Points of principle

The Basel Committee on Banking Supervision published revisions to its principles on liquidity risk management in June, highlighting the need for institutions to articulate their liquidity risk tolerance and to have a sufficient cushion to withstand market stresses. The report offers a more comprehensive set of guidelines than the original principles published in 2000, but how will banks and supervisors respond? Rob Davies reports

In the space of a year, liquidity has jumped to the top of the risk management agenda. In May, PricewaterhouseCoopers and the Centre for the Study of Financial Innovation jointly published their annual Banking Banana Skins survey, ranking the 30 main risks affecting the banking sector. The poll, drawn from the responses of 300 senior managers at financial institutions in 38 countries, ranked liquidity as the number-one risk facing the industry. By way of contrast, liquidity did not make the top-30 risks cited in the 2007 survey.

During the past 12 months, liquidity difficulties were cited as primary causes of the collapse of UK mortgage lender Northern Rock - placed into government administration in February 2008 - and the demise of Wall Street dealer Bear Stearns, acquired in March by JP Morgan after the intervention of US regulators.

In an effort to improve liquidity risk management practices at banks and bolster the powers of supervisors to deal with institutional and market-wide issues, the Basel Committee on Banking Supervision's working group on liquidity issued proposed revisions to its Global Principles for Sound Liquidity Risk Management and Supervision on June 17 (see box).

Market participants were given until July 27 to respond to the 17 principles - a revision of earlier guidance published in 2000 - which focus heavily on governance, measurement and management of liquidity risks, public disclosure and the role of supervisors.

The working group splits liquidity risk into two parts. Funding liquidity risk is defined as the "risk a firm will not be able to meet efficiently both expected and unexpected current and future cashflows and collateral needs without affecting either daily operations or the financial condition of the firm". Market liquidity risk, meanwhile, is the risk that a firm is not able to offset or eliminate a position at market prices due to lack of depth or disruption.

One of the factors behind the Basel Committee's revisiting of the guidelines is the increasing interconnectivity between financial institutions, meaning liquidity issues seemingly concentrated at one firm can have systemic implications. Furthermore, the growth in off-balance-sheet financing has created additional challenges.

"Financial market developments in the past decade have increased the complexity of liquidity risk and its management," states the Basel Committee. "Many of the most exposed banks did not have an adequate framework that satisfactorily accounted for liquidity risks posed by individual products and business lines, and therefore incentives at the business level were misaligned with overall risk tolerance. Many banks had not considered the amount of liquidity they might need to satisfy contingent obligations, as they viewed funding of these obligations to be highly unlikely."

The rapid changes in the market meant liquidity risk principles drawn up in 2000 required a rethink, says Arthur Angulo, senior vice-president in the banking supervision group at the Federal Reserve Bank of New York and co-chair of the Basel Committee's working group on liquidity. "Both sets of principles are a reflection of the time they were written. In 2000, the guidance was developed in the aftermath of the Asian financial crisis - there was a heavy emphasis on management of liquidity risk associated with cross-border and foreign currency exposures," explains Angulo. "In contrast, the 2008 guidance devotes considerable attention to the interaction and implications of market liquidity on funding liquidity, particularly the management of contingent liquidity risks such as those associated with off-balance-sheet financing arrangements."

As well as providing more explicit definitions of existing principles, the latest document establishes new guidance for banks and supervisors. Among the proposals is that a bank should articulate a liquidity risk tolerance "appropriate for its business strategy and role within the financial system". Senior management should be responsible for establishing the policy and maintaining a sufficient level of liquidity, with processes to be regularly reviewed and subject to board approval.

How a firm goes about articulating liquidity risk tolerance is open to interpretation, so it is not altogether unexpected this principle has attracted attention. The Basel Committee suggests it could be quantified by the level of unmitigated funding liquidity risk the bank decides to take under normal and stressed conditions, but other participants have different ideas.

"Everyone has a problem defining exactly what risk tolerance is with respect to liquidity," says Maarten Gelderman, head of quantitative risk management at De Nederlandsche Bank (DNB), the central bank of the Netherlands. "As a regulator, we want to see serious discussions taking place at board level on current liquidity positions, not only during the types of conditions we see today but also in normal market circumstances. The board must show sufficient familiarity with liquidity issues that gives us confidence they are fully aware of risks they are taking."

However, Adam Tyrrell, London-based head of group treasury for the Middle East, South Asia, Africa, Europe and the Americas at Standard Chartered Bank, believes that, unless there is an explicit requirement from regulators, banks will adopt a number of different approaches to articulating risk tolerance.

"Most institutions have found it difficult to specify one number as showing liquidity risk tolerance - I don't think that is possible. It is not as clear cut as credit risk, which is measured by expected loss, or market risk, which is shown through value-added risk," he begins. "Responses could vary from tolerance being presented as the amount of marketable securities on the balance sheet, to how well stress tests are passed."

Elsewhere, the guidelines suggest banks "incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval for all significant business activities". This is intended to align risk-taking incentives of individual business units with the liquidity risks their activities create.

"Banks should have a robust internal transfer pricing mechanism. Liquidity was treated as free at some fairly large organisations, which were clearly surprised that certain liquidity options they wrote actually came home to roost," says Angulo.

According to Tyrrell, considering liquidity when pricing a product is an important shift in the way of thinking. "The implication is that institutions need to appropriately price internally for liquidity as well as interest rate risk. Historically, it was less of an issue: if the two-year cost of liquidity is less than 5 basis points, you probably would not price it because it does not have a material impact on the overall cost of the transaction. But if it is 30bp, you are going to include it - and that is where the mindset is changing."

David Vander, co-founder of the London-based liquidity risk consultancy Liquidatum, agrees. "The notion that all businesses are charged a premium for liquidity risk is not saying a bank should stop doing certain things. But if it wants to steer the balance sheet, there needs to be some recognition of how people are incentivised," he argues. "I don't mean in terms of bonuses, but the charging of liquidity costs to their business. There is also reference to how banks have been too commercially driven from a liquidity point of view, which effectively suggests those responsible for liquidity should not give in to commercial pressures."

The guidance explicitly sets out the need for banks to hold a cushion of unencumbered, high-quality liquid assets as insurance against a range of stressed conditions. Furthermore, there should be no legal, regulatory or operational impediment to using those assets to obtain funding. A related principle recommends banks establish formal contingency funding plans.

Although a diversified funding strategy would seem an obvious way for banks to mitigate liquidity risk, this was not stipulated in the 2000 guidance. It is among the updated principles, however. Additionally, the working group wants banks to focus on the identification of different liquidity risk sources to assist in the measurement, monitoring and management of those risks, enabling them to accurately project cashflows of assets, liabilities and off-balance-sheet items.

With liquidity drying up in the interbank lending market at various points during the recent turbulence - requiring central-bank intervention in the US and Europe - two new principles address issues related to intra-day liquidity and collateral management. Banks should be able to meet payment and settlement obligations under normal and stressed conditions, and are encouraged to use stress tests for institution-specific and market-wide scenarios.

The original document offered little guidance for supervisors. In the new version, supervisors are urged to be more proactive in assessing banks' liquidity positions and risk management frameworks to test if they are resilient to stresses.

In the event of having specific concerns over practices at individual institutions, supervisors should intervene to ensure banks take remedial action to address deficiencies. "If the situation gets increasingly serious, supervisors have tools to increase the pressure on banks to get the desired outcome," explains Angulo. "They could, for example, require the bank to hold a higher cushion of liquid assets, either through persuasion or formal action. A supervisor could also put restrictions on a bank acquiring asset portfolios or businesses if it believes management should first address existing liquidity weaknesses before taking on additional risk. Ultimately, supervisors could even require a bank that has a weak liquidity position to operate with a higher level of capital."

Empowering regulators with such tools is justified given recent risk management failures, argues the Paris-based head of asset and liability management at a major European dealer. "It is the role of supervisors to step in and restrict a bank from participating in a certain business area if they are concerned about its liquidity position," she argues. "And I don't think banks can complain if they are asked to hold more capital if regulators think it is insufficient to withstand certain conditions."

The initial response to the revised principles has, on the whole, been positive, with a variety of respondents welcoming the collective effort to address liquidity issues. "Liquidity is now a shareholder issue, which it wasn't necessarily in the past," notes Liquidatum's Vander. "Banks' share prices have been hit by people's perception on liquidity, and there is a realisation that capital and liquidity risk need to be measured differently. Banks are starting to realise liquidity is a scarce resource. Basel II was very much focused on capital being scarce - we are now going through a similar process in terms of attitudes to liquidity."

Prior to the release of the working group's revised principles, banks worried that the Basel Committee would recommend supervisors establish a regulatory capital charge on liquidity. Although the group says this could be considered by individual supervisors, it stops short of advocating such a move.

"As far as setting out a specific capital requirement for liquidity or a liquidity ratio, this was never on the table: people have a hard time with the idea of setting aside capital for liquidity," explains Angulo. "Periodically, over the past 30 years, the Basel Committee has looked at the question but has never come to a firm resolution. The main reason, I believe, is that it is extremely difficult to reduce liquidity risk, especially for large institutions, to a single metric or set of metrics."

The Bern-based Swiss Federal Banking Commission (SFBC), the national supervisor of Credit Suisse and UBS, has no intention of requesting that banks hold more capital for liquidity. "Robust capital ratios reduce the likelihood of liquidity pressure, but it is important to note that apparently solvent banks may suffer liquidity problems," states the SFBC in an email statement. "Thus, it is indispensable for banks to have a meticulous process to identify all future cashflows on a contractual basis and make adjustments to build up comprehensive liquidity measures - irrespective of its capital adequacy."

"It is not something we have considered because I don't think you can cover liquidity with capital," concurs DNB's Gelderman. "We have an explicit liquidity requirement, which is for banks to maintain a buffer of liquid assets. We think this is the best way to cover liquidity risk, which our framework treats as more or less independent of solvency."

Standard Chartered's Tyrrell supports the view that additional capital offers inadequate protection against liquidity risk. "There is little point holding extra capital for liquidity risk as it does not properly protect you," he argues. "Liquidity is fundamentally different from other risks such as operational or credit risk, because it is not related to an expected loss. If an institution's liquidity ratios are facing stress, probably the last thing it would want to do is go to the market to raise capital. If the market finds out the institution is raising capital at the behest of the regulator, the firm will have an even bigger liquidity issue."

Not everyone shares this view, however. Bob Allen, a senior adviser at the Australian Prudential Regulation Authority until his retirement in January, insists capital is the best means of protecting a firm against any type of risk.

"The argument goes that capital does not provide liquidity, but that statement is patently incorrect," he asserts. "Capital is the most effective source of liquidity, because unlike all other liabilities there is no contractual obligation to repay it. Institutions need economic capital to absorb potential losses from whatever source, and liquidity risk is one of those sources. Most would agree that, if a firm has more capital, other institutions would be happier about lending to them."

Others argue banks must recognise the risk for certain illiquid assets will rise during times of market stress. As such, any capital banks hold should be determined by the expected liquidity of the underlying assets in stressed conditions. "If a bank is exposed to extreme risk as a result of factors such as balance-sheet structure, funding or business lines, it is fair to expect them to hold capital for these endogenous liquidity exposures," notes Gavin Kretzschmar, Edinburgh-based global head of banking risk at Barrie & Hibbert, a consultancy specialising in modelling financial risk. "The default assumption banks need to make is that risk increases for illiquid assets. The capital a bank needs to hold under stressed conditions also rises, and for a longer period of time - but that is not something banks want to hear. During periods where access to funding is closed off, you simply have to hold more matched capital. Banks need to rank assets and liabilities into liquidity buckets based not only on duration, but also the depth of the market."

Rather than an additional level of capital, the focus of the latest Basel Committee document is on the cushion of unencumbered liquid assets to act as insurance against liquidity risk, although this itself has not escaped scrutiny.

"This is clearly an appropriate addition to the new principles, but there is a big issue during a real liquidity crisis as to what exactly is a high-quality liquid asset," says Allen. "Other than central government securities, what else is there? If you look at recent US experience, you could justifiably say nothing."

The idea of a liquidity buffer is already required within the Dutch regulatory framework, which might act as a point of reference to other supervisors. "Our framework, to some extent, is equivalent to the standardised approach to capital under Basel II," says Gelderman. "We apply a weighting factor to all kinds of assets and liabilities. Ordinary savings accounts, for example, count as a liability for 20% of the amount outstanding: it is highly unlikely a bank will experience a withdrawal in excess of 20% from savings accounts. On the other hand, we apply a haircut of 95% to wholesale funding since it could be drawn more or less immediately."

According to Gelderman, DNB has strict requirements on the reporting of liquidity, a measure he believes has benefited both banks and supervisors. "We already require banks to have a consolidated look at liquidity positions to include off-balance-sheet items and contingent claims. One of the main benefits of our approach is that it has forced banks to develop information systems to create a consolidated view on the aggregate liquidity position. They can use those systems on a day-to-day basis to assess the impact of recent conditions, which ultimately may have been more important than the exact framework and risk weighting attached to assets and liabilities."

The success of the revised principles will be determined by how rigidly they are enforced by banks and supervisors. The inability to do this was, according to Angulo, a critical failing of regulators after the original guidance was published.

"You could point to the 2000 guidance and ask whether there was sufficient follow-up by supervisors. In the second half of the year, the working group will devote some time to looking at other ways to make the approach to liquidity supervision more consistent across jurisdictions," he says. "Irrespective of the outcome, there is an expectation national supervisors will, once this guidance is finalised, take it and apply it, and do a more rigorous job of assessing liquidity positions and risk management at firms in future."

The 2008 revised liquidity principles - a summary

1. The fundamental principle is that banks must take responsibility for sound liquidity risk management, establishing a framework to maintain sufficient liquidity, with a cushion of high-quality liquid assets to withstand stress events. This should be monitored by supervisors, which should intervene if they believe banks are deficient. Supervisors should treat liquidity risk as thoroughly as other major risks.

2. Banks must articulate a liquidity risk tolerance "appropriate for its business strategy and role in the financial system".

3. Senior management should develop a strategy to manage liquidity risk in accordance with its risk tolerance and ensure the bank maintains sufficient liquidity. This should be reviewed continuously, with regular reports to the board of directors, which should approve strategy/policies at least annually.

4. Banks should incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval process for all significant business activities (on and off balance sheet).

5. A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk - comprehensively projecting cashflows arising from assets, liabilities and off-balance-sheet items over a set of time horizons.

6. Banks should actively manage liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, all the while taking into account legal, regulatory and operational limitations to transferring liquidity.

7. Banks should establish a funding strategy that provides effective diversification in the sources and tenor of funding. They should maintain an ongoing presence in chosen funding markets for effective diversification, while gauging their ability to raise funds quickly from various sources.

8. Banks should actively manage intra-day liquidity positions and risks to meet payment and settlement obligations under normal and stressed conditions.

9. Banks should actively manage collateral positions, differentiating between encumbered and unencumbered assets.

10. Banks should conduct regular stress tests for a variety of institution-specific and market-wide stress scenarios to identify sources of potential liquidity strain and ensure current exposures remain in accordance with established liquidity risk tolerance. Banks should use the results of stress tests to adjust strategies, policies and positions and to develop contingency plans.

11. Banks should outline a formal contingency funding plan that sets out strategies for addressing liquidity shortfalls in emergency situations. This should include clear lines of responsibility and escalation procedures.

12. Banks should maintain a cushion of unencumbered, high-quality liquid assets to be held as insurance against a range of liquidity stress scenarios. There should be no legal, regulatory or operational impediment to using these assets to get funding.

13. Banks should publicly disclose information regularly to enable other market participants to make informed judgements about the soundness of its liquidity position and risk management policies.

14. Supervisors should regularly assess individual banks' overall liquidity risk management framework and liquidity position to determine if it is sufficiently resilient to market stresses.

15. Supervisors should supplement assessments by monitoring internal reports, prudential reports and market information.

16. Supervisors should intervene to require remedial action by banks to address deficiencies in liquidity positions or risk management processes.

17. Supervisors should communicate with other regulators and public authorities within and across national borders to facilitate effective co-operation on supervision and oversight of liquidity risk management.