Title: Liquidity Risk Management: A Regulators View Simon Topping Hong Kong Monetary Authority 16 November
1Liquidity Risk Management A Regulators
ViewSimon ToppingHong Kong Monetary
Authority16 November 2004
2Outline
- The concept of liquidity
- Liquidity crises
- institution-specific
- systemic
- Traditional regulatory approach
- regulatory liquidity requirements
- HKMAs new guideline A risk management approach
2
3The 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
4The 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
5The 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
6The 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can be withdrawn on demand or at very short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
7Liquidity 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.
8Liquidity 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.
9Traditional 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.
10Traditional 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.
11Traditional 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.
12Traditional 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).
13Traditional 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.
14HKMAs 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.
15HKMAs 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.
16HKMAs 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.
17HKMAs 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.
18HKMAs 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.
19HKMAs 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
20HKMAs 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.
21HKMAs 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.
22HKMAs 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
23HKMAs 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.
24HKMAs 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.
25HKMAs 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.
26HKMAs 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.
27HKMAs 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.
28HKMAs 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.
29HKMAs 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.
30HKMAs 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).
31HKMAs 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).
32HKMAs 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).
33HKMAs 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).
34HKMAs 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.
35Conclusions
- 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
36Conclusions
- 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.
37Conclusions
- 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.