Liquidity swaps - an overview

24/10/2012

FSA approach

Earlier this year the FSA issued final guidance on liquidity swaps and similar arrangements.

Whilst recognising their potential benefits and “seeing a role for these transactions on a sensible scale”, the FSA has a number of concerns about their increased use and the management and mitigation of associated risks.

At a high level, these include concerns as to the potential impact on interconnectedness between banks and insurers,and as to the management of conflicts of interest in intra-group transactions to ensure that these are carried out on an arm’s length basis, especially from the insurer’s perspective.

Accordingly, whilst the FSA is not opposed to liquidity swaps in principle, the guidance makes clear that any “proposed significant transactions” must be notified to the FSA well in advance of execution. Further, in addition issues around the identification, diversification and valuation of collateral assets, insurers will be expected to give specific consideration to:

- the impact on its ongoing liquidity requirements, including under stressed scenarios;
- the legal and operational risks associated with the transaction, particularly around the effectiveness and enforceability of any security arrangements; and
- the potential implications of regulatory changes on such transactions.

What’s on the horizon?

The Solvency II treatment is the key unknown on the horizon. At this stage, the only specific requirement under Solvency II in relation to securities lending and repo transactions is a supervisory reporting obligation. Provided the lent securities remain on the insurer’s balance sheet for accounting purposes, the only capital consequence under Solvency II is likely to be a charge for counterparty default risk (in relation to the bank’s obligation to return equivalent securities and manufacture dividends in the meantime), which can be reduced if the supporting collateral meets certain requirements.