A fluid state of affairs - Liquidity risk management policies are set to change

The Australian Prudential Regulation Authority (APRA) recently announced a review of its policy framework on liquidity risk management and the Basel Committee has set up a special liquidity work stream, which APRA also sits on. As a result, banks' liquidity risk management practices will soon be subject to much closer regulatory scrutiny

Colleen Cassidy, executive director at Ernst & Young and a specialist in regulatory issues explains: "Now that Basel II policy implementations have begun to wind down, regulators have the breathing space to focus on the next big risk for banks - liquidity risk.

"Regulators have alluded to a number of other drivers such as banks' greater concentration in more volatile wholesale funding, the possibility that banks have become complacent and a general re-think about how policy for liquidity risk is set," says Andrew Harmer, Ernst & Young partner and leader of the Financial Services Risk Management practice.

And, perhaps from the general public's perspective, this increased focus on liquidity risk is no bad thing. "Certainly, the funding difficulties experienced by financial institutions over the past few weeks in response to subprime lending losses in the US highlight the need for banks to be vigilant about liquidity risks," says Harmer.

Current obligations and the need for change

APRA's current framework is set out in Prudential Standard APS 210 Liquidity Risk. It requires that authorised deposit-taking institutions (ADIs):

- have a liquidity management strategy agreed with APRA that describes how they will measure, manage and assess their liquidity position. The strategy should include the tools that they will use, e.g., limits on maturity mismatches or diversifying funding sources; and

- measure liquidity risk using either a ratio-based approach, i.e., liquid assets to total liabilities (used by smaller ADIs with straightforward funding principles) or a cash-flow-based scenario analysis (used by larger/more complex ADIs).

According to Harmer, the problem with the current regulation is the amount of prescription in some parts of the Prudential Standard and the lack of focus given to other requirements. "APRA requires most banks to run name crisis scenarios and is very specific about what that entails. To date, the regulator has had less focus on other sorts of scenarios that banks are developing. With changes in market dynamics and industry practices, the regulation is in need of some amendments to ensure it remains relevant," he says.

But is this regulatory overhaul really necessary in Australia? It has been well over 10 years since an Australian bank experienced liquidity management problems sufficient to bring about a crisis of the type envisioned by APRA's existing policy framework. In fact, the performance of many Australian ADIs over the past decade has been so strong that a name crisis, or other form of liquidity pressure, is almost inconceivable.

Cassidy points out that the liquidity flow-on effects from credit quality concerns in the US have changed the playing field. "Regulators around the world are reviewing their liquidity policies and it is very likely that recent liquidity events will be an important factor in regulators' thinking. Regulators will be expecting ADIs to consider severe events that may occur without warning or evolve with an unexpected intensity."

How will the new regulation be structured?

Whatever policy reforms APRA chooses, it will need to keep in mind its objective of maintaining an appropriate balance between prescription regulation and principles-based requirements.

Increasingly, regulators are acknowledging that that one size does not fit all and principles-based regimes are more appropriate. It is therefore likely that APRA's policy reforms will be largely principles-based. That said, there are some aspects of APRA's approach where history suggests that the regulator will take a more prescriptive approach. One example is the setting of specific scenarios that ADIs need to consider in undertaking scenario-based modelling for liquidity - analogous to the changes recently made by APRA for the market risk arising in banks' trading activities.

Next steps

APRA's discussion paper is due to come out later this year. "In the meantime, it would be sensible for ADIs to start thinking about broadening the sorts of liquidity scenarios that are input into liquidity models, as well as developing a framework for how scenarios are derived," says Harmer.