Key Issues in the Management of Liquidity Risk

This is the second article in a series of articles on the management of Liquidity Risk. In my first article “Managing Liquidity Risk – The 2007 Crisis” I dealt with the severe liquidity problems experienced by banks worldwide, which began in the summer of 2007 and which heralded the current financial crisis. I then examined the concept of Liquidity Risk Management, and in reviewing the events of that summer I explored the reasons why many banks came under severe stress. 

The crisis revealed that important issues had been overlooked and ignored. The “Basel Committee on Banking Supervision” in its 2008 review of the situation provided additional guidance in areas like;

·         the acceptability of liquidity risk by banks,

·         ensuring liquidity levels are maintained,

·         the allocation of liquidity costs, benefits and risks to a bank’s activities,

·         identifying and measuring all the liquidity risks,

·         stress testing,

·         contingency funding plans,

·         managing intraday liquidity risk, and

·         public disclosure as a means to promote market discipline.

In this article I deal with the guidance provided in February 2008 Basel Committee document entitled “Liquidity Risk Management and Supervisory Challenges”.

This guidance has been set out in the form of seventeen individual “principles”. In turn these principles have been grouped into five major categories. I will deal with category and the principle or principles that they each contain in turn.

Fundamental principle for the management and supervision of liquidity risk.

This is made up of a single principle that essentially places the responsibility of the management of liquidity risk squarely on the bank. There are a number of actions that the bank needs to take to do this, such as ensuring that a strong risk management framework exists and that a bank is obligated to see that it maintains an appropriate level of liquidity to meet its trading requirements. Within the same principle Bank Supervisors are enjoined to ensure the adequacy of the individual banks liquidity risk management framework.

Governance of liquidity risk management

This section comprises three principles. All relate to the level of liquidity risk that a bank is prepared to take. This includes setting a level of required liquidity to meet the individual banks business strategy, the establishment of an appropriate management structure to manage this risk and the duty of the bank’s board of directors to review and approve all issues relating to liquidity at least annually. The third principle in this section deals with the need for liquidity costs, benefits and risks to be incorporated in product pricing and for the need for all new products to be approved with a view to understanding the effect they have on and how they are affected by the bank’s liquidity position. 

Measurement and management of liquidity risk

This is the “meat” of the proposal. It is made up of eight individual principles. I will deal with each of these principle in turn.

• Banks must have a sound process to identify, measure, monitor and control their own liquidity risk.
• Banks must take a total active liquidity view. This means that they must manage their exposures and their funding across all their business lines, currencies and legal entities at the same time. And they also need to allow for legal, regulatory and practical limits to moving liquidity between business the various entities that make up their business.
• Banks must diversify their sources of funding and they should regularly test their ability to raise adequate funds from these sources at short notice.
• Intraday (as opposed to overnight) liquidity must be actively managed so that it can meet the bank’s obligations as they arise. Furthermore a bank needs to plan to do this under both normal and strained conditions.
• Collateral must also be actively managed and care should be taken to separate assets which are already tied-up and those that are free.
• Regular stress tests must be undertaken, using different scenarios. This is important as it will help determine if the bank can keep its liquidity requirements and usage within the previously set limits.
• The bank must have a formal emergency liquidity plan. This should also include clear lines of responsibility and escalation procedures. This plan should also be tested regularly.
• Banks are also required to maintain a buffer of unencumbered, high quality liquid assets to meet emergency situations. These assets must also be free of any barriers to their use.

Public disclosure

There is a single principle here – that a bank should disclose information regularly that will permit market participants to form their own opinion as to the bank’s liquidity and its liquidity risk management structure.

The role of supervisors

The final four principles deal with the role of the bank supervisor. Firstly supervisors need to do a regular check of the bank’s risk management structure and its liquidity position. On top of this they should be getting additional information like internal reports and current market information. If supervisors find problems they should also intervene to make certain that these problems are addressed promptly. 

There is also a requirement for supervisors to communicate with other supervisors and public authorities, like central banks, both within and across national borders. This is to ensure that there is effective cooperation regarding the supervision of liquidity risk management. This communication needs to take place regularly during normal times. In times of stress this sharing of information needs to increase appropriately.

This guidance was published for initial consolation and comment. In a subsequent article I will deal with some of the “hows”, “whys” and “what to look for” in applying some of these principles.