Respondents recognised the potential conflict of interest with intra-group transactions, but argued that it is possible to mitigate these risks rather than having to ban these transactions.
The FSA has clarified the scope of application and recognised that liquidity swaps are part of a subset of collateralised borrowing now referred to as ‘collateral upgrade transactions’, hence the change to the title of the guidance. There will be a further phase of work that will look more broadly at collateralised borrowing, the possibility of data collection and facilitating market transparency.
The FSA's consultation was issued in response to observing an increasing trend of banks looking to improve liquidity by entering into new types of collateral upgrade transactions: in particular those transactions where banks look to access the liquidity embedded within asset portfolios held by insurers, although there have also been a number of transactions between two bank counterparties.
The FSA recognises that these transactions enable the temporary transfer of liquid assets to firms that need them, whilst at the same time providing the lending firm with secured exposures (which can benefit its creditors including depositors and policy-holders) and potentially an enhanced yield. The FSA sees a role for these transactions on a sensible scale, provided the risks are properly identified and managed by both parties.
Collateral upgrade transactions allow the borrower to exchange poorer quality assets (e.g. illiquid or less liquid and/or low credit quality) for better quality assets (e.g. liquid and/or high credit quality). The FSA's potential concerns with collateral upgrade transactions include:
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the continuing trend to encumber balance sheets to the potential detriment of consumers; using borrowed assets to meet liquidity requirements and/or help funding, i.e. whether this provides resilient liquidity or funding benefits in a time of stress;
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whether risk management frameworks are adequate to deal with the increased risk from extended maturities, significant size, and the use of potentially illiquid or less-liquid, poorer quality and difficult to value assets as collateral; and whether such transactions hinder the resolvability of firms.
© FSA - Financial Services Authority
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