# Q&A: Regulator calls for greater insurance against liquidity risk

On June 17, the working group released draft revisions to its Principles for Sound Liquidity Risk Management and Supervision, which were originally published in 2000. Changes to the principles were necessitated by the turmoil that began in the second half of last year, and which led to a drying-up of liquidity across wholesale funding and interbank markets.

As co-chair of the Basel Committee’s working group on liquidity, Arthur Angulo has been closely involved with efforts to update the principles, which aim to improve banks’ practices as well as bolster the powers of supervisors to take action whenever liquidity issues pose risks at institutional or systemic levels.

Risk: What impact do you hope the revised principles will have on liquidity risk management?

Arthur Angulo: I would point to two key objectives. The industry went through a long period of benign economic and financial conditions, which was marked by increasing asset prices and abundant liquidity. That led some banks to underestimate and under-prepare for the likelihood that one day liquidity would not be as abundant. So, first of all, the principles aim for a greater recognition of liquidity risks in banks’ risk management frameworks.

Secondly, better risk management practices are a necessary but not sufficient outcome. Supervisors will also expect banks to operate with a higher level of insurance against liquidity stress. After a period where banks operated with relatively thin liquidity cushions that left little margin for error, we now expect banks to operate with thicker cushions going forward.

Risk: What are the key differences between the latest principles and the original principles, published in 2000?

AA: One of the first things we did when drafting the latest guidelines was re-read the 2000 principles. The general feeling was that, if certain institutions had paid more attention to them, they would have fared better during the recent turmoil.

Having said that, both sets of principles are a reflection of the time they were written. In 2000, the guidance was developed in the aftermath of the Asian financial crisis – there was a heavy emphasis on the management of liquidity risk associated with cross-border and foreign currency exposures.

In contrast, the 2008 guidance devotes considerable attention to the interaction and implications of market liquidity on funding liquidity; particularly the management of contingent liquidity risks such as those associated with off-balance-sheet financing arrangements. More specifically, the principle in the new guidance recommending banks maintain an adequate level of liquidity - including having a cushion of liquid assets - was not in the 2000 report.

Furthermore, the 2008 guidance includes a separate, standalone principle on allocating liquidity costs, benefits and risks to all business activities. That means banks should have a robust internal transfer-pricing mechanism. Liquidity was treated as a free good at some fairly large organisations, who were clearly surprised that certain liquidity options they wrote actually came home to roost.

There are also new principles on the management of intraday liquidity and collateral. We worked very closely with the Committee on Payment and Settlement Systems to develop the intraday liquidity principle, not because it has been a problem in the current turmoil but because there previously had not been explicit guidance on this topic. Given the increased interdependencies of payment and settlement systems, and the implications should a major bank fail to meet certain critical payments, we thought it was important to develop guidance on this.

Risk: The principles do not make a specific recommendation on a regulatory charge for liquidity risk. Was this something that was considered by the working group on liquidity?

AA: As far as setting out as a specific capital requirement for liquidity, this was never on the table. Liquidity and capital are both important, but folks have a hard time with the idea of setting aside capital for liquidity. In terms of a liquidity ratio or quantitative metric that supervisors can hold banks to, that is also a difficult issue.

Periodically, over the past 30 years the Basel Committee has looked at the question but has never come to a firm resolution. The main reason for that, I believe, is that it is extremely difficult to reduce liquidity risk, especially for large institutions, to a single metric or set of metrics. What the revised principles hopefully do for supervisors is to outline the various elements that should be considered when assessing liquidity. They give them the tools to question the assumptions and judgements banks make, without prescribing a specific liquidity risk formula. Some supervisors do use that kind of formula for smaller banks, but this paper was aimed at larger institutions. Even the jurisdictions that do have such formulas recognise that they could only be a starting point when trying to fully capture liquidity risk at larger, complex banks.

Risk: The principles put the onus on banks to "clearly articulate" their liquidity risk tolerance and to have a capital cushion in line with this. Is this something that should be explicitly stipulated in institutions’ financial reports?

AA: We recognise that disclosure on liquidity is particularly sensitive for a lot of banks, particularly if there is any evidence they will be under strain. But, by the same token, we believe disclosure about liquidity positions and risk management should and can be enhanced. We want banks to do more to articulate their liquidity risk tolerance and outline the type of liquidity cushion they hold; what makes up that cushion in terms of assets and how liquid they are. This is not beyond the realm of possibility.

Risk: The principles advised supervisors to be more proactive on occasions when liquidity risks pose severe challenges to any institution. Do you have any thoughts on what supervisors can and should do in the event of this happening?

AA: There’s a section in the guidance that outlines what supervisors can do in making recommendations to banks under the normal supervisory process. If, for example, a supervisor goes into a bank and discovers its policies or internal controls do not address liquidity risk sufficiently, it can deal with this through the normal supervisory channels.

If the situation gets increasingly serious, supervisors have tools to increase the pressure on banks to get the desired outcome. They could, for example, require the bank to hold a higher cushion of liquid assets either through suasion or formal action. A supervisor could also put restrictions on a bank acquiring asset portfolios or businesses if it believes that management should first address existing liquidity weaknesses before taking on additional risk.

Ultimately, supervisors could even require a bank that has a weak liquidity position to operate with a higher level of capital. That would help it to withstand stress at the margin and hopefully provide enough confidence to counterparties that it can survive.

Risk: How will the Committee assess how the principles are implemented across jurisdictions?

AA: The principles raise the standards for liquidity risk management, both for banks and supervisors. Arguably, you could point to the 2000 guidance and ask whether there was sufficient follow-up by supervisors.

In the second half of this year, the Working Group on Liquidity will devote some time to looking at other things we can do to make the approach to liquidity risk supervision more consistent across jurisdictions. Hopefully this will yield some benefits, but irrespective of the outcome there is an expectation that national supervisors will, once this guidance is finalised, take it and apply it, and do a more rigorous job of assessing liquidity positions and risk management at the firms in the future.

I imagine there could be a formal assessment by the Basel Committee, drawing on the experience of national supervisors, at some point in 2009. There could also be further work by groups of supervisors to develop more consistent approaches, particularly around the home-host issue. This might allow host supervisors to rely more on the judgement of home supervisors in assessing liquidity. The industry is requesting this, and it is something we think is worth considering.

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