Regulating Liquidity Risks within “Institutional Protection Schemes”

Abstract

During an early phase of the financial crisis (2007), many financial institutions — in spite of adequate capital levels — faced heavy difficulties because they didn’t manage their liquidity profile in a prudent manner. Suddenly the crisis reminded the respective sector on the importance of liquidity to the proper functioning of financial markets. In front of the times of crisis, asset markets were broad and deep, funding was readily available at low cost. The quick change in market conditions showed how fast liquidity can dry up, and that illiquidity can endure for an extended period of time. The banks faced severe stress, which required actions by central banks to — one the one hand — keep alive both the functioning of capital and money markets and — on the other hand — support individual banks or banking groups, which lost their most important funding sources. The impact of a liquidity crisis broadly differs among jurisdiction, markets and concrete market participants. Empirically banks, which were very reliant on interbank funding and closely connected to other financial institutions, suffered during the crisis more than e.g. banks with a business model in favour of funding by retail deposits and holding sufficient Liquidity buffers. Especially in Austria and Germany, there is a phenomenon rising of so called “Institutional Protection Schemes” (in the following: “IPS”). The establishment of an IPS means the foundation of a “contractual or statutory liability arrangement which protects those institutions and in particular ensures their liquidity and solvency to avoid bankruptcy where necessary” (Article 113 para 7 CRR). Currently it seems that a huge part of Austrian banks (about 800 institutions in total) will apply for a membership in an IPS. Given that banks within the same IPS are strongly connected and the role of an IPS is to ensure the ongoing solvency and liquidity of its member institutions, such banking networks may create special needs for liquidity risk management and supervision. This paper deals with the question whether IPS’ are sufficiently regulated by CRR and CRD IV, focusing on the topic liquidity and liquidity risk. As mentioned, the basic notion of Basel III focuses on banking groups, not on banking networks and by no means on IPS. This raises the question whether the scope and content of the European regulations regarding liquidity risk deals with networks of banks, especially IPS, in an appropriate manner.