Liquidity Risk Management: A Regulators View Simon Topping Hong Kong Monetary Authority 16 November

1 / 37
About This Presentation
Title:

Liquidity Risk Management: A Regulators View Simon Topping Hong Kong Monetary Authority 16 November

Description:

'The liquidity of an instrument reflects the ease with which it can be turned ... in different currencies (whereas currencies may not be fungible in a crisis) ... – PowerPoint PPT presentation

Number of Views:112
Avg rating:3.0/5.0
Slides: 38
Provided by: hongk93

less

Transcript and Presenter's Notes

Title: Liquidity Risk Management: A Regulators View Simon Topping Hong Kong Monetary Authority 16 November


1
Liquidity Risk Management A Regulators
ViewSimon ToppingHong Kong Monetary
Authority16 November 2004
2
Outline
  • The concept of liquidity
  • Liquidity crises
  • institution-specific
  • systemic
  • Traditional regulatory approach
  • regulatory liquidity requirements
  • HKMAs new guideline A risk management approach

2
3
The concept of liquidity
  • The liquidity of an instrument reflects the ease
    with which it can be turned into something else,
    usually central bank or commercial bank money.
    An instrument can be liquid because it has a
    short maturity, so is due to be turned into
    money in the near future, or because it can
    easily be sold for money in a market, without
    turning the price significantly against the
    seller. BofE


4
The concept of liquidity
  • The risk that a bank may not be able to fund
    increases in assets or meet obligations as they
    fall due without incurring unacceptable losses.
    This may be caused by the banks inability to
    liquidate assets or to obtain funding to meet its
    liquidity needs. The problem could also be the
    result of market disruption or a liquidity
    squeeze whereby the bank may only be able to
    unwind specific exposures at significantly
    discounted values. HKMA


5
The concept of liquidity
  • The essence of banking is the ability to provide
    payment whether routinely from management of
    cashflows access to money markets or, in times
    of pressure, from a cushion of liquid assets, or
    access to central bank facilities when
    contracts are due. Second, liquidity relates to
    the depth of markets the ability to transform
    assets into cash without a significant price
    discount or one-way markets developing. BofE


6
The concept of liquidity
  • The structure of banks balance sheets
    essentially illiquid assets funded by highly
    liquid liabilities leaves them prone to
    liquidity shocks. Banks offer liquidity
    insurance to customers by taking in money that
    can be withdrawn on demand or at very short
    notice providing committed loan facilities at
    longer maturities in providing this service
    they become exposed to significant liquidity risk
    themselves. BofE


7
Liquidity crises
  • Liquidity problems can have an adverse impact on
    a banks earnings capital , in extreme
    circumstances, may even lead to the collapse of a
    bank which is otherwise solvent.
  • A liquidity crisis besetting individual banks
    that play an active or major role in financial
    activities may have systemic consequences for
    other banks the banking system as a whole.
  • A liquidity crisis could also affect the proper
    functioning of payment systems other financial
    markets.


8
Liquidity crises
  • In addition to direct knock-on effects e.g.
    when a bank in difficulty fails to honour its
    obligations to other banks, thereby causing
    difficulties for those banks in turn there can
    be serious indirect knock-on effects e.g. if
    there develops a general loss of confidence in
    (parts of) the banking sector.
  • Sound liquidity management is therefore pivotal
    to the viability of every bank the maintenance
    of overall banking stability.


9
Traditional regulatory approach
  • For authorities, ensuring that banks hold
    adequate liquid assets makes banks individually,
    the system as a whole, more robust better
    able to withstand shocks without recourse to
    central bank support
  • But there is an obvious public policy trade-off
    between risk efficiency in the size of the
    buffer banks hold.


10
Traditional regulatory approach
  • Broadly, regulators have developed 2 approaches
    to liquidity regulation
  • The first is to monitor banks mismatch between
    out-flows inflows at short maturities (e.g. 1
    day, week or month). Banks should measure the
    potential outflows over the period ensure that
    they have sufficient liquidity to meet the
    funding requirement.
  • The second requires banks to hold, at all times,
    a stock of highly liquid assets that can be used
    in the event that they encounter problems raising
    liquidity.


11
Traditional regulatory approach
  • This approach is fine as a starting point, but it
    has a number of limitations
  • It is a broad-brush, one size fits all approach
    which is not tailored to the circumstances of
    particular banks
  • It places insufficient emphasis on qualitative
    factors, particularly the adequacy of systems
    controls for managing liquidity risk
  • It does not reflect the latest liquidity risk
    management practices of major banks.


12
Traditional regulatory approach
  • In Hong Kong, it is a statutory requirement that
    banks should maintain a liquidity ratio of not
    less than 25.
  • This is calculated as the ratio of the sum of the
    banks liquefiable assets (multiplied by the
    relevant liquidity conversion factor) to the sum
    of its qualifying 1-month liabilities.
  • Banks have also generally been required to
    maintain mismatch limits within 10 for 7 days
    20 for 1 month).


13
Traditional regulatory approach
  • Clearly, such an approach is not ideal given the
    diversity of banks operating in Hong Kong large
    small, local foreign.
  • Moreover, this approach
  • Focuses overly on contractual maturity (when
    experience shows that behaviour may differ
    markedly, particularly in a crisis)
  • Does not distinguish between liquidity in
    different currencies (whereas currencies may not
    be fungible in a crisis)
  • Focuses insufficiently on stress situations.


14
HKMAs new guideline
  • Reflects recent developments in international
    standards and best practices on liquidity risk
    management e.g. Sound Practices for Managing
    Liquidity in Banking Organisations issued by
    Basel Committee in 2000
  • Draws on study of the practices adopted by a wide
    range of banks in Hong Kong.


15
HKMAs new guideline
  • The HKMA recognises that the degree of
    sophistication of a banks liquidity risk
    management systems and controls will depend on
    the nature, scale and complexity of its
    operations as well as the level of liquidity risk
    assumed. The focus of the guideline is therefore
    on a banks ability to apply the principles
    guidance laid down to developing systems and
    controls that are appropriate to its particular
    circumstances.

16
HKMAs new guideline
  • Managing liquidity risk is not simply a matter of
    complying with a statutory minimum liquidity
    ratio crucially, it involves understanding the
    characteristics risks of different sources of
    liquidity, determining the appropriate funding
    strategies (including the mix of funding sources)
    to meet liquidity needs deploying the
    strategies in a cost-effective manner.

17
HKMAs new guideline
  • In managing asset liquidity, AIs are expected to
    establish a clear strategy for holding liquid
    assets, develop procedures for assessing the
    value, marketability liquidity of the asset
    holdings under different market conditions,
    determine the appropriate volume and mix of such
    holdings to avoid potential concentrations.

18
HKMAs new guideline
  • In managing liability liquidity, AIs should be
    able to distinguish the characteristics of
    different funding sources and monitor their
    trends separately.
  • AIs should also pay particular attention to the
    impact of changing market conditions on their
    funding structure.

19
HKMAs new guideline
  • Central to effective liquidity risk management is
    a banks ability to maintain adequate liquidity
    in the event of a funding crisis. The HKMA will
    assess this ability in respect of
  • the amount of high quality liquid assets that the
    bank can readily dispose of or pledge for
    funding
  • the results of stress tests carried out by the
    bank on its cash-flow liquidity positions under
    different scenarios

20
HKMAs new guideline
  • the stability of the banks funding sources its
    contingency measures for dealing with crisis
    situations.
  • Every bank is expected to document in a policy
    statement its policies strategies for managing
    liquidity risk, including how it identifies,
    measures, monitors controls that risk. This
    should be approved by the Board of Directors
    agreed with the HKMA.

21
HKMAs new guideline
  • In assessing the overall adequacy of liquidity of
    branches or subsidiaries of banks incorporated
    outside Hong Kong, the HKMA will take account of
    the global liquidity risk management policies of
    the head office or parent bank the extent to
    which liquidity is supervised by the home
    authority. A more flexible approach (other than
    the statutory requirements) will be adopted for
    the supervision of these AIs, provided that their
    liquidity is managed, supervised, on an
    integrated global basis.

22
HKMAs new guideline
  • The HKMA will monitor the level trends of
    banks liquidity positions through their regular
    submission of the following statistical returns
    and management information
  • the monthly Return on Liquidity Position
    MA(BS)1E (Liquidity Return) to monitor banks
    compliance with the statutory requirements on the
    minimum liquidity ratio analyse other
    information on liquefiable assets and funding
    sources

23
HKMAs new guideline
  • the quarterly Return on Selected Data for
    Liquidity Stress-testing (Liquidity
    Stress-testing Return) (only applicable to
    locally incorporated banks) to enable the HKMA
    to conduct across-the-board stress tests on
    individual banks liquidity risk
  • the cash-flow scenario analyses conducted by
    banks (based on their internal management reports
    submitted on a quarterly basis) to analyse
    banks ability to maintain adequate liquidity
    under normal stressed conditions.

24
HKMAs new guideline
  • Banks are encouraged to set a target liquidity
    ratio at a level above the statutory minimum so
    as to provide an early warning signal to the
    management.
  • Banks are expected to adopt a cash-flow approach
    to managing their liquidity risk. This approach
    complements the legal framework on minimum
    liquidity ratio by requiring banks to measure,
    monitor control their cash flow maturity
    mismatch positions under different operating
    conditions.

25
HKMAs new guideline
  • Under the cash-flow approach, banks should have
    in place appropriate systems procedures for
  • monitoring on a daily basis net funding
    requirements under normal business conditions
  • conducting regular cash-flow analyses based on
    stress scenarios
  • developing reasonable assumptions for making the
    above cash-flow projections.

26
HKMAs new guideline
  • Banks should be able to generate cash-flow
    positions by individual currencies in
    aggregate. For those AIs that have significant
    foreign exchange business, there should be
    separate analysis of cash-flow positions for
    individual foreign currencies in which they are
    active.

27
HKMAs new guideline
  • Banks should set internal limits to control the
    size of their cumulative net mismatch positions
    for the short-term time bands up to one month
    (i.e. next day, 7 days and 1 month). Such
    limits should be realistic commensurate with
    their normal capacity to fund in the interbank
    market. Maturity mismatch limits should also be
    imposed for individual foreign currencies in
    which they have significant positions.

28
HKMAs new guideline
  • In order to provide prudent projections of
    expected cash flows, banks should, as far as
    possible, incorporate in the maturity profile
    realistic assumptions underlying the behaviour of
    their assets, liabilities off-balance sheet
    activities rather than relying simply on
    contractual maturities.

29
HKMAs new guideline
  • The HKMA considers that whether a bank can be
    regarded as having sufficient liquidity depends
    to a great extent on its ability to meet
    obligations under a funding crisis. Therefore,
    in addition to monitoring net funding
    requirements under normal business conditions,
    banks should conduct regular stress tests by
    applying various what if scenarios on their
    liquidity positions (for all currencies in
    aggregate and significant individual currencies)
    to ensure that they have adequate liquidity to
    withstand stressed conditions.

30
HKMAs new guideline
  • It is important for banks to construct plausible
    adverse scenarios examine the resultant cash
    flow needs. While banks are encouraged to cover
    stress events of different types levels of
    adversity, they should, at a minimum, include the
    following scenarios in their stress-testing
    exercise
  • an institution-specific crisis scenario
  • a general market crisis scenario (based on
    assumptions prescribed by the HKMA from time to
    time).

31
HKMAs new guideline
  • An institution-specific crisis scenario should
    cover situations that could arise from the bank
    experiencing both real or perceived problems
    (e.g. asset quality problems, solvency concerns,
    rumours on an AIs credibility or management
    fraud, etc.). It should represent the banks
    extreme view of the behaviour of its cash flows
    in a crisis (i.e. a worst case scenario for the
    bank).

32
HKMAs new guideline
  • Foreign banks (including branches subsidiaries
    of foreign banking groups) should consider 2
    types of institution-specific crisis scenario,
    namely a crisis that is restricted to their Hong
    Kong operations a crisis that affects the
    global operations of the banking group (e.g. with
    problems originated from the head office or
    parent bank).

33
HKMAs new guideline
  • A general market crisis scenario is one where
    liquidity at a large number of financial
    institutions in one or more markets is affected.
    Characteristics of this scenario may include a
    liquidity squeeze, counterparty defaults,
    substantial discounts needed to sell assets
    wide differences in funding access among banks
    due to the occurrence of a severe tiering of
    their perceived credit quality (i.e. flight to
    quality).

34
HKMAs new guideline
  • The HKMA would normally expect a bank to have
    sufficient funds to continue in business, at
    least under the institution-specific crisis
    scenario, for the minimum number of days
    necessary for it to arrange emergency funding
    support. As the nature and size of business may
    differ widely among AIs, the HKMA does not intend
    to prescribe a standard minimum number of days
    for all.

35
Conclusions
  • In conclusion, under its new guideline, as part
    of its review of the banks liquidity policy
    statement, the HKMA will consider the suitability
    reasonableness of the following limits
    assumptions set by banks, having regard to the
    nature and complexity of their operations
  • maturity mismatch limits behavioural
    assumptions adopted for constructing the maturity
    profile under normal business conditions

36
Conclusions
  • the cash flow assumptions for conducting
    stress-testing under the institution-specific
    general market crisis scenarios. The HKMA will
    provide input on the scope of the general market
    crisis scenario
  • the minimum number of days of positive liquidity
    targeted by individual banks under the
    institution-specific crisis scenario.
  • Note, however, that the focus is on the banks
    processes controls for managing liquidity risk,
    on the suitability reasonableness of limits
    assumptions.

37
Conclusions
  • There is no magic formula as far as liquidity
    is concerned, no magic ratio which, if it is
    observed, can guarantee that the institution will
    in all circumstances be free from liquidity
    problems.
  • Regulators can provide guidance on sound systems
    controls limits but it is bank managements
    responsibility to put this into practice.
Write a Comment
User Comments (0)