Lessons in liquidity

Turbulent financial markets have created funding difficulties for many financial institutions, making liquidity risk management a critical issue. Risk Australia asks the Australian Prudential Regulatory Authority for its views on the subject. By Christopher Jeffery

Risk Australia: Should liquidity risk be explicitly included in regulatory capital - that is, brought explicitly into the Basel II framework?

The Basel Committee and most national regulators, including the Australian Prudential Regulatory Authority (Apra), have previously issued guidance and requirements for liquidity risk management that are still valid today, although in need of some updating and strengthening. Pillar II of Basel II identifies liquidity risk as one risk against which capital could be held, but there is no consensus internationally about how such a capital charge would be calculated. Without necessarily ruling out some future development in this area, this is not a priority for Apra at the current time.

Risk Australia: Was the failure to explicitly include liquidity risk management in Basel II a fundamental mistake?

In Apra's view, risk management failings and poor underwriting standards contributed far more to the current turmoil than Basel II capital rules, which after all have only come into effect in many countries, including Australia, from January 1, 2008.

Risk Australia: How does Apra treat the area of liquidity risk management? What initiatives has Apra taken to address concerns about the appropriate manner for financial institutions to deal effectively with liquidity constraints?

Apra has a largely qualitative and principles-based approach to the supervision of liquidity risk. In response to the turmoil, Apra intensified its supervision, both on a bank-by-bank basis and across the industry as a whole. Apra commenced a review of its approach to liquidity risk management prior to the turmoil, identifying stress testing and standardised reporting as the major areas for enhancement. The turmoil has underlined the importance of those enhancements.

Apra intends to issue revised draft liquidity rules late this year for consultation. They will be broadly consistent with the recent Basel Committee document Principles for Sound Liquidity Risk Management and Supervision. Informal industry consultation has started.

Risk Australia: Are financial institutions being proactive in their treatment of liquidity risk?

Apra's experience has been that regulated entities are reconsidering their liquidity risk management practices in light of lessons learned in the current turmoil. We expect valuable advances in liquidity risk management to emerge from this process.

Risk Australia: Did the holistic stress tests deployed by financial institutions in the past few years manage to capture the liquidity risks associated with the current tough funding and credit market environment, following the seize-up in markets after the collapse of the US subprime mortgage market?

Globally, few - if any - financial institutions conducted stress tests that reasonably reflected the turmoil we have experienced in terms of severity, duration and interdependencies. In particular, few institutions anticipated the complete seizing-up of some funding markets, such as securitisation.

Risk Australia: What further work needs to be carried out by financial institutions to ensure their stress tests and scenario analyses accurately pick up potential liquidity risk concerns? Will Apra introduce explicit rules in this area?

As mentioned above, financial institutions need to reassess their liquidity management under a wide range of stress scenarios that acknowledge the possible severity, duration and inter-dependencies of liquidity crises, and tailor contingency plans to those scenarios. Apra will require a much wider range of stress tests - including the so-called second-round effects - in its revised approach. We are consulting with the industry on the desirability or otherwise of including some degree of prescription as an element of this approach.

Risk Australia: Does the bailout of Bear Stearns in the US highlight that financial institutions should conduct so-called dealer exit stress tests? Are such tests relevant in the Australian context?

Failure of a significant counterparty or market player is a potentially relevant stress scenario in any jurisdiction, regardless of the regulatory status of the failing entity.

Risk Australia: Do financial institutions have access to sufficient data to accurately asset their potential liquidity risk concerns? Are senior management - up to board level - sufficiently engaged?

Yes, subject to the general caveat that modelling low-frequency, high-severity events is always challenging, and no single 'right' approach has been identified to date. New methodologies tailored to liquidity risk will need to emerge out of industry best practice.

Risk Australia: Financial institutions have pressed for more types of assets to be included for use in Tier 1 and Tier 2 regulatory capital. What's Apra's view on this? What about concerns that many assets contain optionality that can lead to withdrawal or redemption during periods of uncertainty?

Apra has no plans to change the definitions of Tier 1 and Tier 2 capital instruments.

Risk Australia: With increased international financial flows and banks' increased size of overseas operations relative to home markets, large banking groups have multi-currency liquidity needs. But liquidity frameworks and regulations are still jurisdiction-based and often single-currency focused, with each central bank and regulator choosing its own approach and set of tools. While long established, the players in this system - central banks/regulators/banks - have had to deal with some very serious liquidity shortages during the recent crisis. What options would be helpful in improving the current state of affairs?

Supervisors and central banks are well aware of cross-currency issues in liquidity and funding management. In fact, the recent turmoil has demonstrated the ability of central banks and supervisors to work with their counterparts in other jurisdictions. There have been some serious challenges for cross-border banks in the current market turmoil, and it may well be the case that cross-currency exposures were not adequately considered in stress testing. However, this issue has not arisen in the case of the larger Australian banks.

Risk Australia: Should central banks or regulators have ultimate oversight for liquidity supervision?

The key issue is strong communication between the supervision and market operation functions, regardless of how those functions are split between various official bodies. Apra and the Reserve Bank of Australia have long had a close and constructive working relationship in areas of common interest and at many levels, which has proven itself during the market turmoil of the past year.