Liquidity management

inSight

10 Apr 2008

Liquidity management

The credit crisis underlines the need to manage liquidity risk.

One of the lessons from the current credit crisis in the US is the importance of managing liquidity risk. Banks typically take short-term deposits and make long-term loans. This means they are vulnerable to liquidity risk, the risk that demands for repayment might, for one reason or another, become greater than their ability to raise new liabilities (taking new deposits or borrowing more from the interbank market) or liquidate assets.

The concept of liquidity risk and the importance of managing it are not new, particularly in banking. For example, there are clear provisions in the Banking Ordinance requiring banks to maintain a liquidity ratio above the statutory minimum. In line with the philosophy of risk-based supervision that we as the banking supervisor promote, we have also issued a Supervisory Policy Module to guide banks on how to manage liquidity risk. What is now receiving attention, among banking supervisors in developed markets and in the Basel Committee on Banking Supervision, is the changing nature of liquidity risk, as a result of financial innovation and globalisation, and, regrettably, the fact that liquidity-risk management by individual banks has failed to keep pace with these changes.

Over the past decade or so, a number of trends affecting the nature of liquidity risk have developed. First, banks in developed economies with very active capital markets have become more reliant on wholesale funding sources, which are more volatile than traditional retail deposits. Secondly, they have become more reliant on securitisation to turn illiquid assets, such as mortgage loans, liquid, and therefore more reliant on the functioning and stability of financial markets, which, as they have found out recently, is not something that can be taken for granted. Thirdly, banks have been getting increasingly involved in complex financial instruments, both as arrangers for a fee and as holders to earn the attractive yields. But these instruments have no proven track record of liquidity, particularly at times of stress. Fourthly, banks have increasingly used collateral to mitigate credit risk, but the resulting reliance on collateralised transactions with other banks to provide liquidity to ensure the continued adequacy of collateral may have intensified liquidity risk.

There will probably be improvements in liquidity-risk management arising from the current discussions. The HKMA has been playing a part in these international efforts, although fortunately the trends affecting the nature of liquidity risk I mentioned above have not yet caught on in a big way in Hong Kong. But it is clear to us as a banking supervisor, and I hope to the banks in Hong Kong as well, that liquidity risk is a priority. The securitisation market in Hong Kong, for example, is not well developed and therefore has not been relied upon by the banks as a major source of liquidity. Where this has taken place, notably in relation to the activities of the Hong Kong Mortgage Corporation (HKMC), it has been structured very much for the purpose of providing a contingency funding source for the banks, a strategic move on our part to help the banks to manage their liquidity risks, a role of the HKMC that is often overlooked. But the banks do hold securitised assets and other complex financial instruments issued in the developed markets. So they are also exposed to the risk that these normally liquid assets might become illiquid one day.

Contingency funding sources are crucial for banks in their internal strategy for managing liquidity risk. I am not referring to the funding sources provided by us, either through the HKMC or our well established Lender-of-Last-Resort facility. Banks should have first-resort contingency funding plans to which they can turn to in case of need. They should also ensure that they have an abundance of assets that can be used to obtain liquidity, through their own contingency funding plans or, as a last resort, through those available from us. The HKMC, for example, has prudent underwriting standards for the mortgages that they are prepared to take on, but these definitely do not include sub-prime mortgages because sub-prime mortgages of the kind that have caused so many problems in the developed markets do not exist in Hong Kong.

Joseph Yam
10 April 2008

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