BCBS Issues Draft Principles on Managing Liquidity Risk
By Kanaga Raja, Geneva, 18 June 2008
The Basel Committee on Banking Supervision (BCBS), responding to the financial market turmoil, issued on Tuesday draft enhanced global principles for strengthening banks’ liquidity risk management and improving global supervisory practices.
The principles, numbering seventeen, are outlined in a document titled “Principles for Sound Liquidity Risk Management and Supervision”. BCBS has invited public comments on the draft principles by 29 July 2008.
According to the Basel-based Bank for International Settlements (BIS), the principles support one of the key recommendations for strengthening prudential oversight set out in the “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience”, which was presented to G7 Finance Ministers and Central Bank Governors in April 2008.
“The Basel Committee’s goal in developing these global standards is to significantly raise the bar for the management and supervision of liquidity risk at banks,” said Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank.
“The committee fully expects banks and supervisors to implement the enhanced principles promptly and throughly. We will vigorously assess the degree to which the principles are implemented.”
BIS said that the draft principles represent a substantial revision of the Committee’s liquidity guidance that was published in 2000 and reflect the lessons of the financial market turmoil. It added that the work was drawn from recent and ongoing work on liquidity risk by the public and private sectors and is intended to strengthen banks’ liquidity risk management and improve supervisory practices.
“The principles are based on the fundamental premise that a bank’s liquidity risk framework should ensure it maintains sufficient liquidity to withstand a range of stress events, including those that affect secured and unsecured funding,” noted Nigel Jenkinson, co-chairman of the Basel Committee’s Working Group on Liquidity and Executive Director of the Bank of England.
“Supervisors, for their part, should assess the adequacy of both a bank’s liquidity risk management framework and its liquidity position. In order to protect depositors and to limit potential damage to the financial system, supervisors should take prompt action if a bank is deficient in either area,” said Arthur Angulo, the other co-chairman of the Working Group and Senior Vice President of the Federal Reserve Bank of New York.
According to BIS, the principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process. The primary objective of the guidance is to raise banks’ resilience to liquidity stress.
Among other things, the principles seek to raise standards in the following areas:
Governance and the articulation of a firm-wide liquidity risk tolerance; Liquidity risk measurement, including the capture of off-balance sheet exposures, securitisation activities, and other contingent liquidity risks that were not well managed during the financial market turmoil; aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank; stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans; strong management of intraday liquidity risks and collateral positions; maintenance of a robust cushion of unencumbered, high quality liquid assets to be in a position to survive protracted periods of liquidity stress; and regular public disclosures, both quantitative and qualitative, of a bank’s liquidity risk profile and management.
The principles also strengthen expectations about the role of supervisors, including the need to intervene in a timely manner to address deficiencies and the importance of communication with other supervisors and public authorities, both within and across national borders.
BIS said that the proposed guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of banks.
The document notes that implementation of the sound principles by both banks and supervisors should be tailored to the size, nature of business and complexity of a bank’s activities. Other factors that a bank and its supervisors should consider include the bank’s role and systemic importance in the financial sectors of the jurisdictions in which it operates.
In an introduction, the document states that liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. Effective liquidity risk management helps ensure a bank’s ability to meet cash flow obligations, which are uncertain as they are affected by external events and behaviour of other agents.
“Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions,” the document warns.
Financial market developments in the past decade have increased the complexity of liquidity risk and its management, says the document, noting that the market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector.
“In advance of the turmoil, asset markets were buoyant and funding was readily available at low cost. The reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time.”
According to the document, the guidance is arranged around seventeen principles for managing and supervising liquidity risk. The principles for the management and supervision of liquidity risk are as follows:
“FUNDAMENTAL PRINCIPLE FOR THE MANAGEMENT AND SUPERVISION OF LIQUIDITY RISK
Principle 1: A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank’s liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system.
GOVERNANCE OF LIQUIDITY RISK MANAGEMENT
Principle 2: A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.
Principle 3: Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. Senior management should continuously review information on the bank’s liquidity developments and report to the board of directors on a regular basis. A bank’s board of directors should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively.
Principle 4: A bank should incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.
MEASUREMENT AND MANAGEMENT OF LIQUIDITY RISK
Principle 5: A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.
Principle 6: A bank should actively manage liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.
Principle 7: A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.
Principle 8: A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.
Principle 9: A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner.
Principle 10: A bank should conduct stress tests on a regular basis for a variety of institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s established liquidity risk tolerance. A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans.
Principle 11: A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.
Principle 12: A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding.
Principle 13: A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.
THE ROLE OF SUPERVISORS
Principle 14: Supervisors should regularly perform a comprehensive assessment of a bank’s overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank’s role in the financial system.
Principle 15: Supervisors should supplement their regular assessments of a bank’s liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports and market information.
Principle 16: Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position.
Principle 17: Supervisors should communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management. Communication should occur regularly during normal times, with the nature and frequency of the information sharing increasing as appropriate during times of stress.”