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CEBS Public Consultation on Liquidity Cost Benefit Allocation (CP 36) Summary

Core Content

The CEBS Public Consultation on Liquidity Cost Benefit Allocation (CP 36) is a follow-up to the CEBS Recommendations on Liquidity Risk Management from September 2008, and it aims to provide guidance on how institutions should allocate liquidity costs and benefits within their internal risk management frameworks. The consultation paper is intended to support the development of a robust and consistent liquidity management system across the EU financial sector.

Main Objectives

• Promote a strong risk culture around liquidity management
• Enhance the ability of institutions to price products, measure performance, and improve ALM (Asset and Liability Management) tools
• Ensure that liquidity cost benefit allocation mechanisms are aligned with governance, risk tolerance, and decision-making processes
• Support the implementation of the CRD (Capital Requirements Directive) and its amendments, particularly point 14 in Annex V

Key Information

CEBS Overview

• Established in November 2003, with the first meeting in January 2004
• Composed of high-level representatives from EU banking supervisory authorities and central banks
• Includes 27 member states, 3 observers from EEA countries, the EU Commission, the ECB, and the Banking Supervision Committee of ESCB
• Transformed into the European Banking Authority (EBA) in 2011
• Chair: Giovanni Carosio (Bank of Italy)

The Liquidity Cost Concept

The liquidity cost concept includes both direct costs and indirect liquidity costs:

• Direct costs include the cost of raising funds and the interest rate curve cost component
• Indirect costs include:
  • Mismatch liquidity cost (based on liquidity tenor, not interest rate tenor)
  • Cost of contingent liquidity risk (e.g., liquidity buffer and roll-over risk)
  • Other categories of liquidity risk exposure

Guidelines Overview

CP 36 contains five guidelines that aim to improve the internal liquidity cost benefit allocation mechanisms:

1. Guideline 1

   • The liquidity cost benefit allocation mechanism is a key part of the overall liquidity management framework
   • It should be consistent with the institution’s governance, risk tolerance, and decision-making processes
   • Institutions must define clear risk tolerance levels and ensure the mechanism reflects the business model and strategy

2. Guideline 2

   • The mechanism should have a proper governance structure, approved by the management body
   • Internal prices should be transparent, consistent, and regularly reviewed
   • The mechanism should be used for internal pricing, performance measurement, and the appraisal of new products or businesses

3. Guideline 3

   • The output of the mechanism should be actively used by end users and decision-makers
   • It should be tailored to the business profile and provide appropriate granularity
   • The liquidity pricing methodology should compensate liquidity providers and charge liquidity users

4. Guideline 4

   • Internal prices should cover all significant parts of the institution’s assets, liabilities, and off-balance sheet items
   • Sight deposits, trading book assets, and committed credit lines should be properly treated
   • Contingent liquidity risk should be allocated to the responsible business units and products

5. Guideline 5

   • Internal prices should be determined using robust methodologies
   • Modelling of assets and liabilities is essential
   • The selection of an internal pricing yield curve is critical, as it reflects the current marginal cost of funding
   • Common adjustments to the base price include:
     • Own credit risk adjustments
     • Bid/ask spread adjustments
     • Liquidity attributes adjustments
     • Option component adjustments (e.g., prepayment)
     • Other adjustments

Next Steps

• The public consultation runs until 10 June 2010
• CEBS will revise the document based on feedback from market participants
• Final guidelines will be published after endorsement at the CEBS planetary meeting in October 2010
• CEBS expects its members to apply the guidelines by 30 March 2011, while respecting the proportionality principle

Contact Information

• Written comments should be sent to: cp36@c-ecs.org by 10 June 2010
• CEBS Secretariat:
  • Tower 42 (level 18)
  • 25 Old Broad Street
  • London EC2N 1HQ, UK
  • Telephone: +44 (0)207 382 1770
  • Fax: +44 (0)207 382 1771/2