What is it?
Central bankers have drawn up proposals that will force banks to improve their liquidity risk management. They have also suggested how banks’ enhanced liquidity risk policies and practices should be policed by supervisors.
Who dreamed it up?
The Basel Committee on Banking Supervision. Although the committee refers to its principles as “guidance”, in reality they will be compulsory. Only in the detail will banks have some discretion as to how they apply them.
What are the main provisions?
The intention is to ensure that banks establish a robust liquidity risk management framework that is properly integrated into the bank-wide risk management process, therefore raising banks’ resilience to liquidity stress.
The proposed principles seek to raise standards in a number of areas, including:
- Understanding the bank’s tolerance to liquidity risk.
- Liquidity risk measurement, including the capture of off-balance sheet exposures, securitisation activities and other contingent liquidity risks that were badly managed during the financial market turmoil.
- Aligning business units’ risk-taking incentives with the liquidity risk exposures that their activities create for the bank.
- Stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans.
- Strong management of intraday liquidity risks and collateral positions.
- Maintenance of a cushion of unencumbered, high-quality liquid assets to be in a position to survive protracted periods of liquidity stress.
- Regular public disclosures, both quantitative and qualitative, of a bank’s liquidity risk profile and management.
The principles also strengthen expectations about the role of supervisors, including the need to intervene to address deficiencies in banks and communicating with other supervisors and relevant bodies at home and abroad.
What’s in the small print?
Supervisors will be able to prevent any bank “with liquidity risk management weaknesses... from making acquisitions or significantly expanding its activities”.
What does the industry say?
One criticism is that supervisors may impose additional capital requirements on banks. Wilfried Wilms, a senior advisor at the European Banking Federation, likens this to “a stick behind the door” that the Basel Committee could threaten to use.
Another criticism is that the proposals “lack the concept of materiality” – the fact that banks will not be allowed to disregard less relevant incoming and outgoing cash flows.
How much will it cost?
“It will have a cost, but don’t ask me to put a number to it,” says Mr Wilms.
What do the regulators say?
“We therefore want to reinforce the notion that sound risk management begins with the fundamentals, such as strong governance of a bank’s liquidity risk management framework,” says chairman Dr Nout Wellink.
The law of unintended consequences
The committee suggests that for a bank with “excessive liquidity risk”, supervisors could require “the bank to operate with higher levels of capital” (paragraph 140, principle 16, The Role of Supervisors). Mr Wilms says this puzzles him. He agrees that if a bank is well capitalised, the market may regard it more favourably. But forcing it to lock up more capital could be counterproductive and produce the opposite result – less liquidity.
Could we live without it?
Yes, because banks were already improving their practices in this area – but supervisors think a kick up the rump from the regulatory boot will concentrate minds further.
Rating: 4
Rating scale: 5 = Essential; 4 = Useful; 3 = Neutral; 2 = Unnecessary; 1 = Damaging.
