New Principles for Liquidity Risk Management

Jakob Windfeld Lund, Financial Markets

INTRODUCTION

Liquidity risk is a natural part of traditional banking activities where li abilities, e.g. demand deposits, have shorter maturities than assets, e.g. loans.¹ The financial turmoil over the past year has highlighted liquidity risk, particularly because liquidity diminished in some of those financial markets that were previously considered to be the most liquid.² Funding through the financial markets became significantly more difficult and expensive. This led to liquidity pressures on the most vulnerable banks and in a few instances to actual banking crises.

The risk of banking crises with broader economic costs provides a strong economic argument for banking supervision and regulation.

Globalisation of financial markets and financial innovation have widened the opportunities for risk diversification, but have also height ened the risk of international contagion and opportunities for regula tory arbitrage. This has reinforced the need for international coordin ation of financial regulation.

Recent years have seen substantial convergence of rules for the bank ing industry, both in the EU (e.g. the Capital Adequacy Directive) and globally (e.g. Basel II). But so far, liquidity regulation and supervision have not been harmonised, and even within the EU this area has been regarded as a matter for national authorities.

On 17 June, the Basel Committee³ published new principles for liquid ity risk management, and CEBS⁴ published a set of recommendations for liquidity regulation and supervision in the EU.⁵

The financial turmoil over the past year has demonstrated the need to revise risk management and supervision of banks' liquidity. The prin ciples of the Basel Committee and CEBS provide a good foundation for this. The current liquidity regulation in Denmark does not appear to ad equately cover all new principles.

This article reviews the principles of the two reports based on the Basel Committee report.

THE BASEL COMMITTEE AND CEBS REPORTS

Both the Basel Committee and CEBS had already been addressing the liquidity issue for some time before the financial turmoil began in the summer of 2007. The financial turmoil over the past year has highlighted liquidity risk and increased the awareness of the work on liquidity in Basel and CEBS.

The CEBS report was originally planned to be published in January 2008, but in light of the crisis – and as part of the overall compilation of Ecofin's "roadmap" for responses to the crisis – it was postponed to allow for better coordination with the corresponding work in Basel. The reports of 17 June from the two committees were submitted for public consultation with deadlines on 29 July (Basel) and 1 August (CEBS), re spectively. Publication of the final reports is expected in the autumn.

The structure and content of the two reports overlap to some degree, cf. Chart 1. The Basel Committee report includes 17 principles for liquid ity risk management and supervision and is a detailed update of the Committee's report from 2000. The following areas are highlighted:

• the importance of establishing a liquidity risk tolerance

• the maintenance of an adequate level of liquidity, including through a cushion of liquidity assets

• the necessity of allocating liquidity costs, benefits and risks to all sig nificant business activities)

• the identification and measurement of the full range of liquidity risks, including contingent liquidity risks

• the design and use of severe stress test scenarios

• the need for a robust and operational contingency funding plan

• the management of intraday liquidity risk and collateral

• public disclosure in promoting market discipline

• expanded guidance for liquidity supervisors.

The CEBS report, with 30 recommendations, is the second part of CEBS' response to the Call for Technical Advice of March 2007 from the Euro pean Commission. The first part was a survey of the national regulatory frameworks adopted by the EEA countries.⁶

The CEBS report begins with a background analysis of liquidity risk in modern banking. It emphasises a number of conditions that affect liquidity risk, including the globalisation of financial markets, financial innovation (e.g. credit derivatives), new forms of payment systems and other financial infrastructure, increased use of collateral, new account ing principles, and the fact that markets respond differently when under stress.

Compared with the Basel report, the CEBS report focuses more on regulation and supervision of banks' liquidity risk management, includ ing the principle of proportionality and issues related to the banks' use of internal liquidity management methodologies.

The principles of the Basel report and the recommendations of the CEBS report are both designed as high-level principles for what banks and supervisors "should" do regarding liquidity risk management and supervision. Nevertheless, banks and supervisors are clearly expected to improve their practices in this area. The rest of this article briefly reviews the 17 principles of the Basel report.

THE FUNDAMENTAL PRINCIPLE

Principle 1 Fundamental principle for the management and supervision of liquidity
"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 un encumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both un secured and secured funding sources. Supervisors should assess the ad equacy 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."

This fundamental principle establishes clear lines of responsibility. It is the bank's responsibility to ensure sound management of liquidity risk, and it is the supervisor's responsibility to assess the adequacy of the bank's response and to react promptly to any deficiencies.

Principle 1 has both a qualitative and a quantitative dimension in terms of liquidity management and supervision. A bank should have a robust liquidity management framework and hold a liquidity cushion comprised by readily marketable assets. Comparisons of national regu latory frameworks in the liquidity area have previously distinguished between qualitative regulation focusing on the bank's internal frame work (management, strategies, practices) and quantitative regulation focusing on maintaining an established liquidity requirement.⁷ Principle 1 encourages a mixed approach where supervisors should assess both a bank's liquidity risk management framework (qualitative) and its liquid ity position (quantitative).

Principle 1 also provides a clear liquidity supervision objective: to protect depositors and to limit potential damage to the financial system.

GOVERNANCE OF LIQUIDITY RISK MANAGEMENT

Principle 2: Liquidity risk tolerance
"A bank should clearly articulate a liquidity risk tolerance that is appro priate for the business strategy of the organisation and its role in the fi nancial system."

Risk tolerance is a key concept in modern risk management and closely related to risk appetite. In practice, risk tolerance is often set as max imum limits to, for instance, a bank's Value-at-Risk for market risk. The liquidity risk tolerance defines the maximum level of liquidity risk that the bank is willing to assume.

It should be commensurate with the bank's business strategy and its role in the financial system. The business strategy affects the types of liquidity risk to which the bank is exposed, while the bank's role in the financial system determines the consequences of potential liquidity problems. The formulation depends on how the bank calculates its li quidity risk. The tolerance may be expressed as limits to, for example, LaR⁸, the net funding requirement over a specific set of time horizons, or excess cover of the statutory liquidity requirement.

Principle 3: Strategy, policies and practices
"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 3 establishes clear lines of responsibility between a bank's senior management and its board of directors. Both should have a thor ough understanding of liquidity risk and other risks, including market, credit, operational and reputational risks.

The liquidity strategy, key policies for implementing the strategy and the liquidity risk management structure should be communicated throughout the organisation to all business units conducting activities that have an impact on liquidity.

Principle 4: Liquidity pricing and incentives
"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."

Principle 4 encourages banks to use internal transfer pricing for li quidity to ensure that both current funding costs and the risk of in creasing future funding costs are taken into account for each exposure. The objective is to increase individual business lines' awareness of li quidity risk and to create natural incentives for good liquidity risk man agement.

MEASUREMENT AND MANAGEMENT OF LIQUIDITY RISK

Principle 5: Quantitative liquidity model
"A bank should have a sound process for identifying, measuring, moni toring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from as sets, liabilities and off-balance sheet items over an appropriate set of time horizons."

A bank should have reliable systems to give an up to date, exhaustive picture of its liquidity position and risks. This includes future cash flows from both assets, liabilities and off-balance sheet items, e.g. liquidity guarantees. It also includes correspondent, custody and settlement ac tivities.

Banks should design a system of early warning indicators to monitor liquidity risks. Alarms should start to go off when a bank experiences:

• rapid asset growth, especially when funded with potentially volatile liabilities

• growing concentrations in assets or liabilities

• a decrease of weighted average maturity of liabilities

• repeated incidents of positions approaching or breaching internal or regulatory limits

• negative trends or heightened risk associated with a particular product line

• negative publicity

• a credit rating downgrade

• stock price declines or rising debt costs

• counterparties that begin requesting or request additional collateral for credit exposures or that resist entering into new transactions

• difficulty accessing longer-term funding

• increased risk of liquidity drain from products with embedded triggers such as derivatives and back-up lines.

Principle 6: Active liquidity risk management for the bank as a whole
"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."

So far, a distinction has been made between centralised and decen tralised liquidity risk management in international banks.⁹ Principle 6 establishes the need for both, i.e. for a consolidated overview and for taking into account potential limitations to the transferability of liquid ity between a bank's different entities.

Principle 7: Diversified funding
"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 abil ity to raise funds and monitor those factors closely to ensure that esti mates of fund raising capacity remain valid."

Funding can be diversified in many dimensions: maturities (short-, me dium- and long-term), type of counterparty (retail and wholesale), se cured versus unsecured funding, instrument type, currency and geo graphic market. As a general practice, banks should limit concentration in any one particular funding source, notably certain market-based funding sources.

Banks should make efforts to secure access to market-based funding by maintaining strong relationships with counterparties and by regularly testing the funding opportunities in the market.

Banks need to identify alternative sources of funding that strengthen their capacity to withstand potential liquidity shocks, including:

• deposit growth

• the lengthening of maturities of liabilities

• new issues of short- and long-term debt instruments

• intra-group fund transfers, new capital issues, the sale of subsidiaries or lines of business

• the sale or repo of unencumbered, highly liquid assets

• borrowing from the central bank.

Principle 8: Intraday liquidity management
"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."

The time horizon for liquidity risk management has changed in recent years as a result of shorter settlement periods and increased use of real-time systems. Principle 8 underlines the importance of sound intraday li quidity management and emphasises six practical challenges in that con nection:

• capacity to measure expected gross liquidity inflows and outflows and anticipate the timing of net funding shortfalls that might arise during the day

• capacity to monitor intraday liquidity positions against expected ac tivities and available resources (balances, remaining intraday credit capacity, available collateral)

• acquisition of sufficient intraday funding to meet the bank's intraday objectives

• ability to manage and mobilise collateral available to acquire the level of intraday liquidity needed

• capability to manage the timing of the bank's liquidity outflows and the payment outflows of key customers

• preparedness to deal with unexpected disruptions to the bank's intra day liquidity flows.

Principle 9: Collateral
"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."

Increased use of collateral in financial transactions (e.g. repo transac tions and intraday credit) in recent years has enabled banks to reduce uncollateralised counterparty risks, while imposing higher requirements on banks' management of collateral and liquidity. Banks should be aware of the acceptability of assets as collateral to various counterparties (includ ing central banks) and any restrictions on the use of collateral.

Principle 10: Liquidity stress tests
"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 out comes to adjust its liquidity risk management strategies, policies and positions and to develop effective contingency plans."

Liquidity stress tests use a bank's cash flow projecting tools (cf. prin ciple 5) to calculate the effect on liquidity in a variety of stress scenarios. The stress scenarios should be aimed at liquidity risks of relevance to the bank concerned. The scenarios may be institution-specific (e.g. if a bank's credit rating is reduced by the rating agencies, and/or if a bank loses access to important sources of funding) and market-wide (e.g. the closing of important markets for funding). Institution-specific and mar ket-wide scenarios may arise individually and in combination. Stress tests should allow for changed behaviour among counterparties, including the risk of counterparties stockpiling liquidity and of slower intraday payment flows. Stress test outcomes and the resulting modifications to a bank's risk management should be discussed with its board of directors and the national supervisor.

Principle 11: Contingency funding plan
"A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emer gency 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 up dated to ensure that it is operationally robust."

A CFP is the compilation of policies, procedures and action plans for responding to severe disruptions to a bank's ability to fund some or all of its activities. A CFP should be closely integrated with a bank's liquidity risk management and include:

• a description providing the bank's management with an overview of the potentially available contingency funding measures

• clear specification of roles and responsibilities among key employees on the "crisis team", including contact details, and the designation of alternates for key roles

• plans for contacting and communicating with market participants, em ployees, clients, creditors, shareholders and supervisors

• potential steps to meet critical payments on an intraday basis.

CFPs should be reviewed and tested regularly to ensure their effect iveness and operational feasibility.

Principle 12: Liquidity cushion
"A bank should maintain a cushion of unencumbered, high quality li quid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of un secured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding."

The many uncertainties involved in predicting liquidity developments make it necessary for banks to have a cushion of liquidity for immediate use in emergencies.

The statutory liquidity requirement in Denmark is specified in section 152 of the Financial Business Act. The requirement must be observed at all times. This means that the liquidity used to meet the statutory re quirement cannot be used as a cushion. Goodhart (2008) likens binding liquidity requirements to the last taxi at the railway station that cannot be taken if the bylaws require that there must always be one taxi standing ready at the station. For Danish banks, the available li quidity cushion can therefore only be said to be their excess liquidity cover, over and above the requirement in section 152. Operating with low excess liquidity cover therefore seems imprudent, especially during periods of stress.

The assets in a liquidity cushion can be used to obtain funding either in the market or from the central bank. Banks are encouraged to be realistic about both options. Market liquidity can disappear. Nor should banks rely on the central bank helping by altering the amount of or the terms on which it provides liquidity. Other considerations such as moral hazard and the objective of monetary policy may outweigh the central bank's short-term consideration for banks with liquidity problems.

PUBLIC DISCLOSURE

Principle 13: Public disclosure
"A bank should publicly disclose information on a regular basis that en ables market participants to make an informed judgement about the soundness of its liquidity risk management framework and liquidity pos ition."

Public disclosure may contribute to reducing uncertainty and strength ening market discipline. Principle 13 encourages banks to disclose both qualitative information on their liquidity risk management and quanti tative information on their key liquidity numbers. Examples of relevant qualitative information:

• the bank's liquidity risk tolerance (principle 2)

• processes for internal liquidity reporting and monitoring

• details about the bank's liquidity model and its assumptions (principle 5)

• description of the stress test scenarios modelled (principle 10) and CFP (principle 11).

In some countries there has been opposition against disclosing quan titative data concerning the liquidity of individual banks. The reason given is often that different banks have different business models and thus different liquidity needs, and that because liquidity data are not harmonised, they are not comparable. This may entail risk of misunder standings and unjustified disruptions of liquidity. In other countries it has been up to the banks themselves to decide what liquidity infor mation they wanted to disclose. Banks that disclose data on liquidity often have different types of key liquidity metrics and different internal limits for those metrics. Denmark is one of the few countries where banks are required to disclose standardised key metrics for ex cess liquidity cover together with their annual financial statements.

THE ROLE OF SUPERVISORS

Principle 14: Liquidity supervision
"Supervisors should regularly perform a comprehensive assessment of a bank's overall liquidity risk management framework and liquidity pos ition to determine whether they deliver an adequate level of resilience to liquidity stress given the bank's role in the financial system."

Principle 14 clarifies supervisors' responsibility for liquidity supervision. Supervisors should have in place a supervisory framework which allows them to make thorough assessments of banks' liquidity risk manage ment practices and the adequacy of their liquidity, in both normal times and periods of stress. Such assessment may be conducted through on-site inspections and off-site monitoring and should include regular com munication with a bank's management and/or board of directors. The supervisory framework should be publicly available.

Liquidity supervision should be commensurate with the risk profile of an individual bank, especially the risk a bank poses to the smooth func tioning of the financial system as a whole given its size and role in e.g. payment and settlement systems. Supervisors should assess the risk toler ance of a bank and the overall liquidity risk management framework to confirm that it ensures sufficient liquidity. Supervisors should pay special attention to banks' liquidity stress tests and CFP, including stress scen arios and underlying assumptions, and how the results of stress tests are used in liquidity risk management.

Principle 15: Liquidity monitoring
"Supervisors should supplement their regular assessments of a bank's li quidity risk management framework and liquidity position by moni toring a combination of internal reports, prudential reports and market information."

Supervisors should regularly collect and analyse liquidity reports from the banks. Such data should be supplemented with other information on market developments. Close collaboration between supervisors and central banks in monitoring major banks' liquidity positions and finan cial market liquidity conditions is particularly useful during stressed con ditions.

Principle 16: Intervention to address deficiencies
"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 16 clarifies supervisors' responsibility to address deficiencies in a bank's liquidity risk management processes. Supervisors should have a range of tools at their disposal to address any deficiencies they iden tify, including the authority to compel banks to take appropriate and timely remedial action. The choice of tools to use and the timeframe in which any remedial action is expected to be taken by the bank should be proportionate to the level of risk the deficiency poses to the safety and soundness of the bank or the relevant financial system(s). The range of supervisory responses could include:

• requiring actions by the bank to strengthen its management of liquid ity risk

• requiring actions by the bank to improve its CFP (e.g. through stress testing)

• requiring actions by the bank to reduce its liquidity risk

• restricting the bank from making acquisitions or significantly ex panding its activities

• imposing higher capital requirements.

Principle 17: Communication with other authorities
"Supervisors should communicate with other supervisors and public au thorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and over sight of liquidity risk management. Communication should occur regu larly during normal times, with the nature and frequency of the infor mation sharing increasing as appropriate during times of stress."

Principle 17 encourages supervisors to communicate openly with other relevant authorities, both internationally with supervisors in other coun tries and nationally with the central bank. Cooperation and information sharing among supervisors and central banks can contribute to the effect iveness of these authorities in their respective roles. Such cooper ation can help supervisors improve the assessment of the overall profile of a bank, e.g. with additional knowledge about conditions in the financial markets, and help central banks assess the risks posed to the broader financial system, e.g. with assessments of the banks' liquidity risk management.

Not only is international cooperation on supervision of cross-border banking groups necessary; the exchange of knowledge and experience regarding supervisory processes and the banks' liquidity risk manage ment practices may also help supervisors identify potential improve ments.

Communication among the authorities becomes particularly important during times of stress, whereas in normal times, communication can be used to establish good habits and trust among the authorities.

IMPLICATIONS FOR DENMARK'S FINANCIAL SYSTEM

The new principles of the Basel report set a level of ambition for liquid ity risk management that exceeds the capability of many banks in the EU and Denmark at present. Even though the principles are formulated in general terms, they set high expectations for both the banks' liquidity risk management and the supervision thereof.

The principles are likely to be implemented in new bank liquidity regulations. At EU level there are plans to incorporate some of the recommendations into the Capital Requirements Directive. National supervisors are also expected to bring national liquidity regulations and supervision in line with the new recommendations within the foresee able future.

The impact on the framework for financial business in Denmark re mains unclear. It is still too early to establish exactly how the principles of the Basel and CEBS reports are to be implemented, e.g. whether new liquidity regulation is required. However, current liquidity regulation in Denmark (section 152) does not appear to adequately cover all the new principles.

The financial turmoil over the past year has increased the banks' awareness of liquidity risk. The Basel and CEBS reports provide sensible and detailed guidelines for sound risk management and supervision. As a result, both banks and supervisors have good opportunities to strengthen their resilience to liquidity risk. While being a significant challenge, this is also an opportunity that should not be missed.

LITERATURE

Basel Committee on Banking Supervision (2008), Principles for Sound Liquidity Risk Management and Supervision, draft for consultation, 17 June.

Basel Committee on Banking Supervision (2000), Sound Practices for Managing Liquidity in Banking Organisations, February.

CEBS (2007) 1st Part of CEBS' Technical Advice to the European Com mission on Liquidity Risk Management: Survey of the current regulatory frameworks adopted by the EEA regulators, 15 August.

CEBS (2008) 2nd Part of CEBS' Technical Advice to the European Com mission on Liquidity Risk Management: Analysis of specific issues listed by the Commission and challenges not currently addressed in the EEA, consultation paper CP19, 17 June.

Danmarks Nationalbank (2006) Financial stability.

Danmarks Nationalbank (2007) Financial stability.

Danmarks Nationalbank (2008) Financial stability.

ECB (2007), EU Banking Structures, European Central Bank, October.

Goodhart, Charles (2008), Liquidity Risk Management, Banque de France, Financial stability review: Special Issue Liquidity, February.

Lund, Jakob Windfeld (2007), Turmoil in the Financial Markets, Dan marks Nationalbank, Monetary Review, 3rd Quarter.