With the ongoing crisis caused by the securitization of subprime assets, the Basel Committee for Banking Supervision has proposed updated guidance for managing liquidity risk. While the guidance issued in 2000 remains generally relevant, a Basel working group identified areas that need updating and strengthening. The proposed guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of banks. That said, Basel wants banks to tailor the principles of liquidity risk to the nature and complexity of their business. The primary objective of the new guidance is to raise banks’ resilience to liquidity stress
More broadly, since 2000 and leading up to the current market turmoil, there has been a loss of investor confidence in a wide range of structured securities markets that, in turn, has led to risks flowing on to banks’ balance sheets. The initial shock in credit markets was transmitted through a fall in asset market liquidity, which led to an increase in funding risk.
There is also now an international component to liquidity risk. Cross-border coordination becomes critical when an entire global banking group comes under pressure as a single entity. In such a scenario, the host regulator may require the host entity to increase its level of insurance against liquidity risk across the group. Increased cooperation and understanding between national regulators may reduce uncertainties as to the level of resilience provided by other regimes.
The market turmoil that began in mid-2007 has highlighted the crucial importance of market liquidity to the banking sector. The contraction of liquidity in certain structured securities product, as well as an increased probability of off-balance sheet commitments
coming onto banks’ balance sheets, led to severe funding liquidity strains for some banks, which required central bank intervention in some cases.
The job of liquidity risk management is to ensure a bank’s ability to fund increases in assets and meet obligations as they come due. The increasing complexity of financial instruments has led to a heightened demand for collateral and to uncertainty on prospective liquidity pressures from margin calls, as well as to a lack of transparency that can contribute to asset market contraction in times of stress.
Securitization can be used by banks to expand sources of funding and create revenue
through buying and distributing third-party assets they did not originate, such as asset-backed securities. But the Basel Committee cautioned that securitization also presents liquidity risks that need to be managed carefully.
For example, the process of pooling assets, selling to a special purpose vehicle, obtaining credit ratings and issuing securities is time consuming, and market difficulties during this timeframe could result in a bank having to warehouse assets for longer than planned. In addition, some forms of securitization give rise to contingent liquidity risk, i.e. the likelihood that a firm will be called upon to provide liquidity unexpectedly, potentially at a time when it is already under stress.
Moreover, the increasing complexity of financial instruments creates new challenges for banks’ management of liquidity risk. For example, the inclusion of credit rating downgrade clauses and call features complicates the assessment of an instrument’s liquidity profile. Also, complex financial instruments are often not actively traded, which can make assessing their price and secondary market liquidity highly challenging.
Compounding all of this for global financial institutions is the fact that strong cross-border flows raise the prospect that liquidity disruptions could pass quickly across different markets and settlement systems. Banks operating a centralized liquidity risk model may plan to meet a shortfall in one currency with funds in another currency.
The enhanced liquidity risk management principles seek to improve governance and the articulation of a firm-wide liquidity risk tolerance. Banks must also improve liquidity risk measurement, including the capture of off-balance sheet exposures, securitization activities, and other contingent liquidity risks that were not well managed during the financial market turmoil. They should also aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank.
Importantly, banks should conduct stress tests covering a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans. In addition, there must be strong management of intraday liquidity risks and collateral positions, as well as regular public disclosure of the financial institution’s liquidity risk profile.
The Basel Committee also emphasized that the principles strengthen expectations about the role of bank regulators, including the need to intervene in a timely manner to address deficiencies and the importance of communication with other regulators and authorities, both domestically and cross-border.
But liquidity may not be fully transferable across borders, Basel has warned, particularly in times of market stress, since regulators require sufficient liquidity to be held for local operations to protect national interests. Thus, an important element of conducting cross-border operations is the need to understand fully the regulatory practices within each jurisdiction.
Liquidity risk management regimes have been developed along national lines to support the preservation of the safety and soundness of each country’s financial system. The regimes are nationally based according to the principle of host country responsibility, although in some cases, the task, though not the responsibility, of supervision of branches is delegated to the home supervisor.
While the high level cross-border objectives for liquidity regulation are similar, there is much diversity in how these objectives translate into rules and guidelines. Broadly speaking, high-level approaches to supervising liquidity risk are common across regimes. For example, most firms are expected to have specific policies to address liquidity risk and the use of stress tests is commonplace.