The PRA's proposal for modernising the liquidity framework: clarifying expectations and improving firms' resilience to shocks

At a glance

• Consultation Paper 5/26 outlines the PRA’s proposals to strengthen the Pillar 2 liquidity framework in the UK, including enhancements to improve firms’ assessments of, and resilience to, fast-moving liquidity stress events. The proposals draw on lessons learned from the banking turmoil of 2023. Pillar 1 liquidity requirements remain unchanged.
• The PRA makes clear that the onus is on firms to improve their understanding of their short-term liquidity risk profiles, and to mitigate the associated risks through an appropriate composition of the liquid asset buffer, as well as improved capabilities to monetise these assets when required.
• The PRA has also clarified its expectations on the recognition of liquidity available under central bank facilities, amounting to a significant change to the Overall Liquidity Adequacy Rule.
• These changes, if adopted, are likely to affect firms’ ILAAPs, operational capabilities, regulatory reporting, internal liquidity stress testing and broader liquidity risk management frameworks. For some firms, enhanced or new assessments of their liquidity risk exposures may require changes in the composition and overall size of their liquid asset buffer, leading to wider balance sheet and strategic considerations.- Boards and senior management will all need to engage in order to satisfy the PRA that their firms is meeting its PRA’s new expectations.

Introduction

The PRA has published Consultation Paper 5/26, setting out proposed reforms to the liquidity framework for UK banks, building societies and PRA-designated investment firms. Taken together, the proposals amount to the most significant change to the bank liquidity framework in recent years.

A key theme in the PRA’s proposals is the need to modernise the liquidity framework to increase firms’ resilience to the fast-moving risks that became apparent during the 2023 banking turmoil, which led to the collapse of Silicon Valley Bank, Credit Suisse and others. Most notably, that crisis demonstrated how advances in digital banking, payments and digital technology have dramatically increased the scale and speed of liquidity outflows when confidence in a bank is lost. It also demonstrated limitations in some banks’ operational capacity to monetise their assets to meet outflows.

The PRA has chosen not to revise the Pillar 1 liquidity framework (i.e. the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR)), recognising the potentially high costs for firms and the real economy from, for example, mandated increases in LCR deposit outflow rates.

Instead, the PRA’s proposals focus on three core “targeted changes to Pillar 2”, aimed at supplementing existing Pillar 1 standards:

1. enhancing firms’ readiness for sudden liquidity shocks, including their ability to quantify and fund significant short-term liquidity requirements;
2. clarifying the role of central bank facilities within the liquidity framework; and
3. enhancing firms’ collateral management capabilities to support their ability to generate cash when needed in stress.

While implementing the PRA’s proposals will, in the first instance, be the remit of Treasury and risk functions, the updated supervisory statement underscores the PRA’s view that robust balance sheet management requires engagement and oversight from senior leadership. The PRA expects firms to ensure oversight by “effective senior ALM committees” that are “routinely attended by the CEO and chaired by either the CEO or the CFO”. These committees must also consider future planning and strategy in their oversight of an evolving liquidity risk management landscape.

Below, we explore some of the key components of the PRA’s proposals.

1. Enhancing Readiness for Stress

The PRA’s proposals aim to strengthen firms’ resilience to fast-moving stress events through targeted improvements relating to both the way in which firms:

• measure their potential liquidity requirements in these events; and
• assess the appropriateness of the composition of their liquid asset buffers, considering monetisation risk.

i. Quantifying Liquidity Requirements in Highly Short-Term Liquidity Stress Events

The PRA proposes introducing a new requirement for firms to design a liquidity-focused stress scenario that involves “sudden and severe liquidity outflows that peak during the initial days of a stress”. This new stress scenario must provide visibility of daily cash flows over at least a seven-day period. The resulting enhanced visibility of potential inter-day peak liquidity requirements in fast-moving stress events will complement supplementary proposed requirements relating to firms’ assessments of the composition of their liquid asset buffers (see below), providing visibility of the granular timing of liquidity needs that must be met with cash in the early phases of a stress.

Key takeaways: firms which currently have inadequate focus on fast-moving scenarios, or insufficient front-loading of the impacts of longer-term (i.e. 30-day to 90-day) scenarios in existing liquidity stress testing frameworks, may face increased overall liquidity requirement. Firms will need to consider the potential operational costs associated with this expansion to the stress testing framework, including scenario design, validation and governance. Some firms may also identify the need to alter the composition of their liquid assets, if the current monetisation profile does not indicate that liquidity would be realised sufficiently quickly in a stress.

ii. Quantifying Liquidity Resources in Highly Short-Term Liquidity Stress Events

An ongoing challenge for Treasurers is striking a balance between the yield achieved on the liquidity buffer and its ability to fund liquidity requirements as they arise. Getting this balance right is critical in ensuring liquidity resilience, particularly in fast-moving stress events. Liquid securities that a firm aims to monetise through repo transactions with a T+2 settlement timeline will be effectively worthless from a liquidity perspective when considered in the context of liquidity needs arising in the first two days of a stress event.

However, inadequate visibility of the size of the potential liquidity requirements that may arise in the first days of a stress is one factor that may distort the balance. To mitigate this risk, the PRA proposes, in conjunction with the enhancements to liquidity stress testing outlined above, increased expectations relating to firms’ assessment of the composition of their liquid assets. This helps ensure that cash is available as and when required in a stress event, supporting alignment of liquidity resources and liquidity requirements from a timing perspective.

This enhanced visibility of liquid assets’ monetisation would also be captured in an updated “monetisation risk” component of ILAA rule 11.5 of the PRA Rulebook, replacing the prior “marketable asset risk” concept. As part of this, the PRA outlines heightened expectations relating to firms’ assessments of their monetisation capabilities, channels, haircuts, accounting treatment and “key frictions to monetisation identified” (for example, operational delays due to required internal governance processes).

From a regulatory reporting perspective, the PRA is proposing to remove the requirement for firms to report the “monetisation actions” section of the PRA110. While this will be a welcome reduction in the reporting burden for firms, it serves to demonstrate the increased onus on firms’ internal assessments to monitor and manage monetisation risk.

The PRA also proposes to remove the current exemption for LCR Level 1 HQLA¹ from the monetisation testing requirements within Article 8 of the LCR Part of the PRA Rulebook , aligning with the Basel standard. This change recognises the potential operational issues that could arise in the event of monetisation of liquid assets, regardless of their quality.

Key takeaways: expectations relating to the way in which firms assess the composition and monetisation of their liquid assets will be materially heightened under the proposal, resulting in expansions of ILAAP assessments and potential improvements to liquidity stress testing. Conclusions of these assessments may identify mismatches between the liquid asset buffer monetisation profile and near-term liquidity needs in a stress, leading to some firms needing to make changes to liquid asset holdings, as well as improvements to monetisation capabilities and associated controls.

2. Clarifying the role of central bank facilities

The PRA acknowledges the need to provide further clarification on the extent to which central bank liquidity facilities can be relied upon in stress. This is directionally consistent with the principles laid out in the PRA’s December 2024 Discussion Paper on a ‘repo-led operating framework’.

While ILAA rules already provide guidance relating to emergency central bank liquidity facilities, the PRA highlights that “other central bank facilities that are regularly available at published terms could be considered available” to meet the OLAR. This mirrors a similar shift observed in US banking regulation, with the Fed recently highlighting² the “fundamental reform” needed on this topic.

The PRA proposes amendments to guidance on the Bank of England’s market operation facilities to “provide a clearer and updated overview” of firms’ use of “facilities regularly available at published terms”. This represents a potentially significant change to firms’ liquidity risk management frameworks, combining the traditional approach of “self-insurance” through the holding of liquid assets with the recognition of contingent liquidity that may be obtained from non-emergency central bank facilities.

The above theme of operational readiness is extended to firms’ assumed use of central bank facilities in the context of the OLAR. The PRA highlights that, where these facilities are considered in the context of the OLAR, firms must ensure they are “operationally ready to use those facilities”. This includes, for example, adequate pre-positioning of collateral and the execution of test trades, to support ILAAP assessments in demonstrating that potential impediments have been identified and managed to an appropriate level.

Key takeaways: liquidity available under non-emergency central bank facilities may be considered in the context of the OLAR, representing a potentially significant change to the way in which firms manage liquidity and measure resilience. Firms seeking to rely on such facilities will need to ensure robust ILAAP assessments and ongoing monitoring of availability, timelines and operational capability, to ensure that this source of liquidity is considered in a prudent manner that reflects their ability to access it in a severe stress event.

3. Enhancing Collateral Management

Firms seeking to place some reliance on central bank liquidity facilities for OLAR compliance will have to have strong collateral management capabilities. The PRA proposes that firms must have clear visibility, and undertake ILAAP assessments, of “the levels of drawing capacity across all legal entities with central banks, taking into account the currency”, as well as “the frequency and timing of different facilities’ availability”. This will ensure that any recognition of central bank liquidity is prudently assessed. In addition, those firms will be required to ensure ongoing visibility of the aggregate liquidity resources available to them in the event all pre-positioned central bank collateral being drawn against.

Key takeaways: the PRA’s heightened expectations are likely to represent a notable increase in ILAAP requirements, as well as potential requirements to enhance operational capabilities relating to the identification and mobilisation of collateral. In addition, improvements to ongoing monitoring and reporting of collateral are likely to be required, to ensure prudent quantifications of pledged and eligible assets at all times.

Conclusion

Formal regulatory policy-level responses on a global scale have been relatively limited since the banking turmoil events of 2023. However, the proposals set out by the PRA in CP 5/26 represent tangible and, in some cases, material changes to expectations of the way in which firms measure and manage their liquidity risk in the context of liquidity risk profiles that continue to evolve alongside technological advancements. These changes are likely to affect firms’ ILAAPs, operational capabilities, regulatory reporting, internal liquidity stress testing and broader liquidity risk management frameworks.

The PRA makes it clear that the onus remains on firms to identify, measure and manage their risk exposures. This extends to firms ensuring adequate oversight of liquidity risk management by senior committees, including C-suite executives.

Additional author: Samy Bukowski

References:

1. Excluding Level 1 covered bonds
2. Liquidity Resiliency, Financial Stability, and the Role of the Federal Reserve – speech by Vice Chair for Supervision Michelle W. Bowman