and
  4. board approval and review.


FINRA Guidance

FINRA's new guidance on effective liquidity management practices is directed to senior management and risk managers at firms that hold inventory positions or clear and carry customer transactions, including broker-dealers, clearing firms, and large introducing brokers firms. The guidance is the product of a review of policies and practices at 43 firms related to managing liquidity needs in a stressed environment. The review had two broad purposes:

  1. to understand better firms’ liquidity risk-management practices and
  2. to raise awareness of the need for liquidity stress planning.

The stress testing included assessing firm management’s knowledge and understanding of the liquidity risks that their firm faced, the firm’s ability to measure liquidity needs in stress situations, management’s preparedness and plans for addressing such a scenario should it arise, and the specific steps the firm would take to address its needs.

Using the results of the stress tests, FINRA has developed guidance intended to help senior management and risk managers to ensure the availability of cash or highly liquid assets to support a broker-dealer’s funding needs under both normal and stressed conditions, including idiosyncratic or systemic events. 

Investor Protection

The financial crisis exposed the liquidity vulnerabilities of many large and small players in the global financial system. Failure to manage liquidity effectively contributed to individual firm failures and also demonstated vividly the contangion that can result from even small liquidity interruptions.  Now, regulators are taking action to require sound liquidity risk management practices in order to enhance investor protection, particularly in times of stress.