Liquidity Risk | Regulatory-Risk

What is liquidity risk management?

Filed Under: Liquidity Risk, Risk management

At the onset of the financial market crisis in 2007, many banks had adequate capital levels but they still ended up experiencing serious difficulties when it came to liquidity risk management. They had failed to sufficiently accounted for their exposure to liquidity risk.

Before the crisis, funding was readily available and cheap. This created the impression that markets were safe and that liquidity for funding purposes would always be plentiful and available.

However, the uncertainty that the financial market crisis had created rapidly caused cheap funding that had been used by banks to manage their liquidity risk to evaporate as lending rates repriced. Eventually nobody would lend and the loans that were made in the good times of abundant liquidity were no longer rolled-over, they had to be repaid.

Consequently, banks came under severe stress. This resulted in regulators providing support by introducing additional liquidity to money markets and eventually also to individual institutions as they also came under stress.

It’s not surprising that under these conditions the question of what is liquidity risk management? and how should it be managed? was increasingly asked as regulators honed in on this particular risk.

What is liquidity risk management?

Liquidity risk management is a key banking function and an integral part of the asset and liability management process.

The fundamental role of banks is the maturity transformation of short-term deposits (liabilities) into long-term loans (assets) and this makes banks inherently vulnerable to liquidity risk. The transformation process creates asset and liability maturity mismatches on a banks balance sheet that must be actively managed with available liquidity. This is the process known as liquidity risk management.

The availability of liquidity either internally or externally is thus paramount in the management of these maturity mismatches. The effective management of liquidity allows a bank to fund increases in its assets (loans and investments) and to meet obligations as they come due (withdrawal of deposits).

A failure in liquidity risk management may result in a bank becoming unable to meet its obligations. This scenario if played out, could easily cause a bank to fail.

A bank can continue to meet its uncertain cash flow obligations and stay healthy by managing liquidity risk prudently.

How should liquidity risk be managed?

A banks liquidity risk management policies should be set down clearly and communicated to key decision makers in the bank.

The risk management process should make up the following broad minimum requirements.

The risk must be managed within a defined risk management framework (decision-making)
A clear liquidity risk management and funding strategy must be agreed at an executive and non-executive board level
Operating limits to liquidity risk exposures must be set and adhered to
Procedures for liquidity planning under alternative scenarios must be agreed, including crisis situations

Some common failures have been identified in banks liquidity risk management processes, which have contributed to serious sustainability issues.

A weak liquidity risk management framework that did not account for the risks posed by products and business lines
Business incentives that were misaligned with the risk tolerance level of the bank
Misjudging unexpected contingent obligations and the liquidity that would be required by the bank to meet these obligations
The belief that prolonged liquidity disruptions as experienced during the financial market crisis, were improbable
Stress tests that failed to account for possible market wide global strain or the severity and duration of disruptions

Some regulatory wisdom

In September 2008, the Basel Committee on Banking Supervision revised their document “Principles for Sound Liquidity Risk Management and Supervision”, by providing more guidance on the following.

Liquidity risk tolerance
Maintaining adequate levels of liquidity
Allocating liquidity costs, benefits and risks to business
Identification and measurement of contingent liquidity risks
Design and use of severe stress test scenarios
A contingency funding plan
Intraday liquidity risk and collateral
Public disclosure in promoting market discipline

The published document is arranged around seventeen principles that set out guidance to bank regulators on best practice liquidity risk management in banks. Because of the importance of managing liquidity risks in banks, the principles proposed are valuable and may be found useful regardless of what financial market sector your business is in.

This document can be viewed or downloaded here: Liquidity risk

Basel III and liquidity management in banks

Filed Under: Basel, Liquidity Risk

The Basel Committee on Banking Supervision has been mentioned often in the media both during and after the financial crisis. This Committee provides a much-needed forum for regulators to meet at regular intervals and discuss cooperation on banking supervisory matters such as the management of capital under the Basel III capital accord. The aim of the committee is to enhance the understanding of key supervisory issues such as liquidity risk and capital management. In so doing, they strive to improve the quality of banking supervision worldwide.

It is important for banks to monitor the thinking and upcoming policy publications of this committee because it is a very good indicator of what is on the horizon. Local in-country regulators generally follow the guidance issued by the Basel Committee and then apply the standards to banks that operate within their jurisdiction.

The Basel Committee objectives extend to the following

Exchange information on supervisory issues.
Share approaches and techniques used in supervisory processes.
Promote a common understanding of supervisory standards.

What the Basel Committee is best known for

International standards on capital adequacy
The Core Principles for Effective Banking Supervision
Concordat on cross-border banking supervision

The Basel Committee’s management are located at the Bank for International Settlements (“BIS”) in Basel, Switzerland. The management is made up mainly of professional supervisors who are seconded from member institutions.

The Committee does not operate in a vacuum, it encourages members to develop relationships with other regulators and cooperate on issues where there may be a common goal. It also circulates to supervisors throughout the world both published and unpublished papers providing guidance on banking supervisory matters. If you are looking for papers and documents published by the Basel Committee, they are easily downloaded by the public.

New liquidity risk measures under Basel III

Natural disasters are inevitable even man-made like the financial market crisis. The question is whether we have the power to make sure that disasters do not become unnatural tragedies.

According to a recent report released by the World Bank and the United Nations, an ounce of prevention in planning for disasters is worth a pound of cure. So prevention pays, if done right and that means getting incentives right.

The pending roll-out of Basel III does not replace Basel II but rather improves upon the older Basel II requirements. Whether these measure will be effective when applied to liquidity risk management in practice, will still be up for detailed assessment.

The Committee published a paper in December 2010 known as the International framework for liquidity risk measurement, standards and monitoring. It introduced the liquidity coverage ration and the net funding stability ration.

Liquidity coverage ratio

Basel III introduces a new instrument for liquidity risk measurement, the liquidity coverage ratio. The measurement is intended to ensure the following.

Maintenance of an adequate level of unencumbered, high-quality assets.
The assets held must be easily converted into cash.
Cash from assets should meet liquidity needs for a 30-day period.
The liquidity risk management standard requires that the ratio be no lower than 100%.
Liquidity standard must be achieved under an acute liquidity risk stress scenario.

Net funding stability ratio

The net funding stability ration will be put into place to make sure that a bank maintains a minimum amount of stable liabilities in relation to their liquidity risk profile. A banks liquidity risk profile may be made up of activities such as investment banking inventories, off-balance sheet exposures, securitization pipelines and other assets.

The net funding stability ratio is the ratio of available stable funding divided by the required amount of stable funding and this standard similarly to the liquidity coverage ratio, must be no lower than 100%.

Report: Liquidity Coverage Ratio and Net Funding Stability Ratio

The European Banking Authority published on 4 April 2012 its first report on the results of the Basel III monitoring exercise. A key outcome was its findings on the two Basel III liquidity risk standards namely the Liquidity Coverage Ratio and the Net funding Stability Ration.

A total of 157 banks participated in the liquidity risk monitoring exercise. The reporting period of the review was end-June 2011.

Participating banks reported an average liquidity coverage ration of only 70%. The required ratio in terms of the Basel III requirement is 100%. This shortfall of liquid assets is in money terms about €1.2 trillion, which represents 3.7% of the approximate €31 trillion total assets of the sample.

The net funding stability ration reported by participating banks was an average 90%.

To fulfil the minimum standard of 100%, banks would need stable funding of about €1.9 trillion.

The saving grace for banks in Europe is that both liquidity standards are subject to an observation period. This observation period includes a review clause that has been put into place to allow for adjustments to cover any unintended consequences before implementation.

Both these ratios proposed by the Basel Committee continue to be widely criticised. The main concern raised is that very large capital reserves will be concentrated in the liquidity reserve. The Basel Committee being influenced by this criticism has couched its requirements for the ratios and their usage in relatively vague terms. In addition, these ratios will be implemented only in 2018.

The main challenges

Banks that operate across multiple jurisdictions will be faced with different national discretion and variations for the new liquidity risk rules. The result will be various kinds of liquidity risk regulatory reporting templates in different electronic formats per jurisdiction.
Banks will be challenged to put into place robust automated reporting solutions. Regulators will require reports to be submitted for their review at least monthly, with the ability when required to deliver information weekly and under stress conditions daily.
It is highly likely that national regulators will increase the quality and quantity of data included in their national regulatory reports.
There are still many banks who are not Basel II compliant and plan to move from Basel I directly to Basel III. This creates an interesting situation because Basel II is the building block for Basel III.
It is also possible that some banks stay on Basel I with no intention of moving to either II or III. This complicates the regulatory environment that banks and their regulators will work under.

Liquidity risk levels upgraded under Basel III

Filed Under: Basel, Liquidity Risk

The Basel Committee on Banking Supervision has been mentioned often during and after the financial crisis. This Committee provides a forum for regulators to meet at regular intervals and discuss cooperation on supervisory matters relating to banks. The purpose is to enhance the understanding of supervisory issues such as liquidity risk management and to improve the quality of banking supervision globally.

In jurisdictions where bank regulators are party to the Basel process, the banks supervised by these regulators should closely monitor the thinking and policy development. For example, publications by this committee are a very good indicator of what is on the horizon. Local in-country regulators generally follow the guidance issued by the Basel Committee and then apply the standards to banks that operate within their jurisdiction.

The Basel Committee objectives

Exchange information on supervisory issues.
Share approaches and techniques used in supervisory processes.
Promote a common understanding of supervisory standards.