Supervision of liquidity risk

inSight

11 Jun 2009

Supervision of liquidity risk

The current crisis highlights the importance of liquidity risk.

In two previous articles, I discussed recent developments relating to strengthening Basel II as a global capital standard for banks. In this article, I will look at liquidity risk, an equally important area receiving increasing attention from banks and supervisors in the light of the severe liquidity strains experienced by institutions and markets most affected by the current financial turmoil.

Capital and liquidity are two major and related indicators of a bank's financial strength. Banks perceived as having sufficient capital often enjoy more stable and cheaper sources of funding. But this is not to say that capital adequacy is a substitute for sound liquidity-risk management. The recent turmoil has demonstrated all too clearly how swiftly liquidity can evaporate in money markets. Even well-capitalised banks can face serious problems if they have not developed the capabilities to manage liquidity properly in an increasingly complex market environment.

The changing nature of liquidity risk, as a result of rapid financial innovation and globalisation, has been thrown into stark relief by the recent turmoil. We have seen how the securitisation markets, on which many institutions have increasingly relied for funding, were drained of liquidity in times of stress. Market participants hoarded liquidity because they were uncertain of the extent of their counterparties' exposures to complex structured securities regarded as "toxic". Some sponsoring banks felt obliged to support their troubled structured investment vehicles or conduits, or to buy back the underlying securitised assets out of reputational considerations, even when they were not contractually required to do so. All of this culminated in a liquidity squeeze and necessitated repeated injections of liquidity in unprecedented amounts by various central banks to shore up the global financial markets.

The deficiencies, exposed by the recent turmoil, in the way some overseas banks managed their liquidity risk merit further consideration and analysis by banking supervisors. Many banks failed to include the possibility of severe and prolonged market-wide (as opposed to institution-specific) liquidity disruptions into their stress-testing programmes; ensure that their contingency funding plans were effective and workable; or prepare for the liquidity needs arising from their contingent obligations (including exposures to structured investment vehicles and conduits). To address these issues, the Basel Committee on Banking Supervision published Principles for Sound Liquidity Risk Management and Supervision in September 2008 to significantly raise international standards.

The principles address, among other things, the need for banks to –

  • have systems and procedures to identify and measure all liquidity risks, including contingent liquidity risks;

  • maintain adequate highly liquid assets to withstand liquidity stress should their normal funding sources dry up during emergencies; and

  • incorporate plausible stress scenarios based on assumptions made with reference to recent market events into their stress-testing programmes, and develop an effective contingency funding plan sufficiently robust to cater for these scenarios.

International banking groups also need to consider the possibility that funds might not be able to move freely among group entities in different jurisdictions because transfers might be affected or prohibited by legal regulations or other restrictions in different places in times of stress. What appears sufficient at the group level in normal times may turn out not to be during crises when mobility of intra-group funds may be severely restrained.

Unlike capital requirements, the regulatory regimes for liquidity tend to differ among jurisdictions. This diversity calls for better supervisory understanding and co-operation to make liquidity-risk supervision of international banking groups more effective. The Basel Committee is doing further work in this area, including the possibility of developing benchmarks, tools and metrics for supervisors to promote more consistent liquidity standards for cross-border banks and arrangements to strengthen information sharing and co-ordination among supervisors.

Liquidity risk (like capital adequacy) is a supervisory priority of the HKMA. We recognise the importance of ensuring that banks in Hong Kong are resilient to market-wide liquidity shocks similar to those recently experienced by some of their overseas counterparts. Apart from participating actively in the Basel Committee's work on supervision of liquidity risk, the HKMA is reviewing its liquidity regime to see how it can be aligned with the Committee's sound principles or strengthened further. The HKMA has co-ordinated self-assessments by authorized institutions of their compliance with the sound principles and is analysing the results. Our objective is to identify gaps in the authorized institutions' liquidity-risk management and issues that might affect implementation of the sound principles. In line with international recommendations, the HKMA will also explore ways to incorporate further stress-testing standards and monitoring tools into its liquidity regime.

The HKMA intends to consult the banking industry on proposals to revise the liquidity regime in phases before the end of next year. This will be a challenging task. But as in the case of implementing Basel II, we are committed to strengthening the liquidity regime, which is another cornerstone for maintaining banking stability in Hong Kong.

Karen Kemp
Executive Director (Banking Policy)
11 June 2009

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