Originally published July 24, 2008

Keywords: Basel Committee, banking, liquidity, financial market, risk management, disclosure, management, global banking, capital, assets, governance, secured funding, collateral, Principle II, acquisitions

On June 17, 2008, the Basel Committee on Banking Supervision ("Basel Committee" or "Committee") published for comments a revised version of its principles for bank liquidity risk management ("Revised Liquidity Principles" or "Principles").1 These revisions reflect a substantial refinement and enhancement of the Committee's previous liquidity management principles, which were published in 2000 (the "2000 Principles").2

Proper management of liquidity risk has become important in light of the developments in the financial markets in the past decade, which have increased the complexity of liquidity risk and its management. As a result of the deterioration in financial market conditions that began in the United States in mid-2007 and the rapid and unexpected decline in financial liquidity, US and foreign central banks have had to take what some have described as drastic action to provide emergency financial support to individual institutions and the financial markets in general in order to avert a possible systemic failure resulting from inadequate liquidity. Notably, the current liquidity disruptions in the global marketplace were not materially mitigated by the existing regulatory capital framework, either Basel I in the United States, or Basel II in Europe.

In February 2008, the Basel Committee published a study that focused on the failure of many banks to observe some basic principles of liquidity risk management.3 Subsequently, in June 2008, the Basel Committee produced a fundamental review of its 2000 Principles which is designed to address current financial market developments and to apply some lessons learned from the recent financial markets disruptions.

The Revised Liquidity Principles significantly expand a number of key areas. In particular, more detailed guidance is provided on:

  • The importance of establishing a liquidity risk tolerance;

  • The maintenance of an adequate level of liquidity, including through a cushion of liquid assets;

  • The necessity of allocating liquidity costs, benefits and risks to all significant 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; and

  • The provision of public disclosure in promoting market discipline.

In addition, the Revised Liquidity Principles substantially broaden the principles for supervisors by emphasizing the importance of assessing the adequacy of a bank's liquidity risk management framework and its level of liquidity, and recommend steps that supervisors should take if they discover inadequacies. The Principles also emphasize the importance of cooperation and communication between supervisors and other key stakeholders, such as central banks, especially in times of stress.

The Revised Liquidity Principles "[focus] on liquidity risk management at medium and large complex banks, but the principles have broad applicability to all types of banks. The implementation of the principles should be tailored to the size, nature of business and complexity of a bank's activities." A bank's role in the financial sectors, and its systemic importance in those financial sectors, must also be taken into account.

A comparison of the Revised Liquidity Principles with the Basel Committee's 2000 Principles reveals the new Principles' substantially greater emphasis on the importance of consolidated enterprise-levelliquidity risk management and the need to treat liquidity risk management as a mission-critical senior management function. The new Principles also demonstrate a substantially more proactive, sophisticated and granular approach to the assessment and management of liquidity needs, sources of liquidity and liquidity contingency planning by financial institutions. The Revised Liquidity Principles also contemplate a more extensive role for Basel Committee member national supervisors in the oversight of banking organizations' liquidity risk management activities. Unlike the 2000 Principles, the Revised Liquidity Principles require financial institutions to address topics such as intraday liquidity risk and collateral management issues. In addition, the Revised Liquidity Principles state that regulated financial institutions may be required to hold increased levels of capital, in particular capital in the form of liquid assets, to address the liquidity risks inherent in a particular banking organization's business lines and risk profile, although the Basel Committee observes at the same time that capital alone is not a solution to inadequate liquidity. At the same time, the Revised Liquidity Principles fall short of creating prescriptive regulatory capital requirements that are attributable to liquidity risk, and therefore may strike some observers as not being sufficiently robust in their effect.

At the same time, the Revised Liquidity Principles do not articulate any ground-breaking liquidity requirements or suggest overarching best practices that a well-run national or global banking organization would not already have in place in the current environment. Moreover, they do not create any new legal obligations for US banking organizations until and unless the Principles are implemented by US regulators, and even then, any obligations created most likely will be supervisory (prudential) rather than legal in nature (although supervisory obligations are, of course, administratively enforceable by the US banking agencies).

The Revised Liquidity Principles are targeted at medium and large complex banks in the Basel Committee community. However, as noted above, the Principles expressly state that they have broad applicability to all types of banks, and it is fair to expect that national supervisors will apply the Revised Liquidity Principles broadly to their regulated consituents, presumably taking into account the relative size and sophistication of each banking organization's business lines and operations.

The Basel Committee has requested comments on the revised principles to be submitted by July 29, 2008, and US regulators have urged banks to provide comment.4

An Overview of the Revised Liquidity Principles

The Revised Liquidity Principles contain 17 principles for managing and supervising liquidity risk, which are divided into one core principle and four groups: governance, measurement and management, public disclosure and the role of supervisors. The Basel Committee has expressed its expectation that banks and national supervisors implement the revised principles "promptly and thoroughly."

CORE PRINCIPLE

Under the Revised Liquidity Principles, the primary responsibility for effective management and supervision of liquidity risk is with the banks. For this purpose, "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." (Principle 1)

This principle emphasizes that even though strong capital positions reduce the likelihood of liquidity pressure, apparently solvent banks can suffer liquidity problems. In other words, under the Principles the supervisors are required to distinguish between adequacy of a bank's capital and the liquidity of its assets, as the former is not considered to provide sufficient protection against the shortfalls in the latter. Elsewhere in the Revised Liquidity Principles, the Committee emphasizes the role of capital in a bank's ability to obtain liquidity, especially in a crisis, but again emphasizes that capital is not a solution for inadequate liquidity or ineffective risk management processes.5

GOVERNANCE

The second group of principles deal with bank governance issues that affect the management of liquidity risk. Here, the Basel Committee recommends that a bank "clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system," (Principle 2) and that "senior management develop strategies, policies and practices to manage liquidity risk in accordance with the bank's risk tolerance and to ensure that the bank maintains sufficient liquidity." (Principle 3) Principle 3 emphasizes the significance of senior management's close involvement in the management of the bank's liquidity. Finally, the Committee views liquidity risk management as part of overall enterprise risk management and recommends that a bank "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), which will help align the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole" (Principle 4)

MEASUREMENT AND MANAGEMENT

The third group of principles address the issue of measuring and managing liquidity risk. The guidance offered in this group requires a bank to "have a sound process for identifying, measuring, monitoring and controlling liquidity risk ..." (Principle 5) Under this principle, a bank should identify, measure, monitor and control its liquidity risk for all future cash flows, all sources of contingent liquidity demand (and related triggers associated with off-balance sheet positions), all currencies in which a bank is active, and all correspondent, custody and settlement activities.

A bank should also "actively manage its 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 6) and "establish a funding strategy that provides effective diversification in the sources and tenor of funding ..." (Principle 7) In this regard, Principle 7 emphasizes that an essential component of ensuring funding diversity is maintaining market access, including development of markets for asset sales or strengthening arrangements under which a bank can borrow on a secured or unsecured basis.

The Revised Liquidity Principles place substantial emphasis on the management of intraday liquidity. "A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normaland stressed conditions and thus contribute to the smooth functioning of payment and settlement systems." (Principle 8) The guidance enumerates several operational elements for management of intraday liquidity, including capacity to measure and monitor intraday liquidity risk, acquisition of sufficient intraday funding, ability to manage and mobilize collateral, a robust capability to manage the timing of liquidity outflows, and preparation to deal with unexpected disruptions to intraday liquidity flows.

The Revised Liquidity Principles also highlight the significance of proper management of collateral by banks. "A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. It should also monitor the legal entity and physical location where collateral is held and how it may be mobilized in a timely manner." (Principle 9)

The Committee emphasizes the significance of stress testing and contingency planning for dealing with liquidity crises. Principle 10 requires a bank to "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." The Committee further lays out the elements of stress testing process — including establishing criteria for designing the scenarios and determining the appropriateness of the assumptions — and requires banks to take a conservative approach when setting stress testing assumptions. Finally, Principle 10 requires bank management to review stress test scenarios and to incorporate the results in planning for liquidity shortfalls.

The guidance also underscores the importance of contingency funding planning. "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 11) This principle requires CFPs to account for various considerations, including the impact of stressed market conditions on the bank's ability to sell or securitize its assets, the link between asset market and funding liquidity, second round and reputational effects related to execution of CFPs, and the potential to transfer liquidity across group entities. Principle 11 requires that in a crisis, a bank be able to maintain a flow of clear communications to market participants, employees, clients, creditors, shareholders and supervisors.

Finally, in this group of principles, the Committee draws attention to the importance of banks maintaining 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." The guidance clarifies that "there should be no legal, regulatory or operational impediment to using these assets to obtain funding." (Principle 12)

Public Disclosure

Principle 13 requires a bank to "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." Disclosures should address qualitative aspects too, including a bank's liquidity risk tolerance and the concepts utilized in measuring its liquidity position and liquidity risk, among others.

ROLE OF SUPERVISORS

The last group of principles provide guidance to national supervisors on assessing a bank's liquidity management program. "Supervisors should regularly perform a comprehensive assessment of a bank's overall liquidity risk management framework and liquidity position ...," (Principle 14) and "supplement their regular assessments ... by monitoring a combination of internal reports, prudential reports and market information." (Principle 15) In addition, "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) The range of supervisory responses should include requiring the bank to strengthen its management of liquidity, improve its contingency planning, lower its liquidity risk (e.g. by reducing a funding gap) and operate with higher level of capital, as well as restricting the bank from making new acquisitions.

Finally, the last principle requires supervisors to "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 ..." (Principle 17)

Conclusion

The Revised Liquidity Principles are a concrete demonstration of the increasing importance that the Basel Committee – and its constituent national supervisory authorities – place on robust and comprehensive liquidity risk management practices that are closely supervised by national supervisory authorities. They make this point clear in the instruction that banks and national supervisors are expected to implement the revised principles "promptly and thoroughly." Whether these principles will go far enough in addressing some of the root liquidity-related causes of the current global economic displacements is another question, but at a minimum they underscore the central role that good liquidity risk management plays in a well-functioning global financial services organization and the increased regulatory scrutiny of these issues.

Footnotes

1. Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, June 2008, available at http://www.bis.org/publ/bcbs138.htm.

2. Basel Committee on Banking Supervision, Sound Practices for Managing Liquidity in Banking Organizations, February 2000, available at http://www.bis.org/publ/bcbs69.htm.

3. Basel Committee on Banking Supervision, Liquidity Risk Management and Supervisory Challenges, February 2008, available at http://www.bis.org/publ/bcbs136.htm.

4. OCC, Press Release, Basel Committee Issues Revised Principles for Sound Liquidity Risk Management Supervision (June 27, 2008 ) available at http://www.occ.treas.gov/ftp/release/2008-72.htm.

5. On the other hand, the US banking agencies require banks subject to Basel II standards to incorporate liquidity risk into their assessment of capital adequacy, as reflected in their internal capital adequacy assessment program (ICAAP). The agencies specifically require that "[a] bank ... evaluate whether [its] capital is adequate given its own funding liquidity profile and given the liquidity of the markets in which it operates." In addition, under the guidance issued by the agencies in this regard, banks subject to Basel II should consider "the capital adequacy implications of lacking a well-diversified funding base, relying predominantly on wholesale credit markets for its funding, or relying heavily on volatile funding sources." See Supervisory Guidance: Supervisory Review Process of Capital Adequacy (Pillar 2) Related to the Implementation of the Basel II Advanced Capital Framework (July 15, 2008), available at http://federalreserve.gov/newsevents/press/bcreg/20080715a.htm.

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