High Quality Liquid Assets (HQLA) - Treasury tactics

‘A turn in the road is not the end of the road, unless you fail to make the turn’ - Anonymous

Household pets have been covering their ears. During the first calendar quarter, once reticent finance executives, and finance-engaged CEOs, of B.C. and ON credit unions may have been raging expletives. It’s been a frustrating, challenging and unfamiliar period. Financial instruments once wholly alien to small Canadian credit unions, perhaps large ones too, are now commonplace. A whole new lexicon of investment terminology has been explored, digested and applied. Stakeholder reporting may have underwhelmed expectations. New journal entries may have being imagined from first principles. Financial reports and risk oversight may require a refresh. BCFSA has a new guideline and a new regulatory report (and several consultations). And your prudential supervisor Relationship Manager has requested a touch-base video conference call, again.

Note: A formatted, graphical PDF version of this article is available at https://www.bitly.com/rm-hqla

Almost two years ago, FICOM issued a decree. The ‘mandatory liquidity pool’ structure was dead. It had been used for decades to execute credit union compliance with Liquidity Requirement Regulation of the B.C. Financial institution Act and equivalent ON legislation, and as a contingent funding source. Jumping to 2021, substantially all B.C. and ON credit unions likely now have portfolios of fixed income securities, held in legally ring-fenced trust accounts, on their balance sheets. Forget proportionality. Regulatory changes impacted the largest and smallest credit unions alike. Identical regulatory reporting requirements and frequency. Hopefully Canadian consumers can sleep a lot more easily each night, safe in the knowledge that their cooperative financial institution has lower systemic liquidity risk due to it directly holding a ring-fenced portfolio of high quality liquid assets. Or not. Retail banking, it seems, is a whole lot more complex than it used to be.

‘Forget proportionality. Regulatory changes impacted the largest and smallest credit unions alike. Identical regulatory reporting requirements and frequency. ’ - Ross McDonald 

Credit unions should reflect on unpleasant realities. Fixed income securities, once the domain of second-tier entities and wholesale banks, are new to substantially all credit unions and executives. Regulatory guidelines, prudential supervisory expectations, and regulatory reporting in regards liquidity management have escalated to a level unimaginable only a few years ago. This new world seems a permanent, irreversible change. It may contribute to collaboration, amalgamation or other strategic discussions. Any credit union that fails to duly adapt is likely to experience the relentless intervention wrath of its financial regulator.

In the spirit of cooperative values and wiser together, below are several treasury tactic ideas that smaller credit unions may consider in regards statutory liquidity deposits.

First, consider radical simplification. In January 2021, Central 1 Credit Union terminated legacy term deposits and migrated equivalent portfolio of fixed income securities. This provided member credit unions with duly equivalent exposure. Credit unions may continue in this way. But there is no such compulsion. Central 1 Credit Union, and its peers, are now service providers to be duly instructed. Credit unions have discretion in selection of asset manager and in the establishment of related investment strategy. Academic research highlights the ‘cost of complexity’. Were it so inclined then a credit union could consciously instruct its asset manager to discard all fixed income securities and hold familiar bank deposits, provided that they satisfy HQLA criteria. Perhaps lesser yields may result. But the potentially material simplification of accounting journals, risk management and/or resourcing costs could make such an approach attractive. This approach aligns with strategic practice of choosing ‘where-to-play’. Perhaps treasury, for some smaller credit unions, is somewhere not-to-play. K.I.S.S. is a timeliness axiom for a reason.

‘a credit union could instruct its asset manager to discard all fixed income securities and hold familiar bank deposits, provided that they satisfy HQLA criteria’ - Ross McDonald

Second, constrain portfolio scope. Many types of securities qualify as High Quality Liquid Assets. A regulator may recommend, or require, that an Investment and Lending Policy provide detailed criteria of securities attributes (e.g. credit rating) for each security type. For example, if ILP states that corporate bonds are acceptable as a security type then it may need to state which issuers, industries, credit ratings or other attributes are acceptable or unacceptable. A credit union may determine that some potential HQLA security types are undesirable. Maybe the credit rating specification is unfamiliar. Or perhaps the accounting journals are troublesome. A credit union may direct its asset manager not to hold corporate bonds, mortgage backed securities or another type of HQLA. This approach may align with the concept of competitive advantage. Perhaps being good-enough at treasury management is just that - good enough.

Third, evolve oversight. Finance & Risk reporting should include Liquidity Adequacy Ratio. Prudential supervisors appear to have sharpened their liquidity compliance. The legacy broadly defined Statutory Liquidity Ratio has been effectively replaced by a more restrictive Liquidity Adequacy Ratio. Most liquidity held by a credit union outside of the in-trust account(s) does not count towards its compliance with legislative requirements. As part of ‘Quality of Risk Management’, assessment prudential supervisors may be re-reviewing executive expertise and board oversight of liquidity management. This approach may align with measuring what matters. Your friendly regulator may have said that LAR% now matters.

‘As part of Quality of Risk Management assessment, prudential supervisors may be re-reviewing executive expertise and board oversight of liquidity management.’ - Ross McDonald

Fourth, expectation management. Despite commendable enthusiasm, executive/board committees and boards may be content to receive limited reporting on key finance & risk topics. At least for an initial period. Reporting from an asset manager, custodian or other service provider may well be evolving in its rigour, scope or timeliness. Trailblazing credit union executives may have already designed comprehensive internal reporting. Smaller credit unions likely have not. Patience can be a virtue, and may save duplicated effort. Whether as part of mandated work scope; a response to industry feedback; or to mitigate threats from circling competitors then asset manager and/or other service providers have every incentive to provide appropriate reporting at their earliest convenience.

Fifth, professional development. Treasury competences are now cool in credit unions. Who’d have ever guessed that! Executive Asset & Liability Committees and board Investment & Lending Committees may find unfamiliar and elevated stakeholder attention. Some finance executives may need to brush up on technical knowledge of financial instruments. Or to initiate accelerated training. Scary times perhaps. Finance executives with a growth mindset may view HQLA as a wonderful opportunity to expand product knowledge; to extend functional maturity; and to better serve the business and membership. Executives with a curious mindset may ask ‘dumb’ questions about how liquidity, risk, return and cashflows impact their organization. This approach may align with functional maturity. Given changes in external environment, some credit unions may re-evaluate their current and target levels of functional maturity for Finance or treasury. Financial regulator(s) may have moved the goalposts. Time to recalibrate.

‘internal stakeholders may be content to receive limited reporting on key finance & risk topics in regards HQLA, at least for an initial period.’ - Ross McDonald

Lastly, seek help. Sometimes we all need a little help from our friends. As appropriate, reach out to peer credit unions for advice. Or seek a paid contractor relationship with a credit union that has relevant expertise. B.C. credit unions may request the assistance of Stabilization Central Credit Union. Or explore support from service provider(s). 

Make no mistake, prudential supervisors may well dispense some unpleasant letters. Remediation from a regulatory intervention is a thoroughly unpleasant place. Credit unions may mitigate regulatory risk through proactive adaptation of liquidity management practices, rather than naively hoping for the best.

During the pandemic, many executives and staff have been working from home. The presence of domestic pets may provide welcomed comfort and companionship. A wagging dog tail; a purring cat; a chirping bird; or otherwise may bring joy and smiles. Such selfish pleasures may be repaid through fewer expletives from their owners.

DISCLAIMER & COPYRIGHT

This article reflects the personal opinions of the author, Ross McDonald. This article does not represent the views of any financial cooperative, corporate organization, regulatory body, government ministry or other organization. All content is wholly based on information that is in the public domain. Where relevant, sources have been identified and referenced.

Although the author has made significant effort to ensure that the information in this submission was accurate at the date of completion then the author does not assume any liability to any party for any loss, damage, or disruption caused by errors or omissions, whether such errors or omissions result from negligence, accident, or any other cause.

Proportionality in financial regulations. Asset size, business complexity & risk profile should matter.

Financial regulation is not national security. Edward Snowden alleged that 'collect it all' was a mantra at the U.S. National Security Agency. But this seems rather heavy-handed for regulatory oversight of small provincial credit unions. As a self-declared 'data-driven regulator', BC Financial Services Authority (BCFSA) appears intent on maximum data collection regardless of its supervisory framework and industry consequences.

A formatted PDF of this article is available at https://www.bitly.com/rm-proportionality.

Following the 2008 financial markets crisis, regulators of major global banks duly turned up the heat. New mechanisms were designed and introduced to assess the capital, liquidity and risk profile of regulated financial institutions. Entities that regulators deemed 'too-big-to-fail' or 'globally systemically important banks' (G-SIB) were exposed to incremental costs, being higher compliance costs that were commensurate with their regulatory risk profile. These reporting requirements and supervisory expectations have steadily trickled down to domestic equivalents (D-SIB) and, in Canada, to provincially regulated financial institutions. The extent of due adaptation of G-SIB regulatory requirements for small community credit unions seems variable. Copy-and-paste can be a dangerous tool.

The regulatory environment for B.C. credit unions is wholly unrecognizable from a decade ago. Over recent years then BCFSA - and its predecessor FICOM - introduced numerous regulatory guidelines; escalated prudential supervisory expectations; and intensified regulatory reporting. The number, diversity and complexity of these new regulations are dizzying. By way of illustration, in late 2020, BCFSA launched an overhaul of regulatory reporting requirements for credit unions. The proposal seeks to expand data scope; introduce greater data granularity; on a more frequent basis; and from an increased number of credit unions. As regulated entities, B.C. credit unions have but three choices - comply, strategic transformation, or federal charter.

"The intensity of supervision will depend on the nature, size, complexity and risk profile of a PRFI.” - BCFSA Supervisory Framework

BCFSA appears to have discarded FICOM’s risk-based supervisory framework. Default prudential supervision, and regulatory reporting, was relatively modest. But credit unions of larger size, greater complexity and/or intervention stage rating should be subject to commensurately escalated intensity of prudential supervisory requirement and regulatory reporting. Following a flurry of new regulatory requirements then this approach - proportionality - is now being embraced by OSFI, a federal Canada financial regulator. BCFSA should take note. Instead, BCFSA seems intent on a wholly opposite approach - standardization. Vancity Credit Union (C$23 billion assets) and Vancouver Police Credit Union (C$18 million assets) have order-of-magnitude organizational differences, yet BCFSA proposed regulatory reporting would impose substantially similar regulatory reporting requirements. As would credit unions with scarcity or bountiful levels of capital or liquidity. As would credit unions with low-risk or high-risk intervention stage ratings. The objective of regulatory reporting should be to ensure legislative compliance and to assist prudential supervisory assessment of composite risk rating. This risk-based approach wholly aligned with its supervisory framework. No matter. Collect it all. Fill those databases.

"One of the key priorities identified in OSFI's Strategic Plan 2019-2022 is to further adapt its regulatory approaches to reflect the size, complexity and risk profile of financial institutions.’ – Source: OSFI ‘Advancing Proportionality: Tailoring Capital and Liquidity Requirements for Small and Medium-Sized Deposit-Taking Institutions'

BCFSA should stop and think. What is the purpose of the collected data? Why do the proposed changes fall disproportionally on credit unions with less than C$1 billion assets? How will the proposed changes have intended and/or unintended consequences on B.C. credit unions?

BCFSA should consider alternative tactics. Perhaps there could be two sets of 'standardized' regulatory reports - a simple set and a comprehensive set. This may mirror efforts in accounting standards - small, private enterprises and large, publicly listed companies produce financial statements of differing complexity. The Financial Accounting Standards Board 'Simplifying Accounting Standards' is exploring various topics related to proportionality in application of accounting standards. Perhaps there are learnings from the U.S. Federal Reserve, that has four intensities of regulatory reporting for deposits based on financial institution size. Perhaps B.C. credit unions could have an opt-in approach with a distant date rather than a near-term effective date (hat tip to peer for this pragmatic idea). Such an approach would allow smaller credit unions to consider banking system changes, resourcing requirements and/or strategic viability of the proposed changes. Perhaps CUDIC excess capital could be rebated, say on an equal dollar value basis across B.C. credit unions, to help fund process improvements, system implementation or other necessary automation to satisfy elevated reporting requirements?

BCFSA should recognize that there are multiple, diverse & complex changes impacting B.C. credit unions. BCFSA-required transformation of statutory liquidity deposits. Central 1 and membership driven implementation of digital technologies. BCFSA new supervisory expectations, such as the January 2021 Liquidity Guideline. At this time, BCFSA has four active consultations with credit unions - regulatory reporting, CUDIC assessments, IT Security, Outsourcing. Some requirements may even be competitive. For example, if credit unions respond the proposed regulatory reporting by sharing expert resource then this may create resource dependency and outsourcing risk. But if credit unions respond by recruiting dedicated staff or investing in technology then this will impact prudential supervisory assessment of earnings risk. Credit unions less than C$1 billion assets face a lose-lose situation.

“It certainly seems possible that BCFSA consequences and Competition Bureau objectives, as they relate to credit union amalgamations, may be significantly misaligned.” - Ross McDonald

Collectively these, mostly BCFSA driven, changes will permanently impact the B.C. credit union system. Ultimately, ever-increasing baseline regulatory requirements must surely translate into fewer provincial credit unions and increased minimum efficient scale. Should BCFSA continue on its seeming path, there may be only a residual few B.C. credit unions with less than C$1 billion assets by 2025, and perhaps none by 2030. A torrent of amalgamations seems inevitable. Per related member website, the ongoing proposed merger by six B.C. credit unions has been referred to the Competition Bureau. It certainly seems possible that BCFSA consequences and Competition Bureau objectives, as they relate to credit union amalgamations, may be significantly misaligned.

Do-as-I-say, not do-as-I-do. As part of the Ministry of Finance, FICOM reporting to industry was negligible, if anything. As a crown corporation, time will tell if BCFSA complies with the B.C. government 'Performance Reporting Principles For the British Columbia Public Sector'. The related publication, approved by the Auditor General of B.C, frames eight principles of deemed best practice that seek to support an open and accountable government. BCFSA compliance with B.C. government reporting principles for crown corporations require it to provide comprehensive disclosures to industry and to taxpayers. People who live in glass houses shouldn't throw stones.

“BCFSA compliance with B.C. government reporting principles for crown corporations require it to provide comprehensive disclosures to industry and to taxpayers.” - Ross McDonald

BCFSA executive has the near infinite authority over its expanded empire. Oversight lies in its board of directors, and ultimately the B.C. Ministry of Finance. Under the Taxpayer Accountability Principles of the B.C. government state that ‘Board members act independently from the organization’s executive and have the best interests of taxpayers and shareholder as their primary consideration.' Hopefully this enshrines expectations of a principal-agency relationship. Approximately 40% of British Columbians are members of B.C. credit unions. Collectively B.C. credit unions provide substantial benefit to their members, employees, communities and the B.C. economy. BCFSA Board should ask difficult questions of the executive team; demand a business case for proposed changes; and consider the collective impact on British Columbians.

In the short-term, BCFSA may amass a standardized, NSA-worthy database about B.C. credit unions. Probably significantly more than that required to fulfil the needs of executive management, board oversight or risk-based prudential supervision. In the medium term, this database may become a museum relic. A moment in time record of an industry that was subject to accelerated transformation and proactive consolidation by its regulator. A priceless collector’s piece but a needless lament.

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REFERENCES

OSFI January 2020 'Advancing Proportionality: SMSB Capital & Liquidity Requirements - Consultatitve Document' - https://www.osfi-bsif.gc.ca/Eng/fi-if/in-ai/Pages/SMSB20_cp.aspx

OSFI July 2019 'Advancing Proportionality: Tailoring Capital and Liquidity Requirements for Small and Medium-Sized Deposit-Taking Institutions' - https://www.osfi-bsif.gc.ca/Eng/fi-if/in-ai/Pages/smsb.aspx

FICOM/BCFSA June 2012 'Supervisory Framework' -https://www.bcfsa.ca/pdf/aboutus/FICOMSupervisoryFramework.pdf

FASB 'Simplifying Accounting Standards' - https://www.fasb.org/simplification

B.C. Government 2003 - “Performance Reporting Principles” - https://www2.gov.bc.ca/assets/gov/british-columbians-our-governments/services-policies-for-government/public-sector-management/performance_reporting_principles.pdf

Member website for potential amalgamation of B.C. interior credit unions - https://www.exploringstrengthandunity.ca/awesometogether.html

U.S. Federal Reserve Reporting Requirements for deposit reporting: https://www.federalreserve.gov/monetarypolicy/reserve-maintenance-manual-reporting-requirements.htm

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DISCLAIMER & COPYRIGHT

This article reflects the personal opinions of the author, Ross McDonald. This article does not represent the views of any financial cooperative, corporate organization, regulatory body, government ministry or other organization. All content is wholly based on information that is in the public domain. Where relevant, sources have been identified and referenced.

Although the author has made significant effort to ensure that the information in this submission was accurate at the date of completion then the author does not assume any liability to any party for any loss, damage, or disruption caused by errors or omissions, whether such errors or omissions result from negligence, accident, or any other cause.

All rights reserved.