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Liquidity risk management in banksInternational sound practices and cases

Miguel Delfiner, Claudia Lippi & Cristina Pailh1

Central Bank of Argentina

October, 2006

Abstract

This paper studies the sound practices for the management of liquidity risk at financial institutions, fromthe standards viewpoint as well as its treatment by several countries. First it reviews the best practicessuggested by the Basel Committee on Banking Supervision, the developments in European countriesobserved by the European Central Bank, and sound practices for liquidity risk management proposed inthe supervision manuals of the US regulatory agencies. Then it examines particular experiences ofcountries that apply policies to manage liquidity risk, through their supervision manuals or by theirregulation. The paper also includes the experiences of some Latin-American countries that rely on aspecific regulation of liquidity, together with the Argentine case. Although the importance of liquidity

risk is well known, given the idiosyncratic characteristics shown in different banks, the organizationsentrusted with establishing the best practices on the subject prefer to provide general principles that canbe used as a guide for the management of the risk rather than specify a quantitative regulation. Most ofthe countries analyzed have adopted these recommendations, in some cases granting some leeway for thebanks to apply internal methods, in other cases providing guidance for banks that do not yet haveadvanced developments in the subject. In other countries, on the other hand, quantitative regulations havebeen implemented.

Keywords: Liquidity risk, Liquidity Mismatches, Regulations and best practices

1 Miguel Delfiner ([email protected]) and Claudia Lippi ([email protected]) are Principal Analystsand Cristina Pailh ([email protected]) is the manager of the Regulatory Research and PlanningDepartment, Regulations, BCRA. We want to thank Delia Novello and Ana Mangialavori for usefulcomments. We also thank the useful exchange of ideas and experiences with the areas of Supervision andSurveillance and Analysis and Audit of the Superintendency of Financial and Foreign ExchangeInstitutions (SEFyC), which significatively contributed to extend this work. We wish to acknowledge the

support of the Regulations Deputy General Manager Jos Rutman for the completion of this research.Opinions expressed in this article are those of the authors and do not necessarily reflect those of theCentral Bank. All the mistakes are solely the responsibility of the authors.
mailto:([email protected]:([email protected]:([email protected]


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Contents

1. Introduction

2. Best practices for liquidity risk management2.1. Basel Comittee on Banking Supervision2.2. Central European Bank2.3. United States control agencies

3. Experiences in countries that regulate liquidity risk

3.1. United States of America3.2. United Kingdom3.3. Israel

3.4. India3.5. Brazil3.6. Latin American countries with quantitative regulation

4. Argentine regulation of the Liquidity position

5. Conclusions

Appendix 1: Basel reccomendations for liquidity management at banking organizations

Appendix 2: Recent developments of the liquidity risk profile and management inEuropean countriesAppendix 3: Summary of the Argentine rule on the Liquidity positionAppendix 4: FFIEC Uniform Banking Performance Report (UBPR)Appendix 5: Table comparing Latin American rules

Bibliography


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1. Introduction

One of the fundamental roles that the financial system performs is to transformmaturities, which means the capacity to obtain funding from short term deposits in orderto finance loans at a relatively longer term2. As a result of this a bank is exposed to the

risk of the demand for repayment by deposits exceeding its capacity to transform assetsinto cash. Traditionally, liquidity has been defined as: the capacity of financialinstitutions to finance increases in their assets and comply with their liabilities as these

mature3.

Bank liquidity has two distinct but interrelated dimensions: liability (or cash) liquidity,which refers to the ability to obtain funding on the market and acsset (or market)liquidity, associated with the possibility of selling the assets. Both concepts areinterrelated, and the interaction between them tends towards their mutual reinforcement.However, under adverse conditions this dependency tends to weaken market liquiditybecause adverse circumstances that affect one dimension can rapidly be transferred to

the other.

Under normal circumstances liquidity management is basically a cost-benefit trade off,because a financial institution will be able to obtain funding provided it is willing to paythe prevailing market prices, or has the choice of selling or committing its assets. In likemanner a bank can store a stock of liquid assets to ensure some liquidity (liquiditywarehousing), although at the expense of smaller returns. However, in the event of acrisis specific to a bank, its access to liquidity may be found to be severely restrictedbecause its counterparties may be unwilling to provide it with funds, not even providingcollateral nor in exchange for high rates. In a systemic liquidity crisis it may even beimpossible for the bank to place its assets on the market.

The liquidity risk is closely linked to other dimensions of the financial structure of thefinancial institution, like the interest rate and market risks, its profitability, andsolvency, for example. The interest rate risk that results from mismatches of maturitiesor the dates for interest rate adjustments may appear as either market or refinancing(and/or reinvestment) risk. Also, as it operates to transform maturities, subject to theserisks, the bank collects a yield that is related to its profitability. Having a larger amountof liquid assets or improving the matching of asset and liability flows reduces theliquidity risk, but also its profitability. This relationship also operates in the oppositedirection: loans in an irregular situation will impact jointly on profitability and liquidity,

as the expected cash flows do not appear. In addition, there is a relationship withsolvency: more capital reduces liquidity creation, but allows for more strength to facefinancial crises.

Liquidity risk is usually of an individual nature, but in certain situations maycompromise the liquidity of the financial system. As in overall terms it is about asituation that is very dependent on the individual characteristics of each financialinstitution, defining the liquidity policy is the primary responsibility of each bank, interms of the way it operates and its specialization.

2

There is a very extensive literature about the roles of the financial system. An already classical book isFreixas X. and J.C. Rochet (1999).3 BCBS (2000), IPRU.


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In the Argentine case, the Central Bank at one point considered it necessary to define 4,at the supervisory authority level, guidelines or prudential parameters on the subjectwhich must be met, contemplating not only an individual liquidity crisis situation, butalso the possibility that a systemic crisis may emerge.

In this definition the differences between both cases were considered. In fact, in theformer case individual illiquidity- this lack of liquidity does not in itself imply asolvency problem because the interest rates in the economy are not affected, andtherefore neither are the price or value of the assets of the bank involved. Thus, in orderto face a decline of the renewal of its liabilities it will be sufficient to ensure or maintainan adequate level of liquid asset holdings, to which it must resort in order to restore itsliquidity, like the sale of its loan or security portfolios, while not ruling out obtainingloans from other financial institutions and assistance from the central bank according tothe regulatory provisions.

The situation differs when the problem of falling deposits or liabilities does not only

affect a specific entity but instead the financial system as a whole. In this case, as wellas observing an increase in the interest rate with its resulting repercussion on solvency,there are certain assets or credit margins that cannot be relied on.

The significance of this matter for the development of financial activity at one timewarranted the requirement for the banks to have operating structures, with specificoffices responsible for tracking the liquidity position, once policies have been defined toensure a reasonable margin of cash equivalents to face the commitments. Then, basedon these points the financial institutions were required to define liquidity policies ascoverage for different alternative scenarios.

In this framework, the purpose of this paper is to review the best current internationalpractices regarding the liquidity risk management at financial institutions and theirapplication in several countries selected. For this purpose, in Section 2 the bestpractices on the subject issued by the Basel Committee on Banking Supervision andhow they were adopted by the European Committee on Banking Supervision and theUnited States supervisory agencies are reviewed. In Section 3 specific experiences incountries that apply policies to control liquidity risks are mentioned, whether throughtheir supervision manuals (United States), through general guidelines in the supervisionmanuals (UK, Israel, Brazil) or guidelines to be used by the financial institutions thatlack more sophisticated systems (India). The experiences of the Latin American

countries that have a specific liquidity regulation are also included. Section 4 commentsvery briefly on the Argentine experience on the subject, during the years sinceCommunication A 2374 and supplementary rules have been applied. Finally theconclusions are found in Section 5.

4 Grounds for the rules on the Liquidity Position Appendix II of Communication A 2374.


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2. Best Practices for Liquidity Risk Management

2.1. Basel Committee on Banking Supervision

In February 2000 the Risk Management Group of the Basel Committee on BankingSupervision (BCBS) issued a document called Sound Practices for Managing

Liquidity in Banking Organisations5 referred to the management of liquidity in banks.

The BCBS states that bank liquidity, defined as the ability to fund increases in assetsand meet obligations as they come due, is crucial to the ongoing viability of any

banking organisation but also for the whole financial system, since a liquidity shortfallat a single institution can have system-wide repercussions. This document is organizedaround several key principles for managing liquidity, which are summarized below,structured around the following broad categories:

a) Developing a Structure for Managing Liquidity Risk

Each bank should have an agreed strategy for the day-to-day management ofliquidity.

The board should also ensure that senior management takes the stepsnecessary to monitor and control liquidity risk.

Each bank should have a management structure in place to executeeffectively the liquidity strategy.

Banks must have adequate information systems for measuring, monitoring,controlling and reporting liquidity risk.

b) Measuring and Monitoring Net Funding Requirements

Each bank should establish a process for the ongoing measurement andmonitoring of net funding requirements.

A bank should analyse liquidity utilising a variety ofwhat if scenarios.A bank should review frequently the assumptions utilised in managing

liquidity to determine that they continue to be valid.

c) Managing market access

Each bank should periodically review its efforts to establish and maintainrelationships with liability holders, to maintain the diversification of

liabilities, and aim to ensure its capacity to sell assets.

d) Contingency planning

A bank should have contingency plans in place that address the strategy forhandling liquidity crises and include procedures for making up cash flowshortfalls in emergency situations.

5 BCBS (2000). This document replaces a previous document A framework for measuring and managingliquidity, BCBS (1992).


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e) Foreign currency liquidity management

Each bank should have a measurement, monitoring and control system for itsliquidity positions in the major currencies in which it is active.

Banks should, where appropriate, set and regularly review limits on the size

of its cash flow mismatches over particular time horizons for foreigncurrencies in aggregate and for each significant individual currency in whichthe bank operates.

f) Internal controls for liquidity management

Each bank must have an adequate system of internal controls over itsliquidity risk management process.

g) Role of public disclosure in improving liquidity

Each bank should have in place a mechanism for ensuring that there is anadequate level of disclosure of information about the bank in order tomanage public perception of the organisation and its soundness.

h) The role of supervisors

Supervisors should conduct an independent evaluation of a banks strategies,policies, procedures and practices related to the management of liquidity.

In Appendix 1 further details of the BCBS Principles are provided. One of thesignificant aspects to highlight is that the Committee has not set any kind ofquantitative

standard that banks have to meet in order to be regarded as having a goodmeasurement of the liquidity risk associated with their business. This is because,unlike other regulations for example, solvency by defining minimum standards forcapital requirements-, the correct amount of liquidity that a financial institutionshould hold differs significantly between the banks and between financial systems, as itis affected by a large number of factors idiosyncratic to the business of each bank andthe environment in which it operates. That is why the standards in this field have untilnow remained at a qualitative stage. Another significant aspect to highlight is that, ashappens when dealing with other risks, the best practices to be carried out to managethis risk are an integrated approach, which means involving the different levels of an

organization (for example, the board of directors, the senior management and thecontrol areas) and describes risk management as an ongoing process that includes,among others, designing a strategy, its execution, monitoring, internal controls andassessment by the supervisor. The specific issue of liquidity riskmeasurement is one ofthe factors involved in the process, but according to the standards should not be anisolated tool established merely for a compliance purpose, or which is not part of theoverall process of managing the financial institutions risks.

Later, in May 2006 the BCBS issued The management of liquidity risk in financialgroups

6 paper that refers to liquidity risk management at the financial group level.This risk refers to the possibility that a firm may beunable to face its present and future

6 BCBS (2006).


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cash flows efficiently (whether they are anticipated or not) and/or the collateralrequirements without affecting its daily operations or its financial condition.

This paper presents the results of a review by a Working Group of funding liquidity riskmanagement practices at 40 conglomerates engaged in banking, securities, and

insurance activities. All observations are based on information and opinions providedby the firms through written responses to a survey, interviews, and presentations to theWorking Group. The review was designed to address five key questions presentedabove together with the key observations:

How do large, complex banking, securities and insurance groups manageliquidity risks across jurisdictions, sectors, and subsidiary units, particularly in

times of stress: firms in each of the three sectors monitor and manage liquidityrisk primarily through the use of risk limits, monitoring systems, and scenarioanalyses that are incorporated into contingency funding plans (CFPs). However,given differences in business lines3 and funding mix, liquidity risk management

is mostly separated in financial groups that contain firms operating in multiplesectors.

The impact of regulatory and supervisory approaches on liquidity risk

management practices and structures. Some of the surveyed firms indicate thatregulations may have an impact on the design of their structures for managingliquidity risk. Some regulatory restrictions impede the movement of liquidityacross jurisdictions; for example, regulatory restrictions may give rise to theneed to maintain liquid assets in separate jurisdictions and currencies, ratherthan in a single pool.

The nature of the products and activities that give rise to significant demands for

liquidity. Products and activities that give rise to liquidity risk includederivatives, other off-balance sheet instruments, and on-balance sheet contractswith embedded optionality. Additionally, certain market trends serve to increasethe amount of liquidity risk to which firms are exposed. These include changesin funding sources and greater customer awareness of product options.

Assumptions that firms make regarding available sources of liquidity. In a stresssituation, firms nearly universally expect to raise funds through securedborrowing during times of stress. Firms take into account the possibility thatthey will face operational risk in the short-term secured funding market or inclearing and other market mechanisms during a liquidity stress event. However,an implicit, and in some cases explicit, assumption that the official sector would

address any operational risk that causes widespread disruption across multiplemarkets is embedded in certain firms scenario analyses.

the scale of liquidity shocks that firms are prepared to address. As they performstress-testing, most firms test liquidity using firm-specific shocks, generally theimpact of a rating agency downgrade.

Other well known best practices at an international level are reflected in the Basel CorePrinciples, BCP)7, which are regarded as a framework of minimum standards for goodsupervisory practices and are used by countries as a benchmarkto assess the quality of

7 BCBS (2006-b and 2006-c).


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the supervisory systems and to identify the fields for future tasks in order to reach asolid level of supervisory practices.

In this sense, in the new BCP paper8 the liquidity risk is dealt with as Principle Nr. 14(BCP 14), which includes the characteristics and components necessary for a healthy

management of this risk, as described by the BCBSsound practices

BCBS document.

BCP 14 calls for the supervisor to be satisfied that the financial institution has a fullscale liquidity risk management policy, which means it has a strategy, policies and

processes that identify, measure, monitor and control this risk, as well as requiringliquidity management on a daily basis and the existence of contingency plans.

Specifically, BCP 14 states that:

Supervisors must be satisfied that banks have a liquidity management strategy that

takes into account the risk profile of the institution, with prudent policies and processes

to identify, measure, monitor and control liquidity risk, and to manage liquidity on a

day to day basis. Supervisors require banks to have contingency plans for handlingliquidity problem

The following table describes the Essential and Additional Criteria that make up BCP14, which largely reflect the principles included in the sound practices document dated2000 analyzed above.

Basel Core Principle Nr.14: Liquidity risk9

Essential criteria

1. The supervisor sets liquidity guidelines for banks and these take into consideration undrawncommitments and other off-balance sheet liabilities, as well as existing on-balance sheet liabilities.

2. The supervisor confirms that banks have a liquidity management strategy, as well as policies andprocesses for managing liquidity risk, which have been approved by the Board. The supervisor alsoconfirms that the Board has an oversight role in ensuring that policies and processes for risk-taking aredeveloped to monitor, control and limit liquidity risk, and that management effectively implements suchpolicies and processes.

3. The supervisor determines that a banks senior management has defined (or established) appropriatepolicies and processes to monitor, control and limit liquidity risk; implements effectively such policiesand processes; and understands the nature and level of liquidity risk being taken by the bank.

4. The supervisor requires banks to establish policies and processes for the ongoing measurement andmonitoring of net funding requirements. The policies and processes include considering how other risks(eg credit, market and operational risk) may impact the banks overall liquidity strategy, and require ananalysis of funding requirements under alternative scenarios, diversification of funding sources, a reviewof concentration limits, stress testing, and a frequent review of underlying assumptions to determine thatthey continue to be valid.

5. The supervisor obtains sufficient information to identify those institutions carrying out significantforeign currency liquidity transformation. Where a bank or banking groups foreign currency business,either directly, or indirectly through lending in foreign exchange to domestic borrowers, is significant, orwhere a particular currency in which the bank has material exposure is experiencing problems, the

8 BCBS (2006-b and 2006-c).9 BCBS (2006-b and 2006-c).


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supervisor requires the bank to undertake separate analysis of its strategy for each currency individuallyand, where appropriate, set and regularly review limits on the size of its cash flow mismatches for foreigncurrencies in aggregate and for each significant individual currency.

6. The supervisor determines that banks have contingency plans in place for handling liquidity problems,including informing the supervisor.

Additional criteria

1. The supervisor determines that, where a bank conducts its business in multiple currencies, foreigncurrency liquidity strategy is separately stress-tested, and the results of such tests are a factor indetermining the appropriateness of mismatches.

2. The supervisor confirms that banks periodically review their efforts to establish and maintainrelationships with liability holders, maintain the diversification of liabilities, and aim to ensure theircapacity to sell assets.

2.2. European Central Bank

In May 2002 the European Central Bank published the Developments in banksliquidity profile and management

10 paper that provides a structural analysis of how theliquidity of the European banking system has evolved in recent years and how theEuropean banks organized their liquidity management11.

Among the structural factors that affect bank liquidity, the paper highlights that as aresult of an increasing competition by alternative investment possibilities to bankdeposits these have not grown at the same rate as the demand for loans. This obliges thefinancial institutions to seek funds on the more volatile markets like the inter-bank loan

market or by issuing corporate bonds, for example, with the purpose of funding itstraditional lending business, which therefore impacts on its profitability. The fact thatbanks no longer rely mainly on attracting deposits as a source of funding may result in aliquidity crisis no longer being exclusively reflected by the traditional image of a run onbanks, but rather by different impacts such as being impossible to sell assets at areasonable price, or by higher interest rates which could ultimately affect the solvencyof some financial institutions.

The European banking regulation includes liquidity ratios, a deposit insurance scheme,tax and reinvestment rules and minimum cash requirements, among other instruments,all of which may have an impact on the systems liquidity. In the European Union eightof the members set quantitative requirements for the liquidity position, although thesediffer substantially between the different countries. The rest of the countries monitorliquidity by observing non-binding ratios or through qualitative requirements.

The qualitative side is probably more homogeneous, due to the Basel Committeepublication released in 200012 with the best practices for liquidity management. Due tothe lack of consensus about how to measure liquidity risk precisely the regulation mayprovide a reference for small banking institutions and stimulate them to develop theirown indicators.

10

ECB (2002).11 In Appendix 2 further details are added.12 Referred to in the previous section.


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As regards the management of their liquidity risk by the banks, a broad range of theindicators used, the caps that are usually established, and also the time horizons appliedto analyze the liquidity. Among the liquidity risk indicators mentioned are the cashoutflows for different time bands (broken down according to the level of theorganization, type of market, currency and product), the level of uninsured funding, the

ratio of liquid assets to total assets, the ratio of liquid assets to liability contingencies,the ratio of liquid assets to sight deposits, among others. The limits are also associatedwith the scheme used by the bank when monitoring its liquidity (in terms of theindicator that is used, the time horizon and the currencies considered).

Some specific elements dealt with are the way that the banks manage certain items, forexample assets with variable liquidity, or liabilities with undefined maturity (such assight deposits), or the lines committed to. When shares are dealt with, the assets areusually classified based on their degree of liquidity. Likewise, margins can be used toreflect different degrees of liquidity. For debts with a non-contractual maturity and thelines committed to, a performance analysis is used based on the historical changes to

these items.

The use of limits set by the banks to monitor their liquidity is fairly frequent. It iscustomary to consider volume limits (for example, about the net flow of funds indifferent maturity buckets, or the level of eligible assets for loans from the centralbank) and ratio limits (for example, limits in the liquid assets to total assets ratio).

For the time horizon it is worth noting how banks coincide in terms of distinguishingthe management of operating liquidity, with an horizon which begins overnight andextends to one to three months, and ofstrategic liquidity, which may extend for up to ayear and is associated with the planning and budget processes.

Standing out among the measures that the banks often adopt in order to avoid a liquidityshortage on the asset or liability angles, are staying in touch with investors andcounterparties, and contingency financial plans, and they are key elements in the BCBSbest practices. The strategies vary, from ensuring that a credit institution has a presenceon various markets, to establishing programs for access to new categories of liquiditysuppliers to ensure a constant flow of liquid assets or the use of funding lines.

As regards the changes observed in liquidity management imply, one may conclude thatthere are indicators that the liquidity risk under normal conditions has fallen, but it may

possibly have increased during certain crisis periods. Under normal conditions a healthyand solvent financial institution always has access to the funds it needs, whether it bethrough the inter-bank market or by transactions with the central bank, and liquidity willnot be a crucial issue. This viewpoint can be reinforced by a comfortable liquidityposition due to holdings of liquid assets or an access to credit lines. If a crisis occurs(whether it is specific to the bank or generalized) access to liquidity may be seriouslycurtailed if the counterparty is unwilling to provide funds (despite the existence ofguarantees or high prices). In a generalized crisis scenario it may be impossible for afinancial institution to mobilize assets on the market or it may only do so by accepting alarge margin. Therefore, the banks must be aware of this issue as they adopt the soundpractices defined by the Basel Committee.


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2.3. United States control agencies

The control organizations in the United States make suggestions to develop healthypolicies to manage the liquidity risk13. They highlight the principles stated by the BaselCommittee analyzed above14 as a guideline for a proper management. As regards

regional banks different sections of the different supervision manuals are applicable. Fornational banks the reference is to the OCCs Comptrollers Handbook on Liquidity,for state banks that are members of the Federal Reserve (Fed) the Commercial Bank

Examination Manual and for bank holding companies the Holding CompanySupervisory Manual, the latter two are published by the Fed. State banks that are notFed members are supervised by the Federal Deposit Insurance Corporation (FDIC)through its Revised examination guidance for liquidity and funds management15, andthe savings associations guideline is the Office of Thrift Supervision Bulletin 77 underthe title Sound practices for liquidity management at savings associations. The creditunions guideline is the Letter to Credit Unions Nbr. 02-CU-05: Examination programliquidity questionnaire.

All these agencies coincide in recommending institutions that acceptdeposits that a sound liquidity risk management policy must include thefollowing four elements:

Well-established strategies, policies, and procedures for managing both thesources and uses of an institutions funds across various tenors or time frames.This includes assessing and planning for short-term, intermediate-term, andlong-term liquidity needs.

Liquidity risk measurement systems that are appropriate for the size andcomplexity of the institution. Depending upon the institution, such measurementsystems can range from simple gap-derived cash flow measures to verysophisticated cash flow simulation models.

Adequate internal controls and internal audit processes. Internal controls andinternal audit reviews are needed to ensure compliance with internal liquiditymanagement policies and procedures.

Comprehensive liquidity contingency planning. Contingency plans need to bewell designed and should span a broad range of potential liquidity events that aretailored to an institutions specific business lines and liquidity risk profile.

It is worth noting that the Fed set up a discount window program in 2003 in order tocontribute to the liquidity of the system. This consists in a primary lending program,regarded as the main valve to ensure an adequate liquidity in the banking system and

13 Interagency advisory on: The use of the Federal Reserves primary credit program in effectiveliquidity management (Board of Governors of the Federal Reserve, Office of the Comptroller of theCurrency, Federal Deposit Insurance Corporation, Office of Thrift Supervision, National Credit UnionAdministration).14

BCBS (2000).15 In Section 4.1 the liquidity policy recommendations of the FDIC supervisory manual are described indetail.


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intended to be a source of short term funds for eligible financial institutions16. An majortarget for this program is to lower the banks reluctance to use this window. The interestrate was initially set at 100 b.p. above the federal funds rate and transactions are grantedfor a brief period, typically on an overnight basis. The Federal Reserve also has asecondary program available so that the institutions that do not qualify for the primary

program can solve serious financial difficulties.

A very important tool to assess the liquidity position of the banks is the table onliquidity and the investment portfolio in the Uniform Banking Performance Reports(UBPR)17 published by the Federal Financial Institutions Examination Council (as anexample, a copy of a general table is reproduced in Appendix 4). This council is aformal inter-agency body set up to establish uniform principles and to generate reportson the federal assessment of financial institutions by the following agencies: FRB,FDIC, NCUA, OCC and OTS. It also issues recommendations in order to promoteuniform supervision of the financial institutions. The UPBR is an analytical tool createdfor bank supervision and bank management analysis purposes. In a concise format it

includes useful data about the composition and performance in order to assess themanagement of assets and liabilities, revenues, liquidity, capitals and management ofgrowth during various consecutive years. The information is available to supervisorsand the bankers in order to understand the financial situation of the bank. The UBPRsare generated by each bank specifically, for uniform groups of banks and by state. Ittherefore enables an assessment of the current condition of each bank, the trends of itsfinancial performance and to make comparisons with the group in which it is included.

3. Experiences in countries that regulate liquidity risk

3.1. United States (FDIC)18

The way liquidity is dealt with in the supervision manuals of the United States controlagencies is not radically different in general. The analysis in this section focuses on the

Federal Deposit Insurance Corporation (FDIC) rules.

3.1.1. Introduction

Because liquidity is critical to the ongoing viability of any bank, liquidity managementis among the most important activities that a bank conducts. Crucial elements of strongliquidity management are:

good management information systemsstrong analysis of funding requirements under alternativescenariosdiversification of funding sourcescontingency planning

16

Basically banks rated as CAMELs 1, 2 and 3.17 UPBR (2005).18 FDIC.


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Determining a bank's liquidity adequacy requires an analysis of the current liquidityposition, present and anticipated asset quality, present and future earnings capacity,historical funding requirements, anticipated future funding needs, and options forreducing funding needs or obtaining additional funds.

3.1.2. Liquidity Management

All banks should have board-approved written policies and procedures for the day-to-day management of liquidity. The liquidity strategy and policies should becommunicated throughout the bank. The board of directors should be informedregularly of the liquidity situation of the bank, and the board should ensure that seniormanagement monitors and controls liquidity risk. Bank management should have inplace appropriate policies and procedures that set and provide for the regular review oflimits on the size of liquidity positions over particular time horizons. As part of aprocess for the ongoing measurement of funding requirements, management should

analyze liquidity under various scenarios, and the underlying assumptions for suchscenarios should be reviewed periodically.

A sound policy to manage funds and liquidity must include:

- Setting up an ALCO committee19.- Periodical review of the structure of bank deposits (deposit clasess, distribution of maturities,

rates paid, public funds, etc.).- Policies to cater for the excessive concentration of the sources of funding, especially for tose

most sensitive to market interest rates.- Methods to calculate the costs of funding.- Tolerante to liquidity risk, by caps (loan to deposit ratio, long term assets funded with short term

debt, individual or agrgate limites according to source and class, etc.).- Adequate internal control system.- Contingency plans that stipulate alternative sources of funding.

- Procedures foir exceptions to the policies, caps and predefined authorizations.

A necessary prerequisite to sound funds management decisions is a sound managementinformation system. It will contain reports detailing the following::

Liquidity needs and the sources of funds available to meet these needs overvarious time horizons and scenarios. The maturity distribution of assets and

liabilities and expected funding of commitments would prove useful inpreparing this report.

List of large funds providers.Asset yields, liability costs, net interest margins and variations both from the

prior month and budget.Longer-term interest margin trends.Economic conditions in the bank's trade area, interest rate projections, and any

anticipated deviations from original plan/budget.Information on maturity of the instruments, and concentrations or other limit

monitoring and reporting.

19 Asset / Liability Committee.


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Management should monitor various internal as well as market early warningindicators, including:

Rapid asset growth funded by potentially volatile liabilities.Real or perceived negative publicity.

A decline in asset quality.A decline in earnings performance or projections.Downgrades or announcements of potential downgrades of the institution's

credit rating by rating agencies.Cancellation of loan commitments and/or not renewing maturing loans.Wider secondary spreads on the bank's senior and subordinated debt, and

increasing trading of the institution's debt.Counterparties increase collateral requirements or demand collateral for

accepting credit exposure to the institution.

Indicators that the institution potentially may have a serious liquidity problem include

the following:

Rating sensitive providers, such as money managers and public entities, abandonthe bank.

Volume of turndowns in the brokered markets is unusually large, forcing theinstitution to deal directly with fewer willing counterparties.

Transaction sizes are decreasing, and some counterparties are even unwilling toenter into short-dated transactions.

An increasing spread paid on deposits relative to local competitors, or nationalor regional composites.

Each institution's liquidity policy should have a contingency plan since in a crisissituation management has little time to plan alternative strategies. The contingency planshould be updated on a regular basis and:

Define responsibilities and decision-making authority so that all personnelunderstand their role during a problem-funding situation

Include an assessment of the possible liquidity events that an institution mightencounter. The types of potential liquidity events considered should range fromhigh-probability/low-impact events that can occur in day-to-day operations, tolow-probability/high impact events that can arise through institution-specific,

systemic market, or operational circumstances.Assess the potential for erosion (magnitude and rate of outflow) by fundingsource under optimistic, pessimistic, and status quo scenarios.

Assess the potential liquidity risk posed by other activities such as asset salesand securitization programs.

Analyze and make quantitative projections of all significant on- and off-balancesheet fund flows and their related effects.

Match potential sources and uses of funds.Establish indicators that alert management to a predetermined level of potential

risks.Identify and assess the adequacy of contingent funding sources. The plan should

identify any back-up facilities (lines of credit), the conditions related to theiruse and the circumstances where the institution might use them.


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Identify the sequence in which sources of funds will be used for contingentneeds.

Assess the potential for triggering legal restrictions on the bank's access tobrokered deposits and the effect on the bank's liability structure.

On the other side, banks may access a broad range of alternative funding sources indifferent situations:

Funding sources

A. Sale of liquid assetsB. Liability creation

B.1. Deposit managementB.1.1. Core deposits

B.1.2. Wholesale funding sourcesB.2. Access to the money market

C. REPO operationsD. Rediscount window at the Central Bank

Liquidity needs may be met by managing the bank's asset structure through either thesale or planned pay-down of assets. However holding liquid assets for liquiditypurposes becomes less attractive because of thin profit margins and because assetsnormally assumed to be liquid sometimes are not liquidated easily and / or profitably.The amount of liquid assets that a bank should maintain is a function of i) the stabilityof its funding structure, and ii) the potential for rapid loan portfolio expansion.Generally, a relatively low allowance for liquidity is required. Factors that may indicatethat a higher allowance for liquidity is required include:

The competitive environment is such that bank customers can invest inalternative instruments.

Recent trends show substantial reduction in large liability accounts.Substantial deposits are short-term municipal special assessment-type accounts.A substantial portion of the loan portfolio consists of large problem credits with

little likelihood of reduction or marketability.A substantial portion of the loan portfolio consists of non-marketable loans

(e.g., longer term, non-amortizing, non-homogeneous loans).A significant portion of assets is pledged to support wholesale borrowings.

In order to sell assets their accounting classification has to be considered, because inprinciple the assets on the investment account are unavailable (unless the feasability ofthe financial institution is at risk). Therefore, banks tend to classify their liquid assets inthe available for sale category, although this means their values are marked tomarket prices. As well as their liquid assets, banks may rely on the securitization ofassets, letters of credit or remaining assets.

Another alternative to create liquidity is bygenerating liabilities. A growing number ofbanks are observed combining the management of their asset and liability structures inorder to satisfy their liquidity requirements. The growing competition between banks toretain their depositors shows the need for these funds for the day to day operations. An

effective deposit management program should, at a minimum, include the followinginformation:


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If the economic situation worsens the possibility of obtaining loans vanishesjust when they are most needed.

Changes in the market conditions could make it difficult to ensure funds and tomaintain the maturity profile.

The concern about obtaining funding at least cost could increase the risk of

concentrating the sources of funding and the risk of fluctuations in interestrates.

Another way to manage liquidity is through repo transactions (repurchase optionagreements). The agreements might mean that the repurchase of the same asset has to bereported as a loan, because the right to the earnings from the asset is retained. They tendto be short term agreements (less than three months) and are distinct from overnighttransactions: the so called overnight repos. The repos managed in an appropriate assetsand liabilities management program are not subject to objections by the regulatoryauthorities. However, it is necessary to asses the counterparty correctly because the riskof a loss of value of the asset granted as collateral during the transaction may exceed the

margin requested, exposing the financial institution to a credit risk. Due to the numerousfailures observed in controlling these transactions, the FDIC has set minimum standardsfor any depository institution that is active on this market.

The Federal Reserve discount window is also available for any bank that maintainsdeposits that are subject to reserve requirements. The Fed provides short term loanswith appropriate assets as collateral (usually sovereign bonds, municipal bonds,mortgages, etc.). These loans consist of primary credit (usually overnight), secondarycredit (for those that do not qualify for the primary segment), extended credit (forfinancial institutions with liquidity problems) and emergency credits (which are veryrare). Adequately capitalized institutions with CAMELs 1, 2 and 3 can resort to the

primary credit as a backup source in order to face their short term funding needs, whichshould not call for attention by the regulatory agencies.

3.1.3. Evaluation of a Banks Liquidity

Perhaps more than any of the other component ratings (CAMELS), the liquiditycomponent should be assigned in the context of other financial factors. Banks with verystrong capital positions and earnings fundamentals are likely to be able to easily fundongoing operations and have no difficulty raising liquidity for even unforeseen events.

Under the

Uniform Financial Institutions Rating System

21

, in evaluating the adequacyof a financial institution's liquidity position, consideration should be given to the currentlevel and prospective sources of liquidity compared to funding needs, as well as to theadequacy of funds management practices relative to the institution's size, complexity,and risk profile.

Liquidity is rated "1" through "5" by agencies with respect to the following:

Volatility of deposits.Reliance on interest-sensitive funds and frequency and level of borrowings .

21

The Uniform Financial Institutions Rating System (UFIRS), is a banking rating system developed bythe four American banking agencies, sponsored by the Federal Financial Institutions ExaminationCouncil (FFIEC).


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Unused borrowing capacity.The capability of management to properly identify, measure, monitor, and

control the institution's liquidity position, including the effectiveness of fundsmanagement strategies, liquidity policies, management information systems, andcontingency funding plans.

Level of diversification of funding sources.Ability to securitize assets.Availability of assets readily convertible into cash.Ability to pledge assets.Access to money markets.The institution's earnings performance.The institution's capital position.The nature, volume, and anticipated usage of the institution's credit

commitments.

Agencies liquidity rating factor

1 Strong liquidity levels and well-developed funds management practices. Theinstitution has reliable access to sufficient sources of funds on favourable terms tomeet present and anticipated liquidity needs.

2 Satisfactory liquidity levels and funds management practices. The institution hasaccess to sufficient sources of funds on acceptable terms to meet present andanticipated liquidity needs. Modest weaknesses may be evident in funds managementpractices.

3 liquidity levels or funds management practices in need of improvement. Institutionsrated 3 may lack ready access to funds on reasonable terms or may evidencesignificant weaknesses in funds management practices.

4 deficient liquidity levels or inadequate funds management practices. Institutions rated4 may not have or be able to obtain a sufficient volume of funds on reasonable terms tomeet liquidity needs.

5 liquidity levels or funds management practices so critically deficient that the continuedviability of the institution is threatened. Institutions rated 5 require immediate externalfinancial assistance to meet maturing obligations or other liquidity needs.

Examiners should employ the uniform banking performance UBPR22 ratios as helpfultools to analyse the institution's liquidity position. UBPR ratios should be viewed inconcert with the institution's internal liquidity ratios on a level and trend basis whenassessing the liquidity position. Peer group comparisons might not be meaningful sincethe liquidity and funding needs will be different for each institution.

3.2. United Kingdom

The prudential treatment for liquidity risk is set out in the Interim PrudentialSourcebook (IPRU), which states that the responsibility for ensuring a bank can meet itsobligations as they fall due rests with the banks own management. The bank shouldtake account of its characteristics and position within the banking system in determininga prudent liquidity policy.

22 Uniform Banking Performance Report (section on Liquidity & Investment Portfolio, see Annex 4)


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A bank should be able to satisfy the FSA on an on-going basis that it has a prudentliquidity policy, and adequate management systems in place to ensure that the policy isadhered to. This is checked during the course of normal supervision through prudentialdiscussions and the Form LR23 (which describes its liquidity position on a quarterly

basis).

The framework to measure liquidity risk is based on an analysis of the mismatchesbetween incoming and outgoing flows in different time bands. The mismatches(liabilities less debts) of each band are measured and are added up to obtain a netcumulative mismatch. The FSA analyzes the liquidity position of the bank as the ratioof the net cumulative mismatch to total deposits and recommends that it should notexceed a specified percentage. It also defines a guideline for the maximum acceptablemismatch only for the 0-8 day and 0-1 month time bands. The periods of up to sixmonths must be recorded on a cash flow basis and for the longer periods in terms of thematurity of the principal. The items have to be booked following the criteria in the table

below marco para medir el riesgo de liquidez est basado en un anlisis de descalcesentre los flujos entrantes y salientes en diferentes bandas temporales. Se miden losdescalces para cada banda (pasivos menos activos) y se los suma para obtener undescalce acumulado neto. La FSA analiza la posicin de liquidez del banco a travs delratio del descalce acumulado neto sobre total depsitos y recomienda que no supere unporcentaje determinado. Tambin establece una gua para el mximo descalce aceptablesolamente para las bandas temporales de 0 8 das y de 0 1 mes. Los perodos hasta 6meses debern ser registrados en base a los flujos de caja y los perodos ms lejanos enfuncin de la madurez del monto principal. Los conceptos deben ser asentadossiguiendo los criterios que se exponen en el cuadro siguiente.

Criteria to include assets and liabilities in the time bands FSA (Based on IPRU)

Assets Liabilities

Will generally be included in the maturity ladder, apart fromthe exceptions set out below:

inflows (assets) only nominally repayable on demand (e.g.overdrafts); may be adjusted according to their historicalmaturity pattern.

undrawn committed standby facilities provided by otherbanks are treated as a sight assets.

marketable assets should be shown as a sight assets (at adiscount) .

Assets known to be of doubtful value are excluded from thematurity ladder and treated on a case by case basis.

For liquidity monitoring purposes only, a bank should classifyits cashflows as being either retail or wholesale, because oftheir different behaviour (e.g. size, volatility).

Should be included in the maturity ladder according to theirearliest contractual maturity (although some certain behaviouralAdjustments may be done in certain cases).

Specific points to note are:

A bank is required specifically to report information onclient accounts, since the FSA may require client moneyto be returned if a bank is perceived to be in difficulties.

Known firm commitments to make funds available on aparticular date are to be included in the appropriate timeband at their full value.

Contingent liabilities are not included in the maturityladder, unless there is a likelihood that the conditionsnecessary to trigger them will be fulfilled.

The bank policies may include holding a stock of liquid assets for its liquiditymanagement policy. In order to enable assets traded on the market to be calculated aspart of this stock, the FSA has to bear in mind whether the Bank of England will dealwith these securities in its open market transactions, the depth of the market, theprobability of a loss due to its forced liquidation and its scale, the proportion of the issuethat a bank holds in its portfolio, and the exchange rate risk. The minimum criteria to

23 IPRU - Form LR: Liquidity Return.


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include assets negotiable on the market in the bands include their usual prices, theirregular trading and that they can be easily sold (including repos). They will be assignedto the 0-8 day band. In general a discount to the market price is applied, in terms of thecredit rating of the issuer, the possibility of trading them and their currency.

In order to make these reports easier, the FSA will authorize the banks to excludecertain cash flows if they are insignificant. For this purpose the bank must report theitems and justify their non inclusion with an estimate of cash flows in the past and aprediction for the future. The FSA will bear in mind the quality of the past statisticaland prudential reports and the banks performance regarding the violation of the self-imposed limits.

For supervisory purposes the worst cases scenarios are usually analyzed, and that is whythe incoming flows are recorded at their longest maturity and the outgoing flows at theirshortest maturities. However, the FSA acknowledges that in many cases the actualflows are not closely related to their maturities, so that it allows the banks to opt to

report the flows in two manners: contractual or according to certain behavioralassumptions. As the second alternative is more favorable for the banks, they must makea proposal to the supervisor that includes:

Empirical evidence about debt profiles.

Sensitivity analysis that refers to the behavior of the flows.

Breaking down the flows (especially relevant for the credit card and mortgage loanportfolios which cover a broad range of products targeted at different marketsegments).

Relevance of the models.

Customer profile. Currency denominations.

Penalty clauses for early withdrawal of funds.

Any adjustment agreed to with the FSA regarding recording the flows according to thebehavioral assumption has to be recorded in the bank statement about its liquiditypolicies and be reviewed annually by the bank and the FSA.

The facility commitments granted to the bank should not be included in the time bands.However, the FSA can authorize a financial institution to include some portion if it iscalculated on a behavioral basis, which is determined on a case by case basis. The

factors considered for such purposes are:

- If the facility is legally required.- If it is a facility used in a regular manner to fund the banks activities or if it

is only available for emergencies.- The relationship between the provider of the facility and the bank.- The existence of cancellation clauses in the documentation

Procedures are agreed on with each bank to allocate the cash flows to the 0 8 day and8 day one month bands. They are specific for each bank and consider the followingfactors:

Volatility, diversity and the source of the deposits.


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Presence of highly concentrated deposits, including investment fundaccounts.

Quality of the assets tradable on the market: depth and volatility of theirprices.

Degree of diversification of the tradable asset portfolio.

Availability and reliability of the unused credit lines. Impact of the off-balance headings like FRAs, swaps, etc..- Qualitative factors such as the asset profile, the quality of the information

systems, and the market reputation of the financial institution.

3.3. Israel

In this country guidelines for the liquidity policy are provided in the supervisionmanual24. This policy must at the least include procedures that define the duties of the

hierarchy and the authorities, quantitative targets associated with the liquiditymanagement, restrictions on mismatches and how deviations for the stated policyshould be dealt with. The bank also has to review the policy in accordance withdevelopments of the economy and the banking system.

As regards the information system, it should be adequate to measure, control, monitorand report the liquidity position. It must also allow for the liquidity position calculationin each of the currencies operated in on a daily basis for assets and liabilities. Likewise,it has to provide information that enables a comparison with defined restrictions and thetrends of changes in liquidity, and report on the liability structure in general and onlarge depositors in particular.

3.3.1. Management, measurement and control of the liquidity position

Estimation of the liquidity position: calculating the mismatch according to therepayment periods and the liquid assets to liabilities ratio over a repaymentperiod ofup to a month.

Resource management: the management must discuss the sources of fundingperiodically and make decisions regarding the composition, characteristics andvariety of the sources, so that it can diversify the liabilities.

Liquidity crisis: determining a plan for liquidity crisis cases (definition of theprocedures to follow, sources for coverage of a liquidity mismatch and setting

up a team to cater for such a crisis). Scenarios: cash flow analysis in different scenarios related to the financial

institution and the financial system as a whole, based on experience.

3.3.2. Restrictions

Limits and restrictions are established bearing in mind:

The liquidity mismatch (related to the repayment periods) overnight, at one

week, a month, three months, six months, a year, and over a year.24 Israel (2003).


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The liquid assets to liabilities ratio for a repayment period of up to a month. Inorder to calculate this ratio only assets for which there is a market should beincluded.

The restrictions related to the structure of sources, concentration of depositors,types of depositors and repayment period.

In order to determine the liquidity restrictions, the goodwill of the financial institutionand its rating must be considered; the degree of trust in its trading book, the size of themarket and the volatility of its prices; the skill of the risk-management staff and thequality of the reports; the diversification of the deposits; the degree of certainty andavailability of the unused credit lines and the impact of the flows not considered in theliquidity calculation.

3.3.3. Management of foreign currency liquidity

The financial institutions have to maintain a system to measure, control and monitor the

foreign currency liquidity position on aggregate and in the main currencies in which itoperates. It must also report to the supervisory organization any deviation or liquidityproblem that appears.

3.4. India

The Reserve Bank has prepared a guide that includes suggestions made by the financialinstitutions at seminars and meetings with bank management and whose final directiveswere adopted as from April 199925. Its purpose is to be a guideline for the financial

institutions that lack an ALM (Asset Liability Management) system. Banks that haveadopted more sophisticated systems can continue using them, but it is necessary tocheck that they are in line with the suggested guideline. Initially the financialinstitutions had to ensure coverage of 60% of their assets and liabilities. For theremaining 40% they could include a position based on estimates. Later it becamenecessary for the banks to establish targets to cover 100% of their business by April2000. Once the banks gained in experience they would be in a position to achieve moresophisticated techniques like duration gap analysis, simulation and value at risk, forinterest rate risk.

The financial institutions must establish an internal asset and liability management

committee, which must control the adoption of the ALM system and review itsoperations periodically. They must also prepare a report on structural liquidity to assessthe structure of the cash inflow and outflow maturities, at fortnightly periods. Thetolerance levels for different maturities can be defined by the senior management.

3.4.1. Guide for the ALM system at banks

ALM provides a dynamic framework to measure, monitor and manage the liquidity,interest rate, exchange rate and equity of a bank, which needs to be integrated into thebusiness strategy. This includes the valuation of several kinds of risk, alternating theassets and liabilities portfolio in a dynamic manner to be able to manage them.

25 India (1999) BO.BC.8/21.04.098/99 Asset Liability Management (ALM) System.


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ALM has to be organized on a management basis that clearly specifies the risk policiesand the tolerable limits. Due to the diversity of bank portfolios a uniform system cannotbe adopted. As regards the process, this guide specifically refers to the liquidity andinterest rate risks. The ALM guideline only includes the banking transactions in

domestic currency.

ALM is based on three pillars

Information system Organization Process

Systems managementAvailability of information,certainty and adequacy

Structure and responsibilityManagement level involved

Risk parametersIdentifying riskMeasurementManagementPolicies and tolerance level

3.4.2. Liquidity risk management

The management of a bank not only has to measure the liquidity position, but must alsoexamine its probable development under different assumptions. A standard tool tomeasure and manage the funding requirements is to use a staggered maturity with acalculation of cumulative profits and losses at specific maturity dates. The time bandsare distributed from overnight to 14 days; 15 to 28 days; 29 days to three months; overthree months and up to five years, and longer than five years.

Investments in securities are considered as not liquid due to the absence of a secondary

market, and nevertheless must be shown in the bands according to their remainingmaturity. However, some financial institutions can hold securities in their tradingbook26, which can be assigned to the 1-14 days, 15-28 days and 29-90 day bands.

Within each time band there may be asymmetries depending on the cash flows. Whilethe asymmetries of up to a year can be relevant because they provide early warningsignals to avoid liquidity problems, the main focus has to be on the short termasymmetry at 1-14 days and 15-28 days. However, the financial institutions mustmonitor their asymmetries over all the time bands, setting prudential in-house limitswith the approval of the management committee. The asymmetries (negative gap) in the1-14 day and 15-28 day periods cannot be more than 20% of the cash flows in these

periods (prudential limit). In this case the bank must show its proposal to finance thegap and restore the prudential limits in a note. They can be funded by loans from themarket (call or term), rediscount bills, repos, or funds in foreign currency after they areconverted to domestic currency. So that the institutions can monitor their short termliquidity over a 1-90 day time horizon the banks must estimate their short term liquidityprofile based on their business projections.

26 The securities held in the trading book have to meet some preconditions: clearly defined composition

and volume, the maximum maturity of the portfolio is restricted, and the holding period cannot be over 90days.


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The guide also describes the method to measure deposits in savings accounts and incurrent accounts, among others, which can partly be classified as volatile and partly ascore. The volatile share can be included in the 1-14 day bucket, the core in the 1-3 yearbucket. For time deposits the bucket may be modified depending on their performanceon maturity for retail deposits. In the wholesale case the maturity bucket must be

respected.

3.5. Brazil

The ruling on liquidity risk in Brazil is enunciative27. It states that the financialinstitutions must have systems to control the liquidity risk, structured according to theiroperating profiles and that allow for tracking the positions adopted on the financial andcapital markets, in order to show the liquidity risk that emerges from them. It definesliquidity risk as disequilibria between negotiable assets and liabilities on demand(mismatches) occurring which might affect the payment capacity of the institution28.

These systems must at least allow for a daily assessment of the transactions withsettlement terms of less than 90 day terms. The following procedures must be adopted:

documentation on the structure and the criteria to control liquidity risk;

preparation of economic-financial analysis that allow for an assessment of theimpact of different scenarios;

preparation of reports that enable the monitoring of the risks that are assumed;

assessment of the options for access to sources of liquidity on the financial andcapital markets;

carrying out tests to evaluate the system, including stress tests, adherence tests

and others that enable an identification of the problems; disclosure of information and the result of the analysis to the board of directors

and management; and

establishing a contingency plan for liquidity crisis situations.

The control systems has to be prepared to identify the risks of each institutionindividually, and if pertinent also in a consolidated manner29.

3.6. Latin American countries with quantitative regulation

Some Latin American countries have a specific quantitative regulation on the liquidityrisk management issue. The rules applied at present in Colombia, the DominicanRepublic, Chile and Uruguay have thus been analyzed. Appendix 5 provides acomparative table of their respective regulations.

27 Consejo Monetario Nacional do Brasil (2000).28 Ibid.29 It is important to highlight that the liquidity risk does not seem to be a central concern in the regulation

of the Brazilian financial system, probable due to the liquidity level resulting from the large mandatoryreserves.


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The conclusion from the comparison is that:

There is no uniform horizon for the information to be submitted, as it rangesfrom a short horizon in Chile (90 days) to longer terms in the DominicanRepublic (up to five years). Nevertheless in general the regulation is stipulated

for short terms. The frequency of their preparation is at least quarterly, although in most of these

countries it is monthly.

The starting point of the information is contractual by maturity (if it exists), andin Chile and Colombia it permits adjustments for expectations that consider thenormal behavior of the variables.

In general these countries define the liquidity gap as the difference betweenassets plus off-balance debt items and the liabilities plus off-balance credititems.

Only the Dominican Republic specifies the indicators to be submitted, althoughit does not set a minimum ratio that has to be met.

As regards the accounting methodology to record credits, deposits and otheritems, the regulation defines general criteria that consider statistical andvolatility analysis (Colombia and the Dominican Republic and, to a certainextent, Chile).

In these countries the regulation in general compares the liquidity gap with thevalue of the liquid assets (Colombia, Dominican Republic) or the basic capital(Chile) or the adjusted calculated equity responsibility (Uruguay), establishingspecific limits that in general consider not exceeding those values.

All the countries request differential positions in domestic and foreign currency.

4. Argentine regulation on the Liquidity position

As from September 1995 the Central Bank of Argentina (BCRA) established30the guidelines that the financial institutions must follow in order to ensure that liquiditylevels are available, which allow them, under different economic scenarios toefficiently cater for their deposits and other commitments of a financial nature. Thefinancial institutions must foresee the procedures used to asses their liquidity conditionswith sufficient foresight, arranging the measures that tend to eliminate the liquiditymismatches or adopting provisions that foresee obtaining funds at market cost sufficient

to prudently support the assets over a longer term. In this sense, the degree to whichtheir liabilities or assets with certain clients, the overall situation of the economy andthe market and its likely development, the repercussion on the availability of creditlines and the capacity to obtain funding by sales of government securities and/or loanportfolio, among others, be considered31.

As a subsequent stage, the rule contemplated defining liquidity coefficients of aprudential nature that the financial institutions should maintain in the scenariosconsidered (ratio between the cumulative global mismatch to the cumulative liabilities

30

By CommunicationA

2374 and supplementary rules.31 Appendix 3 summarizes the key points of the rule.


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of up to three months maturity), for which purpose it expected to have the results ofassessing the information that the financial institutions would provide in the followingmonths and/or with possible proposals that the banking associations would submit,indicating that they might possibly differ according to the type of institution,considering their specialization and size. However, this stage was not adopted.

As from February 2002, due to the economic crisis Communication A 3465 informedthat the submittal of the Liquidity Position Information Regime for December 2001 andlater months was suspended until further notice, and in January 2006 the regime wascancelled32.

5. Conclusions

As indicated by the Basel Committee on Banking Supervision recommendations,liquidity, defined as the capacity to fund asset increases and cater for the debts on theirmaturity, is crucial for the feasibility of the financial institutions considered individuallyand also for the system as a whole.

Nevertheless, and although the significance of the liquidity risk has been acknowledged,due to the particular characteristics that it exhibits in different financial institutions theorganizations entrusted with establishing the best practices for the subject have notestablished a specific nor a quantitative regulation, but have limited themselves toestablishgeneral principles which can be used as a guide for risk management.

Most of the countries considered in this paper have reflected these recommendations intheir supervision manuals or regulations, in some cases granting the financialinstitutions freedom to apply the in-house methods provided they meet the statedprinciples or have created a guide for the banks that have not yet advanced on the issue.In other cases it is considered important to set up a quantitative regulation. In thisdirection, from the experience of the Latin American countries surveyed some wereseen as having adopted strict regulations that set quantitative limits on the liquiditymismatch issue (Chile) while others have only proposed guidelines that the financialinstitutions should follow (e.g. Brazil).

Most of the advanced countries are seen to have specific rules to manage this risk,

which are in line with the spirit of the best practices suggested by the BCBS. Thismeans that it is clearly established that the banks must have a liquiditystrategy, policiesand processes to manage the risk approved by the board and that this corporate level hasan active role in supervising the risk, and that the management effectively implementtheses policies and processes.

On the whole, the policies and processes must include an ongoing measurement andmonitoring of the net requirements for funds; consider other risks that may impact onthe liquidity strategy and analyze the requirements for funds under alternative scenarios;the quality and diversity of the funding sources; control over the limits of concentrationof deposits; the preparation ofstress testing and contingency plans in order to face

32 Communication A 4482.


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liquidity problems. In general the specific characters of each bank and the nature of therisk are observed to not make a single procedure for the quantitative risk measurementand comparison of different financial institutions easy, so that on the measurement issuethe trend is for the banks themselves to assess this risk in the context of a full scaleliquidity risk management program. The financial institutions that do not have their own

sufficiently sophisticated systems are usually provided with a model or minimumguidelines supplied by the regulator.


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Appendix 1: Basel sound practices for managing liquidity in banking

organisations (extracts)33

Developing a Structure for Managing Liquidity

Principle 1: Each bank should have an agreed strategy for the day-to-day management of liquidity.

This strategy should be communicated throughout the organisation..

The liquidity strategy should set out the general approach the bank will have to liquidity, includingvarious quantitative and qualitative targets. This strategy should address the banks goal of protectingfinancial strength and the ability to withstand stressful events in the marketplace. A banks liquiditystrategy should enunciate specific policies on particular aspects of liquidity management, such as thecomposition of assets and liabilities, the approach to managing liquidity in different currencies and fromone country to another, the relative reliance on the use of certain financial instruments, and the liquidityand marketability of assets. There should also be an agreed strategy for dealing with the potential for bothtemporary and long-term liquidity disruptions.

Principle 2: A banks board of directors should approve the strategy and significant policies related

to the management of liquidity. The board should also ensure that senior management takes the

steps necessary to monitor and control liquidity risk. The board should be informed regularly of

the liquidity situation of the bank and immediately if there are any material changes in the banks

current or prospective liquidity position.

Because of the critical importance of liquidity management to the viability of any bank, the board shouldapprove the banks strategy for managing liquidity risk. The board should approve significant policiesthat govern or influence the banks liquidity risk. The board should also ensure that senior managementhas the policies and procedures in place to effectively monitor and control liquidity risk.

Principle 3: Each bank should have a management structure in place to execute effectively theliquidity strategy. This structure should include the ongoing involvement of members of senior

management. Senior management must ensure that liquidity is effectively managed, and that

appropriate policies and procedures are established to control and limit liquidity risk. Banks

should set and regularly review limits on the size of their liquidity positions over particular time

horizons.

Banks management should set limits to ensure adequate liquidity and these limits should be reviewed bysupervisors. Alternatively, supervisors may set the limits. Limits could be set, for example, on thefollowing:

I. The cumulative cashflow mismatches (i.e. the cumulative net funding requirement as apercentage of total liabilities) over particular periods next day, next five days, next month.

These mismatches should be calculated by taking a conservative view of marketability ofliquid assets, with a discount to cover price volatility and any drop in price in the event of aforced sale, and should include likely outflows as a result of drawdown of commitments etc.

II. Liquid assets as a percentage of short term liabilities. Again, there should be a discount toreflect price volatility. The assets included in this category should only be those which arehighly liquid i.e. only those in which there is judged to be a ready market even in periodsof stress.

Banks should analyse the likely impact of different stress scenarios on their liquidity position and settheir limits accordingly. Limits should be appropriate to the size, complexity and financial conditionof the bank. Management should define the specific procedures and approvals necessary forexceptions to policies and limits.

33 BCBS (2000)


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Principle 4: A bank must have adequate information systems for measuring, monitoring,

controlling and reporting liquidity risk. Reports should be provided on a timely basis to the banks

board of directors, senior management and other appropriate personnel.

The management information system should have the ability to calculate liquidity positions in all of themajor currencies in which the bank deals, both individually and on an aggregate basis. All banks should

have the ability to calculate their liquidity positions, on a day to day basis for the shorter time horizons(e.g. out to five days) and over a series of specified time periods thereafter, including for more distantperiods, in order to enable them to effectively manage and monitor their net funding requirements.

Assumptions should be set out clearly so that management can evaluate the validity and consistency ofkey assumptions and understand the implications of various stress scenarios.

Measuring and Monitoring Net Funding Requirements

Principle 5: Each bank should establish a process for the ongoing measurement and monitoring of

net funding requirements.

At a very basic level, liquidity measurement involves assessing all of a banks cash inflows against its

outflows to identify the potential for any net shortfalls going forward. This includes funding requirementsfor off-balance sheet commitments. A number of techniques can be used for measuring liquidity risk,ranging from simple calculations and static simulations based on current holdings to highly sophisticatedmodelling techniques. As all banks are affected by changes in the economic climate and marketconditions, the monitoring of economic and market trends is key to liquidity risk management.

An important aspect of managing liquidity is making assumptions about future funding needs. Whilecertain cash inflows and outflows can be easily calculated or predicted, banks must also makeassumptions about future liquidity needs, both in the very short-term and for longer time periods. Oneimportant factor to consider is the critical role a banks reputation plays in its ability to access fundsreadily and at reasonable terms. For that reason, bank staff responsible for managing overall liquidityshould be aware of any information (such as an announcement of a decline in earnings or a downgrading

by a rating agency) that could have an impact on market and public perceptions about the soundness ofthe institution.

Whereas many banks have historically relied on core deposits for the bulk of their funding, in today smarket environment, banks have a wide variety of funding sources that should be considered in managingliquidity on an ongoing basis. Cash inflows arise from such things as maturing assets, saleable non-maturing assets, access to deposit liabilities, established credit lines that can be tapped, and, to anincreasing extent, through securitisation. These must be matched against cash outflows stemming fromsuch things as liabilities falling due and contingent liabilities, especially committed lines of credit that canbe drawn down.

The relevant time-frame for active liquidity management is generally quite short, including intra-dayliquidity. In particular, the first days in any liquidity problem are crucial to maintaining stability. The

appropriate time-frame will depend on the nature of the banks business. Banks which are reliant onshort-term funding will concentrate primarily on managing their liquidity in the very short term (say theperiod out to five days). Other banks (i.e. those that are less dependent on the short term money markets)might actively manage their net funding requirements over a slightly longer period, perhaps one to threemonths ahead.

In addition, banks should collect data and monitor their liquidity positions in more distant periods.Collecting data on distant periods will maximise the opportunity for a bank to close the gap well inadvance of it crystallising.

Principle 6: A bank should analyse liquidity utilising a variety ofwhat if scenarios.

The scenarios should take into account factors that are both internal (bank-specific) and external (market-related).


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For each funding source, for example, a bank would have to decide whether the liability would be: (1)repaid in full at maturity; (2) gradually run off over the next few weeks; or (3) virtually certain to berolled over or available if tapped. The bank's historical experience of the pattern of flows and aknowledge of market conventions could guide a bank's decisions, but judgement often plays a large role,especially in difficult scenarios.

Principle 7: A bank should review frequently the assumptions utilised in managing liquidity to

determine that they continue to be valid.

Assumptions regarding liquidity:

a) Assets: assumptions about a banks future stock of assets include their potential marketabilityand use as collateral, the extent to which assets will be originated and sold through assetsecuritisation programs, and the extent to which maturing assets will be renewed, and new assetsacquired. In determining the marketability of assets, they can be segregated into four categoriesby their degree of relative liquidity:

the most liquid category includes components such as cash and government securitieswhich are eligible as collateral in central banks routine open market operations; these

assets may be used to either obtain liquidity from the central bank or may be sold orrepoed, or otherwise used as collateral in the market;

a second category is other marketable securities, for example equities, and interbankloans which may be saleable but which may lose liquidity under adverse conditions;

a less liquid category comprises a bank's saleable loan portfolio. The task here is todevelop assumptions about a reasonable schedule for the disposal of a bank's assets.Some assets, while marketable, may be viewed as unsaleable within the time frame ofthe liquidity analysis;

the least liquid category includes essentially unmarketable assets such as loans notcapable of being readily sold, bank premises and investments in subsidiaries, as well as,possibly, severely troubled credits;

assets pledged to third parties are deducted from each category.The view underlying the classification process is that different banks could assign the same asset

to different categories on the maturity ladder because of differences in their internal asset-liability management.

b) Liabilities: to evaluate the cash flows arising from a banks liabilities, a bank would firstexamine the behaviour of its liabilities under normal business conditions. This would includeestablishing:

the normal level of roll-overs of deposits and other liabilities;

the effective maturity of deposits with non-contractual maturities, such as demanddeposits and many types of savings accounts;

the normal growth in new deposit accounts.In examining the cash flows arising from a banks liabilities under abnormal circumstances(bank-specific or general market problems), a bank would examine four basic questions:

which sources of funding are likely to stay with the bank under any circumstance, andcan these be increased?

which sources of funding can be expected to run off gradually if problems arise, and atwhat rate? Is deposit pricing a means of controlling the rate of runoff?

which maturing liabilities or liabilities with non-contractual maturities can be expectedto run off immediately at the first sign of problems? Are there liabilities with earlywithdrawal options that are likely to be exercised?

does the bank have back-up facilities that it can draw down and under whatcircumstances?

Factors such as diversification and relationship building are seen as especially important inevaluating the extent of liability runoff and a banks capacity to replace funds. Nevertheless,when market problems exist, some high-quality institutions may find that they receive larger-than-usual wholesale deposit inflows, even as funding inflows dry up for other market

participants. However, banks should be wary of relying on this as a source of funding, ascustomers may equally decide to favour holding cash or transferring their assets outside thedomestic banking system.


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Some banks, for example smaller banks in regional markets, may also have credit lines that theycan draw down to offset cash outflows. While these sorts of facility are somewhat rare amonglarger banks, the possible use of such lines could be addressed with a banks liabilityassumptions. Where such facilities are subject to material adverse change clauses, then they maybe of limited value, especially in a bank specific crisis.

c) Off-balance-sheet activities (other than the loan commitments already considered): Contingentliabilities, such as letters of credit and financial guarantees, represent potentially significant drainof funds for a bank, but are usually not dependent on a banks condition. A bank may be able toascertain a "normal" level of cash outflows under routine conditions, and then estimate the scopefor an increase in these flows during periods of stress. However, a general market crisis maytrigger a substantial increase in the amount of drawdowns of letters of credit because of anincrease in defaults and bankruptcies in the market. Other potential sources of cash outflowsinclude swaps, written over-the-counter (OTC) options, other interest rate and forward foreignexchange rate contracts, margin calls, and early termination agreements.

d) Other assumptions: Correspondent banks offering services for foreign banks or provide access topayment systems for smaller domestic banks and other financial institutions should ask thesecustomers to forecast their payment traffic so that the bank can plan its overall liquidity needs. In

addition, net overhead expenses, such as rent, salary and tax payments, although generally notsignificant enough to b

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