Liquidity Risk Management: A Regulator's View

1. Liquidity Risk Management: A Regulator’s ViewSimon ToppingHong Kong Monetary Authority16 November 2004

2. Outline • The concept of “liquidity” • Liquidity crises • institution-specific • systemic • “Traditional” regulatory approach • regulatory liquidity requirements • HKMA’s 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 bank’s 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 Banks offer liquidity insurance to customers by taking in money that can be withdrawn on demand or at very short notice & providing committed loan facilities at longer maturities – & in providing this service they become exposed to significant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 bank’s 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 bank’s 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. HKMA’s 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. HKMA’s new guideline • The HKMA recognises that the degree of sophistication of a bank’s 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 bank’s ability to apply the principles & guidance laid down to developing systems and controls that are appropriate to its particular circumstances.

16. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s new guideline • Central to effective liquidity risk management is a bank’s 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. HKMA’s new guideline • the stability of the bank’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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. HKMA’s 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 AI’s credibility or management fraud, etc.). It should represent the bank’s extreme view of the behaviour of its cash flows in a crisis (i.e. a “worst case” scenario for the bank).

32. HKMA’s 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. HKMA’s 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. HKMA’s 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 management’s responsibility to put this into practice.