## _cr16159

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---

### Executive summary
- The U.K. is a leading financial center; the GFC exposed diverse liquidity needs and prompted scaling up liquidity provision and redesign of liquidity insurance.
- The Bank of England’s (BoE’s) Sterling Monetary Framework (SMF) covers:
  - tools to implement monetary policy;
  - tools to backstop sterling liquidity needs of individual institutions and the overall system (“liquidity insurance”);
  - tools to support market functioning—Market Maker of Last Resort (MMLR).
- Emergency Liquidity Assistance (ELA) is a broad, largely unpublished bilateral idiosyncratic liquidity support framework outside the SMF and includes all other liquidity provision activities, including lending in foreign exchange.
- Key questions raised by the broader, more accessible liquidity insurance framework:
  - contingent implications for the BoE balance sheet;
  - safeguards against excessive use (for example, global liquidity arbitrage);
  - extent to which the framework weakens incentives for financial institutions to self-insure against liquidity risk.
- Four other financial stability issues: adequacy of the ELA framework; BoE capacity to provide FX ELA; adequacy of the MMLR framework; degree to which facilities remain stigmatized.
- Institutional response: new Division for enterprise-wide financial risk assessment to evaluate scenario impacts on the Bank’s balance sheet.
- Overall assessment highlights:
  - Safeguards generally sufficient, but ensure lower supervisory scrutiny of small- and medium-sized firms does not impair horizon-scanning.
  - CCP access to the SMF since 2014 requires continuous assessment of incentives.
  - ELA framework operationally ready; BoE retains capacity for covert ELA where possible.
  - BoE has built capacity for FX ELA; FX availability from multiple sources suggests adequacy.
  - MMLR is well-designed and flexible; consider additional instruments (e.g., non-recourse repos); extension to Asset Managers poses challenges.
  - De-stigmatization mixed: ILTR popular with little stigma in normal conditions; DWF not part of normal liquidity planning and likely used only in extreme situations.

### Main recommendations
- Assess incentives created for CCPs in managing liquidity risk and ensure appropriate arrangements and incentives via CCP supervision and SMF management.
  - Timing: Short term
  - Authorities: BoE
- Ensure PRA supervisory scrutiny over small and medium-size firms does not adversely impact SMF risk management and ELA horizon scanning.
  - Timing: Short term
  - Authorities: BoE
- Complete a broad financial sector stress scenario to assess aggregate exposure to liquidity insurance across the full range of SMF facilities.
  - Timing: Short term
  - Authorities: BoE

### Overview of the liquidity provision framework and recent developments
- Pre-GFC:
  - Conventional, narrowly focused liquidity provision regime with a traditional mid-corridor system; banks held relatively low reserves determined each reserves maintenance period.
  - Liquidity insurance was last-resort, aimed at commercial banks, against very high quality collateral including U.K. Gilts; ELA was the only liquidity insurance tool and BoE emphasized minimizing moral hazard.
  - BoE applied “constructive ambiguity” to ELA—acknowledging an ELA role while publishing few details.
- Post-GFC and permanent adjustments:
  - Broader eligible collateral; introduction of Discount Window Facility (DWF); lengthened and increased frequency of liquidity operations; MMLR operations in corporate bonds and commercial paper; Quantitative Easing (QE); move to a “floor” monetary policy implementation system.
  - Reviews (Winters and Plenderleith) led to governance concordats and new tools: Indexed Long Term Repo (ILTR), Contingent Term Repo Facility (CTRF); DWF reform with transparent pricing and volumes and widened eligible collateral consolidated into three categories; eligible counterparties widened to include broker dealers, building societies and CCPs.
- Current SMF:
  - SMF covers monetary policy implementation, liquidity insurance, and MMLR operations; ELA is separate and comprises sterling lending outside the SMF plus any FX lending.
  - Monetary Policy Implementation: Objective—implement MPC decisions to meet inflation target; Governance—MPC; Tools—Level of Bank Rate; Remunerate reserves at Bank Rate; Operational Standing Facilities (OSF); Asset Purchase Facility (APF); FX Intervention.
  - Liquidity Insurance: Objective—reduce cost of disruption to key financial and payment services; Governance—Bank; Tools—ILTR, CTRF (system); DWF (individual); MMLR (market functioning).

### Issues of relevance to financial stability
- Key issues identified:
  - Are adequate safeguards in place to protect the BoE balance sheet?
  - Has the BoE quantified and managed contingent exposure to future liquidity insurance needs?
  - Does the SMF undermine incentives for SMF participants to self-insure?
  - Does the BoE have sufficient capacity to provide FX ELA?
  - Is the ELA framework robust to future needs?
  - Is the MMLR framework adequate?
  - Will future monetary policy implementation function adequately with the liquidity insurance framework?
  - Have the BoE’s facilities been sufficiently de-stigmatized?
- Scope and comparative context:
  - BoE’s liquidity provision model is wide-ranging compared to peers; few central banks provide regular term liquidity outside monetary policy or offer liquidity to nonbanks/broker-dealers absent a banking operation in-country.
  - BoE is among the first central banks to open DWF to CCPs (other current example: Reserve Bank of Australia).
- Managing global “liquidity arbitrage”:
  - BoE retains discretion to deny DWF draw-downs or participation if drawdown is for inappropriate purposes.
  - Bank has relationships with foreign regulators to assess global arbitrage risks.
  - ILTR has an upward sloping pricing curve as demand increases.

### Quantification, safeguards, and incentives
- Quantification of balance sheet implications:
  - Work in progress; a new Financial Risk and Resilience Division is developing forward-looking capacity to evaluate scenarios.
  - Relevant scenario: large financial sector shock, possibly with macroeconomic shock, involving SMF counterparties such as CCPs and their largest members; analysis should examine interconnections across SMF facilities.
  - Early work included impact analysis of scenarios: a U.K. housing market shock; default of an FX ELA recipient; risks of providing a bridge loan to an institution in resolution.
  - Gap: specific scenarios to date do not yet quantify aggregate demand for liquidity across all facilities in a serious financial sector shock.
  - Recommendation: explore a broad-based financial sector shock scenario to assess contingent exposure across all operations.
- Safeguards and supervisory attention:
  - Safeguards generally adequate: BoE retains discretion, assesses counterparty creditworthiness, increases liquidity cost with demand, supervises eligible entities, and maintains foreign regulator ties for foreign SMF participants.
  - PRA’s risk-based supervision grants less attention to smaller institutions; BoE should ensure supervisory attention supports horizon scanning.
- Incentives to self-insure and CCP access:
  - Structure of DWF might raise questions about incentives to self-insure; mitigants include Bank discretion and reluctance to use facility except in extreme circumstances.
  - Basel III liquidity regulation has increased self-insurance among participants.
  - CCPs typically have liquidity-rich business models and liquidity contingency plans not dependent on central bank access.
  - Risk: central bank access could reduce CCP incentives to self-insure.
  - Recommendation: continuously assess incentives for CCP liquidity risk management and ensure appropriate arrangements via CCP supervision and SMF management.
  - Fee detail: all CCP participants in the SMF pay an annual fee of GBP 50000 for membership; this is modest relative to a risk-based commitment fee and not related to the risk being managed.

### The Bank of England’s Capital Adequacy Framework (Box 1)
- Rationale and principles:
  - Central banks need capital for independent and credible policy functions; no universal benchmark—depends on mandate, risks, and environment.
  - Policy solvency (realized revenues exceed realized costs in the long run) is of greater importance.
  - Realized net losses should be covered by capital to preserve credibility; some central banks have operated with negative capital where policy solvency prospects were sound.
  - Seigniorage drives policy solvency for many central banks; BoE does not retain its seigniorage revenue.
- BoE specifics and changing environment:
  - Lower risk profile relative to many central banks; U.K.’s foreign reserves not held on Bank’s balance sheet.
  - Many crisis operations, including QE, were indemnified by the Crown, reducing need for capital.
  - As Bank exits QE, Crown indemnities that supported expanded risk profile will wind down.
  - Financial system likely to have significant ongoing liquidity needs; part of Bank’s balance sheet devoted to monetary policy implementation may remain large, implying larger ongoing risk profile and significant contingent balance sheet risks from liquidity insurance.
- Design principles:
  - Ensure policy solvency, be capital efficient, provide sufficient capital buffers to cover a reasonable range of risks, and allow additional capital to be supplied expeditiously.
  - Risks from independent policies should be covered first by prudent risk management and second by capital up to reasonable potential losses.
  - Other extraordinary operations may be backed by Crown indemnities as Treasury ultimately assures capital adequacy.

### Foreign exchange liquidity insurance (Section D)
- Forms and constraints:
  - Two forms: market-wide FX insurance (systemic FX shortage—typically via auction) and idiosyncratic FX insurance (firm-specific—typically ELA).
  - All FX liquidity insurance constrained by availability of FX.
- Sources and preparations:
  - Primary source: central bank FX swap lines, requiring approval of both central banks at time of use; approval more likely for systemic needs.
  - Protocols for FX swap lines are in place; detailed preparatory work considered alternatives if swap lines unavailable.
  - If swap lines unavailable, Bank would seek market sources and other available FX; capacity and operational efficiency drive choices.
- Conclusion: Authorities have prepared for FX liquidity provision in stress scenarios; capacity, protocols, and procedures appear adequate.

### Is the ELA framework robust to future needs? (Section E)
- Operational readiness and horizon scanning:
  - ELA framework is well-organized and operationally ready.
  - BoE’s horizon-scanning function appears adequate in proactively identifying ELA needs.
- Covert capacity and limitations:
  - BoE has retained capacity to conduct covert ELA and actively monitors disclosure risks while balancing transparency benefits.
  - Recognizes it will not always be possible or desirable to keep ELA covert, particularly when ELA is very large or extended.
  - IMF welcomes BoE steps in this regard.
- ELA terms and collateral:
  - ELA can be advanced in Sterling or foreign exchange; pricing flexible with starting point DWF pricing plus a margin.
  - Recipients likely solvent financial institutions but ELA may be provided to any entity; Chancellor may direct provision to an insolvent firm under the MOU.
  - ELA expected to be collateralized; accepted assets may be broader than SMF operations and could include equities, wider foreign government and corporate securities, non-SMF conforming loans, loans under foreign law and ultimately a floating charge over residual assets.
  - Crown indemnity might be sought; ELA is considered a use of Crown funds and should require government approval, though Bank would prefer to manage risks on its own where possible.

### Is the MMLR framework adequate? (Section F)
- Design and flexibility:
  - MMLR is well-designed and appropriately flexible; objectives and principles are clear and Bank retains flexibility.
  - GFC experience informed design.
- Potential additional instruments:
  - Non-recourse repos could be useful in some MMLR applications (U.S. Federal Reserve used non-recourse repos to support CP/ABS markets in the GFC).
- Asset manager challenge:
  - Asset Managers are not SMF participants and present significant policy, legal, and operational challenges (not necessarily U.K. domiciled; do not own assets they manage).
  - Commercial banks may have limited capacity to channel liquidity to asset managers in stress, which could blunt effectiveness of MMLR if asset manager liquidity problems arise.

### Will the future monetary policy implementation model function with the liquidity insurance framework? (Section G)
- Consistency and robustness:
  - Monetary policy framework must be consistent with liquidity insurance so Bank can control short-term interest rates when demand for liquidity insurance varies.
  - Should avoid confounding liquidity insurance/ELA (e.g., sterilization operations making covert ELA obvious).
  - Framework should be robust and efficient amid liquidity shocks from active liquidity insurance.
- QE exit and implementation considerations:
  - Winters review suggested possible ultimate return to a mid-corridor system but not critical; existing floor system remains viable.
  - A floor system is likely inevitable during initial stages of exit from QE due to the large APF that will run off over time.
  - APF has remained stable at around GBP 375 billion since 2012/13.
  - Staff speculated post-QE demand for reserves may be close to current levels; market participants did not necessarily agree.
  - Market participants expect bank liquidity portfolios to shift from holding cash to other liquid assets as exit proceeds.
  - Floor system would not be incompatible with the liquidity insurance framework.
  - Demand for liquidity likely to remain more variable than in 2006; BoE can accommodate swings via operations such as ILTR, possibly resulting in larger swings in reserves availability and requiring sterilization in a mid-corridor framework.
  - Interbank trading benefits from a corridor system may be constrained by Basel III structural effects and reserve averaging systems.

### Have the BoE’s facilities been sufficiently de-stigmatized? (Section H)
- Objective and approaches:
  - Aim to limit contagion via overcoming stigma; excessive stigma delays facility use and increases contagion risk.
  - Winters/Plenderleith recommended increase accessibility of facilities, increase ILTR regularity, reduce DWF disclosure requirements, and reduce discretion to access DWF funding.
- Current state:
  - Liquidity available on more accommodating terms; firm-level moral hazard managed more effectively via micro-prudential liquidity regime than facility terms.
  - BoE focus on de-stigmatization appropriate, with emphasis on horizon scanning and supervisory integration via PRA.
  - ILTR is popular with SMF participants and has little stigma in normal market conditions (albeit untested in significant stress).
  - DWF is not part of normal liquidity planning; participants reluctant to use it except in extreme situations.
  - Market participants report ILTR’s longer term nature is helpful given limited repo market liquidity beyond three months, even for Gilt collateral.

### Monitoring a wide range of SMF participants (Section 10)
- Finding: Key mitigant for broad liquidity insurance is that the Bank supervises SMF participants.
- Practice: Bank’s risk department conducts independent risk assessments before admitting counterparties to SMF, using supervisory input and other information; assessments reviewed regularly with site visits where required.
- Risk: Smaller and mid-size institutions receive lower supervisory attention by the PRA, increasing risks to SMF from these entities.
- Recommendation: BoE should ensure risk-based supervision does not allow risks to creep in and that horizon scanning (which builds on supervisory relationships) remains effective.

### Appendix highlights and historical figures
- GFC ELA experience:
  - ELA was covertly provided via collateral swaps priced at a penal rate of 200 basis points over Bank rate.
  - The volume of ELA peaked at an equivalent of GBP 61.5 billion.
- Operational features and pricing examples:
  - ILTR: Method—Repo vs. cash; Frequency—Monthly; Pricing—Bank rate + 25 bps; Maturity—6 months; Eligible collateral—Levels A, B & C.
  - CTRF: Pricing—Sliding scale based on collateral and level of borrowing; Eligible collateral—Levels A, B & C.
  - DWF: Method—Collateral swap (cash for CCP’s); Frequency—Daily; Pricing—Sliding scale based on collateral and level of borrowing; Maturity—30 days; Eligible collateral—Levels A, B & C.
  - Note: DWF loans may only be for a maturity of a maximum of seven days (table note).
  - Reserve accounts for CCPs are unremunerated beyond an individually allocated maximum.
  - Starting points for the liquidity upgrade fee: 25 bp, 50 bp and 75 bp for Level A, B and C collateral respectively.
- Eligible collateral categories:
  - A: Gilts; U.K. Treasury Bills; U.K. Government FX debt; BoE securities; Sovereign and central bank debt in GBP, EUR, CAD and USD of Canada, France, Germany, the Netherlands and the U.S.; Other high quality sovereign debt; International Financial Institutions.
  - B: RMBS and Covered Bonds; U.S. Agency securities; HMT SU.K.U.K. and debt issued in currencies outside Cat A; ABS; Some non U.K. government guaranteed bank debt.
  - C: Non financial corporate bonds and CP; Other securities excluded from Cat A and B; Raw loans and loan pools; Retained RMBS and covered bonds.
- Counterparty access:
  - Wide range: commercial banks, building societies, eligible broker dealers, and eligible CCPs (operating in U.K. markets and authorized or recognized under EMIR and meeting operational/legal criteria).

*Italic: Source: _cr16159.*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### _cr16159 - EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### Executive summary
- The U.K. is a leading financial center with diverse liquidity needs that were exposed during the global financial crisis (GFC), prompting the authorities to scale up liquidity provision and redesign their liquidity insurance framework.
- The Bank of England’s (BoE’s) Sterling Monetary Framework (SMF) directs liquidity provision and includes:
  - tools to implement monetary policy;
  - tools to backstop sterling liquidity needs of individual institutions and the overall system (termed “liquidity insurance”);
  - tools to support market functioning—Market Maker of Last Resort (MMLR).
- Emergency Liquidity Assistance (ELA) is a broad, largely unpublished bilateral idiosyncratic liquidity support framework that lies outside the SMF and includes all other liquidity provision activities, including lending in foreign exchange.
- The BoE’s broader, more accessible liquidity insurance framework raises three key questions:
  - what are the contingent implications for the BoE balance sheet;
  - what safeguards are in place against excessive use (for example, through global liquidity arbitrage);
  - to what extent the framework weakens incentives for financial institutions to self-insure against liquidity risk.
- Four other issues relevant to financial stability are: adequacy of the ELA framework, BoE capacity to provide FX ELA, adequacy of the MMLR framework, and the degree to which the Bank’s facilities remain stigmatized.
- A new Division dedicated to enterprise-wide financial risk assessment has been tasked with developing a deeper and more forward-looking capacity to evaluate the impact of a range of scenarios on the Bank’s balance sheet.
- Safeguards are generally sufficient, though the BoE should ensure that the lower level of supervisory scrutiny directed at small- and medium-sized firms does not adversely impact horizon-scanning for firms at risk of requiring liquidity support.
- The BoE has permitted CCPs to apply for access to the SMF since 2014; the Bank should continuously assess incentives created for CCPs and ensure appropriate arrangements and incentives via supervision of CCPs and management of the SMF.
- The BoE’s ELA framework is well-organized and operationally ready; the Bank’s horizon scanning function appears adequate and the BoE has retained capacity to conduct covert ELA where possible.
- The BoE has built capacity to implement foreign exchange (FX) ELA; availability of FX from multiple sources suggests arrangements and operational procedures are adequate.
- The BoE has a well-designed and appropriately flexible MMLR framework; the BoE could consider access to further instruments, such as non-recourse repos, and faces challenges in extending MMLR support to Asset Managers who are not SMF participants.
- De-stigmatization efforts have been mixed: the ILTR is popular with SMF participants and has little stigma in normal market conditions; the DWF is not part of normal liquidity planning and would likely be used only in more extreme situations.

### Main recommendations (Table 1)
- Assess the incentives created for CCPs in managing their liquidity risk and ensure, both via supervision of CCPs and management of the SMF, that appropriate arrangements and incentives are in place.
  - Timing: Short term
  - Authorities: BoE
- Ensure that the level of PRA supervisory scrutiny over small and medium-size firms does not have an adverse impact on SMF risk management and ELA horizon scanning.
  - Timing: Short term
  - Authorities: BoE
- Complete a broad financial sector stress scenario to assess the aggregate exposure to liquidity insurance across the full range of SMF facilities.
  - Timing: Short term
  - Authorities: BoE

### Overview of the liquidity provision framework and recent developments
- Pre-GFC framework and impact of the GFC:
  - Prior to the GFC the BoE operated a conventional, narrowly focused liquidity provision regime heavily focused on monetary policy implementation within a traditional mid-corridor system; banks held relatively low levels of reserves determined each reserves maintenance period.
  - Liquidity insurance pre-GFC was a last-resort tool aimed at commercial banks, provided against a relatively narrow range of very high quality collateral including U.K. Gilts; ELA was the only liquidity insurance tool in place and the BoE emphasized minimizing moral hazard.
  - The BoE applied “constructive ambiguity” to ELA—acknowledging an ELA role while making few public details available—to prevent moral hazard and reinforce self-insurance incentives.
  - The GFC overwhelmed the SMF and temporarily widened its scope: broader eligible collateral, introduction of the Discount Window Facility (DWF), lengthening and increased frequency of liquidity provision operations, introduction of MMLR operations in corporate bonds and commercial paper, introduction of Quantitative Easing (QE), and a move to a “floor” monetary policy implementation system.
  - Reviews (Winters and Plenderleith) led to permanent adjustments: governance concordats between the Bank’s executive and the MPC and FPC; new tools (Indexed Long Term Repo (ILTR), Contingent Term Repo Facility (CTRF)); DWF reform with transparent pricing and volumes and widened eligible collateral consolidated into three categories; eligible counterparties widened to include broker dealers, building societies and CCPs.
- The current Sterling Monetary Framework (SMF):
  - The SMF is the omnibus operational framework covering all published sterling market operations and comprises monetary policy implementation, liquidity insurance, and MMLR operations; ELA is separate and comprises sterling lending outside the SMF plus any FX lending.
  - Table 2 overview (preserves source structure):
    - Monetary Policy Implementation
      - Objective: Implement MPC decisions to meet inflation target
      - Governance: MPC
      - Guiding principle: Maintain risk-free interest rates in line with MPC target
      - Tools: Level of Bank Rate; Remunerate reserves at Bank Rate; Operational Standing Facilities (OSF); Asset Purchase Facility (APF); FX Intervention
    - Liquidity Insurance
      - Objective: Reduce cost of disruption to key financial and payment services to the U.K. economy
      - Governance: Bank
      - Guiding principle: The market should be the first/prime source of liquidity
      - Tools: Liquidity to the system: ILTR, CTRF; Liquidity to individual entities: DWF; Support of market functioning: MMLR

### Issues of relevance to financial stability
- Key issues identified:
  - Are adequate safeguards in place to protect the BoE balance sheet against excessive use of its facilities?
  - Has the BoE adequately quantified and managed its contingent exposure to future liquidity insurance needs?
  - Does the SMF unduly undermine incentives for SMF participants to self-insure against liquidity risk?
  - Does the BoE have sufficient capacity to provide FX ELA?
  - Is the ELA framework robust to future needs?
  - Is the Market Maker of Last Resort framework adequate?
  - Will the future monetary policy implementation model function adequately with the liquidity insurance framework?
  - Have the BoE’s facilities been sufficiently de-stigmatized for them to function effectively?
- Scope of liquidity insurance and adequacy of safeguards:
  - The Bank has adopted a very wide-ranging liquidity provision model compared to peers; few central banks provide regular term liquidity to markets outside monetary policy operations, and few offer liquidity to nonbanks or broker-dealers unless they have a banking operation in the country.
  - The BoE is one of the first central banks to open the DWF to CCPs (the other current example is the Reserve Bank of Australia).
  - Risks of global “liquidity arbitrage” seem adequately managed:
    - The BoE retains discretion to deny DWF draw-downs or participation in liquidity insurance operations if drawdown is for an inappropriate purpose.
    - The Bank has relationships with foreign regulators to assess global liquidity arbitrage risks.
    - The ILTR operation has an upward sloping pricing curve as demand increases.

### Quantification, safeguards, and incentives
- Quantification of balance sheet implications:
  - Work in progress; a new Division is developing forward-looking capacity to evaluate scenarios affecting the Bank’s balance sheet.
  - A relevant scenario: a large financial sector shock, possibly with a macroeconomic shock, involving SMF counterparties such as CCPs and their largest members; analysis should examine interconnections between SMF facilities.
- Safeguards and supervisory attention:
  - Safeguards generally appear adequate: the BoE retains sufficient discretion, assesses counterparty creditworthiness as part of SMF risk management, increases cost of liquidity with demand, supervises entities eligible for liquidity insurance, and maintains close ties to foreign regulators for foreign SMF participants.
  - The PRA’s supervisory activity is part of risk management and horizon scanning, but the BoE should ensure sufficient supervisory attention is provided to support these functions, given risk-based supervision grants less attention to second-tier or smaller institutions.
- CCP access and incentives to self-insure:
  - CCPs have been allowed to apply for SMF access since 2014; while no evidence indicates CCPs have reduced their self-insurance, access could reduce incentives to self-insure.
  - The Bank should continuously assess incentives for CCP liquidity risk management and ensure appropriate arrangements via CCP supervision and SMF management.

### ELA, FX ELA, MMLR, and de-stigmatization
- ELA framework:
  - Well-organized and operationally ready; horizon scanning function appears adequate.
  - The BoE has made efforts to retain capacity for covert ELA, recognizing that very large or long-lived ELA episodes are difficult to keep covert; the IMF recognizes covert intervention capacity can be valuable in some circumstances.
- FX ELA:
  - The BoE has built capacity to implement FX ELA; availability of FX from multiple sources suggests arrangements and operational procedures are adequate for future liquidity support.
- MMLR framework:
  - Well-designed and appropriately flexible.
  - The BoE could consider access to further instruments, such as non-recourse repos, which have been used successfully elsewhere.
  - A challenge is how Asset Managers could benefit from MMLR given they are not SMF participants and operational challenges in dealing with them.
- De-stigmatization of facilities:
  - Mixed results: ILTR is popular and has little stigma under normal conditions; DWF is not part of normal liquidity planning and would likely be used only in extreme situations.

*Prepared by Kelly Eckhold, Senior Financial Sector Expert, IMF Monetary and Capital Markets department, for the 2016 U.K. FSAP.*

### 10.      The Bank should ensure adequate effort is directed at monitoring a wide range of SMF

### _cr16159 - 10.      The Bank should ensure adequate effort is directed at monitoring a wide range of SMF participants.

### Monitoring a wide range of SMF participants
- Finding: A key mitigating factor for a broadly accessible liquidity insurance framework is that the Bank itself supervises SMF participants.
- Practice: The Bank’s risk department conducts an independent risk assessment before admitting counterparties to the SMF, drawing on supervisory input and other information.
- Ongoing process: These assessments are reviewed regularly thereafter, with site visits for counterparties where more detailed review is required.
- Risk: Smaller and mid-size institutions receive a much lower level of supervisory attention by the PRA which, other things being equal, raises the risks to the SMF from these entities.
- Recommendation: The Bank should ensure that its risk-based approach to supervision of SMF participants does not allow risks to creep in and that the horizon scanning process (which builds on supervisory relationships) remains effective.

### How well-quantified and managed is the Bank’s exposure to liquidity insurance? (Section B)
- Finding: The Bank has a wide-ranging balance sheet exposure that is inevitably difficult to quantify.
- Correlation risk: The strongly interconnected nature of the SMF counterparties (notably CCPs and their largest customers) means that demand for liquidity could be strongly correlated across the full range of the Bank’s facilities and counterparties in times of significant financial stress.
- Institutional response: The BoE has created a new Financial Risk and Resilience Division dedicated to forward-looking assessment and challenge of enterprise-wide financial risk.
- Early work: In its first months, the Division completed impact analysis of initial scenarios including a U.K. housing market shock, the default of an FX ELA recipient and the risks associated with providing a bridge loan to an institution in resolution.
- Status: Substantial further work is planned to add to the BoE’s assessment of the balance sheet implications of their facilities and operations.
- Purpose of scenarios: Provide an assessment of the quantum and form of financial backing required, together with monitoring thresholds.
- Capital context: The BoE has modest upfront capital on balance sheet; historically larger risks have needed to be supported by a Crown Indemnity.
- Monitoring thresholds: Scenarios provide estimates of “monitoring thresholds” that provide management indicators of when upfront capital risks becoming depleted.
- Gap: Specific scenarios examined so far do not yet quantify the aggregate demand for liquidity across all facilities in a serious financial sector shock.
- Recommendation: The BoE should explore a broad-based financial sector shock scenario, so as to assess its contingent exposure across the full range of its operations.
- Example policy question posed: whether liquidity should be provided to CCPs directly through the DWF or indirectly through banks (who are customers of CCPs).

### Incentives for SMF participants to self-insure against liquidity risk (Section C)
- Structure and moral hazard:
  - The structure of the DWF might raise questions about incentives for market participants to self-insure against liquidity shortfalls.
  - Mitigant: The Bank retains discretion for draw-downs that limits over-reliance, and the reluctance of firms to use the facility except in extreme circumstances means low moral hazard in practice for most SMF participants.
- Regulatory environment: Liquidity regulation has been tightened, with the advent of Basel III helping boost the degree of self-insurance among SMF participants.
- Participant feedback: By design, the DWF was not seen as a “business as usual” funding option but one for use in a near-resolution situation, when no other options are available and the business is being wound down.
- CCP-specific concerns:
  - CCPs generally have little or no need for funding from either the central bank or the markets; business models tend to leave them in a liquidity-rich position in normal course of business.
  - CCPs are required to have a liquidity contingency plan that shows how they would deal with a liquidity shortfall should two of their largest customers fail to settle; this plan should not (and in practice does not) depend on central bank liquidity access.
  - Risk: Access to central bank facilities could reduce CCP incentives to self-insure, whether through committed lines or other arrangements.
- Recommendation: The Bank should continuously assess the incentives created for CCPs in managing their liquidity risk and ensure—both via their supervision of CCPs and management of the SMF—that appropriate arrangements and incentives remain in place.
- Fee note: The Bank notes that all CCP participants in the SMF need to pay an annual fee of GBP 50000 for membership. However, this is modest relative to the cost of a risk-based commitment fee and is not related to the risk being managed.

### The Bank of England’s Capital Adequacy Framework (Box 1)
- Rationale: Central banks typically need some level of capital—for different reasons than corporations—to support independent and credible policy functions.
- No universal benchmark: Capital needs depend on policy mandate, risks faced, and operational environment.
- Policy solvency: Of greater importance is policy solvency, where realized revenues exceed realized costs in the long run, allowing operations without recourse to the Treasury.
- Coverage of losses: If realized net losses accrue they should be covered by capital to preserve credibility and independence; some central banks have operated with negative capital where prospects of policy solvency were sound.
- Seigniorage: For many central banks, seigniorage revenue drives policy solvency; the Bank of England does not retain its seigniorage revenue.
- BoE specifics:
  - Lower risk profile relative to many central banks; U.K.’s foreign reserves are not held on the Bank’s balance sheet.
  - Many crisis-related operations, including QE, were indemnified by the Crown reducing the need for capital.
- Changing environment:
  - As the Bank exits from QE, Crown indemnities that supported the expansion of the Bank’s risk profile since the GFC will wind down.
  - The financial system will likely have significant ongoing liquidity needs, implying that the part of the Bank’s balance sheet devoted to monetary policy implementation may continue to be large, potentially implying a larger ongoing risk profile.
  - The liquidity insurance framework may imply significant contingent balance sheet risks.
- Operational and capital framework design principles:
  - Ensure policy solvency, be capital efficient, provide the Bank of England sufficient capital buffers to cover a reasonable range of the risks faced, and allow for additional capital to be supplied expeditiously.
  - Risks arising from policies for which the Bank has independence should be covered first by prudent risk management practices, and second by capital up to some reasonable level of potential losses.
  - Other extraordinary operations may not need capital but could be backed by Crown indemnities, as the Treasury ultimately assures the Bank’s capital adequacy.

### Foreign Exchange liquidity insurance (Section D)
- Forms: Two forms of foreign currency liquidity insurance—market-wide and idiosyncratic.
  - Market-wide FX insurance: Relevant in systemic FX shortage; typically offered via an auction.
  - Idiosyncratic FX insurance: Relevant for firm-specific FX liquidity shortage; typically offered in the form of ELA.
- Constraint: All forms of FX liquidity insurance are naturally constrained by the availability of FX.
- Primary source: The Bank’s first choice source of foreign currency liquidity insurance would be central bank FX swap lines.
- Approval: The use of such swap lines would require the approval of both central banks at the time; approval is generally more likely where need is systemic than idiosyncratic.
- Preparations: Protocols for using the FX swap lines are in place; detailed preparatory work has been done to consider alternative sources if swap lines are unavailable.
- Alternative: If swap lines are unavailable, the Bank would look to market sources and other available sources of foreign currency liquidity, with capacity and operational efficiency driving choices.
- Conclusion: Authorities appear to have done what they can to prepare for provision of foreign currency liquidity in stress scenarios; capacity seems adequate and protocols and procedures for raising FX are in place.

### Is the ELA framework robust to future needs? (Section E)
- Operational readiness: The Bank’s ELA framework is well-organized and operationally ready.
- Horizon scanning: The BoE’s horizon-scanning function is helping to proactively identify ELA needs and seems adequate.
- Covert capacity: The Bank has made good efforts to retain the capacity to conduct covert ELA and actively monitors and seeks to mitigate a range of disclosure risks while balancing benefits of market transparency.
- Limitations: The Bank recognizes it will not always be possible or desirable to keep ELA covert, particularly where ELA is very large or extended in duration.
- IMF stance: The IMF welcomes the steps the Bank has taken in this regard.

### Is the MMLR framework adequate? (Section F)
- Design: The Bank has a well-designed and appropriately flexible MMLR framework.
- Experience: The Bank gained significant experience through the GFC with implementing MMLR; clear and appropriate objectives and principles are in place and the Bank retains flexibility.
- Non-recourse repos: Non-recourse repo operations might be of use in some MMLR applications (U.S. Federal Reserve used non-recourse repos to support CP/ABS markets in the GFC).
- Asset managers: Open question on how Asset Managers might interact with future MMLR operations:
  - Asset managers do not have SMF access but are an important part of the sterling market.
  - Significant policy, legal, and operational challenges exist given asset managers are not necessarily domiciled in the U.K. and do not own the assets they manage.
  - Market participants suggested commercial banks might have more limited capacity to channel liquidity to asset managers in a stress situation, which might blunt the effectiveness of future MMLR operations if there were liquidity problems at asset managers.

### Will the future monetary policy implementation model function adequately with the liquidity insurance framework? (Section G)
- Consistency requirement: The future monetary policy framework needs to be consistent with the BoE’s liquidity insurance framework so the Bank can continue to control short-term interest rates even when demand for liquidity insurance varies.
- Avoiding confounding: The monetary policy framework should not confound the liquidity insurance or ELA framework (e.g., by making covert ELA more obvious through offsetting sterilization operations).
- Robustness: The framework should be robust and efficient in the face of liquidity shocks from an active liquidity insurance framework.
- Winters review: Recommended considering an ultimate return to a mid-corridor system but did not see this as critical; existing floor system remains a viable option.
- QE exit implications:
  - A floor system is likely inevitable during initial stages of exit from Quantitative Easing due to the large APF that will run off over time.
  - Market interest rates will lie close to the Bank Rate floor for some time to come.
  - Staff speculated post QE demand for reserves may be close to current levels, while market participants did not think so.
  - Most market participants anticipate that as exit proceeds, the structure of bank liquidity portfolios will shift from holding cash to other liquid assets.
- Compatibility: Even after QE exit, the floor system would not be incompatible with the liquidity insurance framework.
- Liquidity variability: Demand for liquidity is likely to continue to be more variable than in 2006; the Bank will accommodate some swings via operations such as ILTR, resulting in larger swings in reserves availability and possibly requiring sterilization operations in a mid-corridor framework.
- Interbank trading: The expected benefit of a corridor system for increased interbank trading may not be realized because:
  - Money market turnover is being structurally constrained by Basel III, reducing incentives and capacity for institutions to trade in short-term markets.
  - A reserve averaging system with more flexibility reduces incentives for active liquidity management by market participants.

### Have the BoE’s facilities been sufficiently de-stigmatized to function effectively? (Section H)
- Objective: Limit contagion through liquidity in a crisis by overcoming stigma; excessive stigma delays use of facilities and increases contagion risk.
- Winters/Plenderleith suggestions: Reduce stigma by increasing accessibility of BoE facilities, increasing regularity of ILTR operations, reducing disclosure requirements on DWF usage, and reducing discretion required to access DWF funding.
- Current state: Liquidity is now available on more accommodating terms; firm-level moral hazard is more effectively managed via micro-prudential liquidity regime than via facility terms.
- Supervision and horizon scanning: The Bank’s focus on de-stigmatization seems broadly appropriate given its central regulatory and supervisory role; increased focus on horizon scanning and use of supervisory capacity from integration of the PRA into the Bank is seen as key to managing moral hazard risks.
- Comparative advantage: The U.K. has advantages in this area compared to some peers (e.g., the U.S.).

*Italic: International Monetary Fund — UNITED KINGDOM (excerpted content).*

### 35.      However efforts at de-stigmatizing the Bank’s liquidity insurance facilities have had

### _cr16159 - 35.      However efforts at de-stigmatizing the Bank’s liquidity insurance facilities have had

### De-stigmatization of Bank liquidity insurance facilities
- ILTR seems popular with SMF participants and has little stigma in normal market conditions (albeit untested in a period of significant market stress).
- The DWF does not form part of SMF participants’ normal liquidity planning, and participants would be reluctant to use the facility except in more extreme situations.
- Market participants report that the longer term nature of the ILTR is helpful as there is limited liquidity in the repo markets beyond the three months, even for Gilt collateral.

### Appendix I — Challenges from the GFC and subsequent reviews
- The GFC severely damaged market functioning, weakened the macro environment, and caused precautionary liquidity demand to surge; the narrowly focused SMF was inadequate to meet these challenges.
- Liquidity demand surged and overwhelmed the SMF; many institutions struggled to raise market funding, increasing demand for funding from the Bank.
- Special Liquidity Scheme (SLS) introduced to meet demand via long term asset swap of Residential Mortgage Backed Securities (RMBS) for Treasury bills.
- Extended long-term repos were introduced to lend cash against a widened range of collateral.
- The increase in liquidity demand significantly expanded reserves in the system that were unevenly distributed in segmented markets.
- With QE, a new monetary policy implementation framework was developed: a “floor” system where all reserves are remunerated at the Bank rate; reserves averaging and contractual reserves were suspended.
- Significant ELA was required in both sterling and FX for RBS and HBOS; initially provided by the Bank at its own risk, later covered by a new Crown indemnity.
- ELA was covertly provided via collateral swaps priced at a penal rate (200 basis points over Bank rate).
- The volume of ELA peaked at an equivalent of GBP 61.5 billion.
- Other market support operations as part of the Asset Purchase Facility included primary-market commercial paper purchases and two-way auctions of corporate bonds; the Bank participated in concerted USD liquidity operations with other central banks.

### Winters and Plenderleith reviews — conclusions and recommendations
- Winters review (2012): SMF broadly fit for purpose, some enhancements possible; monetary policy framework judged robust; suggested return to mid-corridor reserves averaging after exit from QE; recommended revising liquidity insurance facilities to decrease stigma and increase accessibility/scalability; suggested governance improvements to clarify roles of FPC and MPC and widen senior staff involvement in ELA decisions.
- Plenderleith review: recommended improvements to ELA framework to improve operational readiness and horizon-scanning; key recommendations included:
  - developing early warning indicators and “horizon scanning”;
  - developing protocols for providing LOLR (legal arrangements, collateral/risk management capacity, monitoring arrangements, etc.);
  - extending ELA net to non-banks (CCP’s and NBFIs);
  - developing capacity to provide ELA in FX.
- The Bank appears to have successfully implemented Plenderleith recommendations.

### Appendix II — The current sterling monetary framework

Monetary policy implementation
- Pre-GFC: traditional mid-corridor system; Bank Rate and remuneration of reserves with operational standing facilities; contractual reserves and reserves averaging provided stability.
- Post-GFC/QE: all reserves remunerated at Bank rate and contractual reserves system suspended; APF has remained stable at around GBP 375 billion since 2012/13.

Table: Operational features of the current BoE liquidity provision framework (as described)
- Reserve Accounts: Method — Standing facility; Repo vs. cash — Repo vs. cash; Frequency — Daily; Pricing — Bank rate; Maturity — O/N; Eligible collateral — N/A.
- ILTR: Method — Repo vs. cash; Frequency — Monthly; Pricing — Bank rate + 25 bps; Maturity — 6 months; Eligible collateral — Levels A, B & C.
- CTRF: Method — Repo vs. cash; Frequency — As reqd; Pricing — Sliding scale based on collateral and level of borrowing; Maturity — Flexible; Eligible collateral — Levels A, B & C.
- DWF: Method — Collateral swap (cash for CCP’s); Frequency — Daily; Pricing — Sliding scale based on collateral and level of borrowing; Maturity — 30 days; Eligible collateral — Levels A, B & C.
- Notes in table:
  - Reserve accounts for CCP’s are unremunerated beyond an individually allocated maximum.
  - Pricing charge is the basis point fee for the liquidity upgrade of swapping less liquid collateral for liquid U.K. government security collateral. Starting points for the upgrade fee are 25 bp, 50 bp and 75 bp for Level A, B and C collateral respectively.
  - DWF loans may only be for a maturity of a maximum of seven days.

Liquidity insurance
- Systemic term liquidity can be met through:
  - regular monthly ILTR operation: term (six month) liquidity against a wide collateral pool;
  - CTRF: flexible repo operation tailored in frequency, maturity and volume in response to unusual systemic liquidity demand.
- DWF meets idiosyncratic needs: short-term (30-day) sterling liquidity via collateral swap, rollovers at Bank discretion; cost on sliding scale dependent on amount and collateral; a viability test and ongoing solvency analysis by the Bank’s risk management department is required.
- DWF access for CCPs: 5 day funds in cash as opposed to collateral; loans may be rolled over at Bank’s discretion.

MMLR (Market Maker of Last Resort)
- MMLR must be catalytic and terms unattractive in normal conditions; operations can occur in primary and secondary markets depending on market type; focus on promoting funding provision to markets rather than supporting derivatives markets.

Eligible collateral
- Collateral categories A, B, C summarized (as listed):
  - A: Gilts; U.K. Treasury Bills; U.K. Government FX debt; BoE securities; Sovereign and central bank debt in GBP, EUR, CAD and USD of Canada, France, Germany, the Netherlands and the U.S.; Other high quality sovereign debt; International Financial Institutions.
  - B: RMBS and Covered Bonds; U.S. Agency securities; HMT SU.K.U.K. and debt issued in currencies outside Cat A; ABS; Some non U.K. government guaranteed bank debt.
  - C: Non financial corporate bonds and CP; Other securities excluded from Cat A and B; Raw loans and loan pools; Retained RMBS and covered bonds.

Counterparty access to SMF facilities
- A wide range of counterparties: commercial banks, building societies, broker dealers (eligible broker dealers are those the PRA designates as “investment firms”), and CCP’s (eligible CCP’s are those operating in the U.K. markets that are either authorized under EMIR by a competent authority, or recognized under EMIR by ESMA, and meet other operational/legal criteria).
- Table summary (textual):
  - Banks and building societies: access to Short Term Repo, Reserve Accounts, Operational Standing Facilities, ILTR, DWF, CTRF — Yes for all.
  - Broker Dealers: Yes for all listed facilities.
  - CCP’s: access to Reserve Accounts, Operational Standing Facilities, ILTR, CTRF (with specific arrangements for DWF noted elsewhere).

### Appendix III — The ELA framework
- ELA is all liquidity insurance provided outside the published SMF “Red Book” framework.
- Legal basis: MOU describes agency cooperation in a crisis; Financial Services Act (2012) requires authorities to cooperate and MOU operationalizes this.
- Approvals: ELA must be approved by the Chancellor and the Bank’s Court of Directors; where not practical, the Governor in consultation with a sub-committee of Court (Transactions Committee of three nonexecutive directors, one must be Chair of Court or designate) may decide.
- ELA terms:
  - Flexible; can be advanced in Sterling or foreign exchange.
  - Bank uses horizon scanning to identify potential ELA needs and aims to prepare bespoke responses.
  - ELA pricing flexible; starting point would be DWF pricing plus a margin.
  - ELA can be provided in foreign exchange using FX swap lines and other market sources; haircuts on FX ELA would be higher.
- Recipients and collateral:
  - Recipients likely financial institutions that should be solvent but need not be systemically important; ELA may be provided to any entity.
  - Counterparties must be solvent (on a balance sheet basis) though the Chancellor may direct provision of ELA to an insolvent firm under the MOU.
  - Going concern assessment performed in conjunction with the Bank’s Resolution Directorate; firms expected to provide collateral.
  - ELA expected to be collateralized; accepted assets may be broader than SMF operations and might include equities, a wider range of foreign government and corporate securities, non-SMF conforming loans, loans contracted under foreign law and ultimately a floating charge over residual assets of an ELA recipient.
- Crown indemnity:
  - A Crown indemnity might be sought and any ELA should be approved by the Chancellor; ELA is considered a use of Crown funds and should require government approval.
  - Decision to request indemnity reflects riskiness and size of ELA; Bank would prefer not to require an indemnity and aims to manage ELA risks on its own.

*Source: _cr16159.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16159.pdf_