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    Iif liquidity paper_0307 Iif liquidity paper_0307 Document Transcript

    • Principles of Liquidity Risk Management Institute of International Finance March 2007
    • Principles of Liquidity Risk Management Table of Contents 2 IIF Special Committee on Liquidity Risk 6 Drafting Committee 7 Complex Financial Instruments Task Force 8 Executive Summary 10 Preface 12 General Notes 13 Emerging Liquidity Issues in a Changing International Environment 19 Recommendations on Industry Practice for Liquidity Risk 19 A. Governance and Organizational Structure for Managing Liquidity 27 B. Analytical Framework for Measuring, Monitoring, and Controlling Liquidity Risk 34 C. Stress Testing and Contingency Planning 40 Considerations for the Official Sector 44 Analytical Discussion 1: Reliance on Secured-Financing Sources 48 Analytical Discussion 2: The Impact of Complex Financial Instruments upon Liquidity-Management Policies and Practices 55 Appendix 1: Possible Sources of Liquidity Vulnerabilities and Potential Metrics 59 Appendix 2: Recommendations on Industry Practice for Liquidity Risk
    • IIF Special Committee on Liquidity Risk Chairman Vice-Chairman Mr. Ahmass Fakahany Mr. Chris Grigg Vice Chairman & Chief Executive Chief Administrative Officer UK Business Banking Merrill Lynch & Co., Inc. Barclays PLC Committee Members Mr. Armin Widjojoatmodjo Mr. Joseph C. Noto Senior Vice President Managing Director Directorate Group ALM London Corporate Treasury ABN AMRO Bank N.V. Bear, Stearns & Co., Inc. Mr. Charalambos Kourtidis Mr. Robert Upton Assistant Manager Senior Managing Director & Treasurer Risk Management Division Bear, Stearns & Co., Inc. Alpha Bank Mr. Christian Lajoie Mr. Jackson Ricardo Gomes Senior Vice President Senior Managing Director Basel II Group Coordinator Banco Itaú S.A. BNP Paribas Mr. Carlos Eduardo Lara Ms. Catherine Royere General Manager Liquidity Management Treasury ALM Treasury Banco Itaú S.A. BNP Paribas Mr. Alejandro González Sosa Mr. Michael G. Horrocks Executive President Executive Vice President Banco Mercantil, Venezuela Treasury & Risk Management CIBC Mr. Millar Wilson Chief Risk Officer Mr. Marc Weinberg Banco Mercantil, Venezuela Head of Global Liquidity Oversight Citigroup Inc. Mr. Richard Pattinson Head of Regulatory & Mr. Wolfgang Hartmann Industry Issues Member of the Board of Managing Directors Global Payments Chief Risk Officer Barclays PLC Commerzbank AG Mr. Miguel Angel Iglesias Mr. Willi Schwarz Head of Market Risk Department Senior Vice President BBVA Head of Market Risk Control Commerzbank AG 2
    • IIF Special Committee on Liquidity Risk Committee Members (continued) Mr. Markus Sunitsch Ms. Veronica Foo Managing Director Vice President Head of Liquidity & ALM Corporate Treasury Credit Suisse Goldman Sachs & Co. Mr. Cato Baldvinsson Mr. Michael Kurlander Senior Vice President Vice President Head of ALM Corporate Treasury Danske Bank Goldman Sachs & Co. Dr. Knut Pohlen Mr. John Flint Deputy Group Treasurer Group Treasurer Deutsche Bank AG HSBC Bank plc Mr. Geert M. Tuinema Mr. Edmund Stokes Head of Liquidity Management Head of Business Development Deutsche Bank AG Global Balance Sheet Management HSBC Bank plc Mr. Matthias Behrens Head of Liquidity Risk Control Ms. Vishakha Mulye Risk Governance and Controlling Group Chief Financial Officer Dresdner Bank AG ICICI Bank Limited Dr. Martin Knippschild Mr. Constant Thoolen Head of Strategic Risk & Head of Corporate Risk Management Retail Treasury Control ING Group N.V. Dresdner Bank AG Mr. Alessandro Frascarolo Mr. Michael Santer Treasury & Liquidity Management Group Liquidity Manager Intesa Sanpaolo S.p.A. Head of Foreign Exchange & Money Markets Erste Bank Mr. Renato Maino Head of Risk Capital and Policies Mr. Werner D’Haese Risk Management Department Market Risk Advisor Intesa Sanpaolo S.p.A. Central Risk Management Fortis Mr. Tod J. Gordon Managing Director Ms. Elizabeth E. Beshel Treasury Managing Director & Treasurer J.P. Morgan Chase & Co. Goldman Sachs & Co. 3
    • IIF Special Committee on Liquidity Risk Committee Members (continued) Mr. Rik Janssen Mr. Ulf Grunnesjö General Manager Senior Vice President & ALM Risk Management & Economic Capital Head of Investor Relations KBC Group N.V. SEB Mr. Paolo R. Tonucci Ms. Agathe Zinzindohoue Managing Director & Head of Funding Global Co-Treasurer Asset & Liability Management Lehman Brothers Société Générale Group Mr. Christopher B. Hayward Mrs. Helene Faracci-Steffan Senior Vice President Head of Asset & Liability Management Global Treasurer Société Générale Group Merrill Lynch & Co., Inc. Mr. Phil Leverick Mr. Marc Saidenberg Head of Balance Sheet Management Managing Director Group Treasury Regulatory Policy & Relations The Royal Bank of Scotland Group Global Treasury Merrill Lynch & Co., Inc. Mr. Bill Rickard Senior Manager Mr. Takeshi Ogasawara Group Treasury Executive Officer & General Manager The Royal Bank of Scotland Group Corporate Risk Management Mitsubishi UFJ Financial Group, Inc. Mr. A. Aykut Demiray Deputy Chief Executive Mr. Koji Nishiwaki Treasury & Foreign Relations Department Deputy General Manager Turkiye Is Bankasi A.S. Risk Management Division Mizuho Financial Group, Inc. Ms. Wendy Lucas Executive Director Mr. Michael Cervasio Group Treasury Internal Auditor UBS AG National Bank of Kuwait, S.A.K. Mr. Sergio Sorrentino Mr. Francois Tremblay Head of Market Risks & Head of Liquidity Management Basel II Project Corporate Treasury UniCredit Group RBC Financial Group 4
    • IIF Special Committee on Liquidity Risk Committee Members (continued) Mr. Alessandro Brusadelli Mr. Thierry Nardon Head of Group ALM & Managing Director Financial Planning Group Treasury Group Finance Area WestLB AG UniCredit Group Mr. Thorsten Kanzler Group Treasurer-Member of Division Board UB ALM/GB Group Treasury WestLB AG 5
    • IIF Special Committee on Liquidity Risk Drafting Committee Committee Members Mr. Richard Pattinson Mr. Edmund Stokes Head of Regulatory & Industry Issues Head of Business Development Global Payments Global Balance Sheet Management Barclays PLC HSBC Bank plc Ms. Catherine Royere Mr. Marc Saidenberg Liquidity Management Managing Director ALM Treasury Regulatory Policy & Relations BNP Paribas Global Treasury Merrill Lynch & Co., Inc. Mr. Marc Weinberg Head of Global Liquidity Oversight Mr. Francois Tremblay Citigroup Inc. Head of Liquidity Management Corporate Treasury Mr. Willi Schwarz RBC Financial Group Senior Vice President Head of Market Risk Control Ms. Wendy Lucas Commerzbank AG Executive Director Group Treasury Mr. John Flint UBS AG Group Treasurer HSBC Bank plc 6
    • IIF Special Committee on Liquidity Risk Complex Financial Instruments Task Force Chairman Mr. John Flint Group Treasurer HSBC Bank plc Task Force Members Mr. Richard Pattinson Mr. Geert M. Tuinema Head of Regulatory & Industry Issues Head of Liquidity Management Global Payments Deutsche Bank AG Barclays PLC Mr. Edmund Stokes Mr. Willi Schwarz Head of Business Development Senior Vice President Global Balance Sheet Management Head of Market Risk Control HSBC Bank plc Commerzbank AG Mr. Marc Saidenberg Mr. Markus Sunitsch Managing Director Managing Director Regulatory Policy & Relations Head of Liquidity & ALM Global Treasury Credit Suisse Merrill Lynch & Co., Inc. 7
    • Principles of Liquidity Risk Management1 ment of policy positions and in evaluation of firms’ positions and practices. Executive Summary It is important to underscore that the deliberations of the Special Committee demonstrated repeatedly that In late 2005, the Institute of International Finance (IIF) firms’ needs and strategies can, for legitimate business established a Special Committee on Liquidity Risk. The reasons, vary considerably, so that the Recommenda- Special Committee, chaired by Ahmass Fakahany, Vice tions proposed must be understood as describing a Chairman and Chief Administrative Officer of Merrill range of good practices, not a prescriptive list of nec- Lynch, with Chris Grigg, Chief Executive, UK Business essarily “best” detailed practices. Moreover, all Rec- Banking of Barclays as vice chairman, includes repre- ommendations and commentary apply on a “comply sentatives of about 40 of the largest global financial in- or explain” basis, and controlled firms may have good stitutions. The objective of the Special Committee was reasons to take quite different approaches. to develop a perspective and Recommendations on li- quidity risk measurement, monitoring, management, A brief overview of Emerging Liquidity Issues in a and governance at financial institutions. The focus is Changing International Environment offers a review timely, as the liquidity characteristics of international of market developments behind the analysis. While it markets have been undergoing significant changes at a can be argued that the markets have become more re- time when the industry and the regulatory community silient with recent innovation and increasing intercon- have been giving relatively greater attention to other nectedness, it cannot be known with certainty whether issues. The Special Committee is broadly encouraged new vulnerabilities have been created or old ones dis- by the growing sophistication of firms’ approaches to placed in ways that will need to be dealt with in the liquidity risk management and does not see any immi- event of a liquidity crunch. This appreciation of what nent cause for special concern. Nevertheless, increased we may not know or fully understand is why attention globalization of firms and the financial system, the in- to good practices is timely and why the industry on creasingly concentrated number of firms that provide the whole has made substantial investments in liquid- market volume and liquidity, the increased reliance ity risk management. on secured funding, and the lack of harmonization of global liquidity standards suggested that a closer look Both effective governance and organizational structure was needed. for managing liquidity are critical given that liquidity issues come up in various ways for firms with different This report focuses on funding liquidity risk, explor- mixes of business, funding structures, market char- ing appropriate practices and making a number of acteristics, and risk appetites. Because no formulaic Recommendations for the private sector on three approach will yield appropriate or prudential results broad topics: governance and organizational structure across the board, internal governance and controls are for managing liquidity; an analytical framework for the keys to reducing liquidity risk for a firm. Similarly measuring, monitoring, and controlling liquidity; and critical is public disclosure of information about each stress testing and contingency planning. The intent firm’s liquidity risk management practices. of the report is to raise expectations for liquidity risk management. The fundamental premise is that firms The analytical framework for measuring, monitoring, should deliver, and supervisory and regulatory ap- and controlling liquidity risk in each firm receives con- proaches should recognize, risk-management frame- siderable attention, reflecting the priority that firms works that are tailored to each firm’s business model need to give to developing appropriate measurement and market position. To this end, the report also in- and monitoring tools. Current risk-management tech- cludes some Considerations for the Official Sector that niques provide firms with clearer views, better-under- the Special Committee hopes will be useful in assess- stood internal strategies, and better control overall. 1 Related regulatory papers consulted include “Sound Practices for Managing Liquidity in Banking Operations,” Basel Committee on Banking Supervision, February 2000; “Sound Practices for the Management of Liquidity Risk at Securities Firms,” Report of the Technical Committee of the International Organization of Securities Commis- sions, May 2002; and “The Management of Liquidity Risk in Financial Groups,” The Joint Forum, Basel Committee on Banking Supervision, May 2006. They are referenced where appropriate. 8
    • Such techniques, however, require careful review of risk management structures. Although complete con- assumptions and experience to provide strong under- vergence of regulations may not be feasible, regula- pinnings for the sound judgment that each firm must tors should seek to harmonize regulations in order to apply to assessing its needs and risks in both business- facilitate sound internal risk-management systems. as-usual and stressed conditions in order to establish Liquidity regulations should be based on qualitative appropriate metrics and limits within its strategy. The approaches designed to foster sound enterprise risk Special Committee believes that no simple, prede- management, not prescriptive, quantitative require- termined metrics or quantitative measures with pre- ments. As part of any review of the regulatory and su- scribed assumptions would work to provide either ad- pervisory approach, the problem of trapped pools of equate liquidity safeguards or truly useful disclosures. liquidity must be addressed in order to enable groups Imposing such simple measures across institutions to manage firm-wide liquidity more efficiently and to might have some immediate appeal but is unlikely to avoid unnecessary potential problems. To this end, give truly comparable results across institutions. In central banks and settlement systems should expand fact the lack of comparability may render the informa- and harmonize the range of collateral that they ac- tion yielded by such measures at best not useful and at cept. Finally, central banks should consider providing worst potentially deceptive. greater and more uniform clarity on their role as lend- ers of last resort and, where they are not already doing Each firm’s liquidity management must include sub- so, participate more actively in firm- and system-wide stantial attention to stress testing and contingency contingency planning. Although this raises moral haz- planning. While methodological work is constantly ard issues that need to be managed, the trade-off be- improving sensitivity analyses and scenario testing, tween the ability to plan for a crisis against time-bound management judgment remains critical and the ques- “constructive ambiguity” needs to be reexamined. tion becomes, essentially, how to structure the process to make sure that modern and well-founded tech- Given their significance in recent market develop- niques are used to support but not to supplant good ments, the report highlights two additional emerging judgment. Part of that analysis needs to be focused on issues: the increased reliance on secured funding as an clearly understanding the role of central bank facilities incremental source of liquidity and the need to con- and the limits on these facilities. sider how complex financial instruments can affect a firm’s liquidity. Secured financing is now fundamental The short but significant list of Considerations for the to the liquidity profiles of international financial in- Official Sector reflects the concerns of the industry stitutions. Recommendations are thus aimed at firms’ about the increasing disconnect in globalized markets developing a deep understanding and robust planning between firms that conduct a substantial amount of for issues of access to secured funding, and refining their business across borders, often largely managed their risk-management and risk-mitigation practices. on a group-wide basis, and historical patterns of local Central banks’ policies have a critical effect on firms’ regulation. While it is essential to recognize the ben- access to secured funding, and this fact is a central efits of liquidity risk regulations, both for the public at facet of contingency planning. Similarly, the complex large and firms in the financial industry, and certain financial instruments that have emerged recently have jurisdictional constraints faced by the official sector, significantly affected the market, and while many of failing to adapt regulatory and supervisory structures these ways have been beneficial, Recommendations to more integrated and responsive markets may in- still are needed as to the prudent monitoring and ef- crease the chance of firm-specific or systemic cross- fective mitigation of the liquidity risks arising from border problems, and reduce the efficiency of liquidity such instruments. risk management for firms. It is the IIF’s hope and intent to generate a constructive As in other areas of regulation, it is essential that home dialogue on risk-management issues, using this report and host supervisors of international groups coordi- as a point of departure. nate their supervision of groups’ integrated liquidity 9
    • Preface there have been significant advances in risk-manage- ment practices at financial institutions and a strength- In late 2005, the IIF established a Special Committee ening of market infrastructure in recent years, struc- on Liquidity Risk. The Special Committee is chaired tural changes in markets, including growing product by Ahmass Fakahany, Vice Chairman and Chief Ad- complexity and the entry of new participants, as well ministrative Officer of Merrill Lynch, and Chris Grigg, as the important role of large and complex global insti- Chief Executive of Barclays UK Business Banking, is tutions, highlight the need for continual reassessment the vice chairman. It includes representatives from and improvements. Lessons from past market liquidity about 40 of the largest global financial institutions.2 crises can be studied with an eye toward steps that can The objective of the Special Committee was to develop be taken to prevent future crises and improve response a perspective and Recommendations on liquidity risk preparedness. The Special Committee deliberated as to measurement, monitoring, management, and gover- whether gaps exist in processes for timely internation- nance at financial institutions. This focus is timely, as it al information sharing among authorities at times of has been noted for some time that while a vast body of crisis. regulatory and academic literature exists about credit, market, insurance, and operational risks, relatively less A detailed but relatively informal questionnaire was attention has been given to liquidity risk. Moreover, a developed and distributed among IIF members. The proper distinction between the various types of liquid- responses formed the basis of this report and provided ity risk and corresponding risk measurement models a point of departure upon which a working group of and outputs is not always made. Concerns have also experts built its analysis.4 been expressed that the lack of harmonization of li- quidity requirements and practices at the international Recommendations for the Private Sector; Public-Sector level has resulted in suboptimal prudential and com- Considerations. The report proposes Recommenda- petitive conditions. To address these concerns and to tions that include objectives and specific and action- perform a review of industry practices, the IIF estab- able items. These Recommendations would apply lished a Special Committee on Liquidity Risk. under an umbrella “comply or explain” ethic, whereby industry participants who do not adopt, or develop In the course of preparing its Recommendations, the plans to meet, these Recommendations should be ex- Special Committee also considered the integration of pected to explain why they consider a particular Rec- liquidity risk with other existing risk-management ommendation inapplicable or inappropriate or why processes, namely, market, credit, and operational risk they have failed to comply with a Recommendation if management. In addition, it addressed the relationship it is applicable. between liquidity risk and capital adequacy require- ments, including the obligation to take liquidity into A number of Recommendations in this report origi- consideration for the purposes of Pillar 2 of Basel II, nate from the principles set out in the February 2000 Supervisory Review Process. Basel Committee on Banking Supervision (BCBS) pa- per, “Sound Practices for Managing Liquidity in Bank- There has been growing private sector and regulatory ing Operations.” The principles represent a sound concern in this area. The Counterparty Risk Manage- foundation to build on and from which to reflect on ment Policy Group II in its report states, “The evapo- the increase in the complexity of the financial industry ration of market liquidity is probably the second most and its products since their adoption in 2000. important variable in determining whether and at what speed financial disturbances become financial shocks In addition to the Recommendations for the private with potentially systemic traits.”3 The Special Commit- sector, this report includes a short but significant list tee considered not only institutional liquidity, but also of Considerations for the Official Sector that reflect the resilience of the financial system to shocks. While the concerns of the industry about the increased dis- connect in globalized financial markets between firms 2 See the list of participants attached. 3 “Toward Greater Financial Stability: A Private Sector Perspective,” The Report of the Counterparty Risk Management Policy Group II, July 27, 2005. 4 Responses to the questionnaire were provided on an anonymized basis with distinctions being made only between commercial and investment banks and domicile. 10
    • that conduct a substantial amount of their business platforms, but their perspective has likely not been com- across borders, often largely managed on a group-wide pletely covered. basis, and historical patterns of local regulation. While it is essential to recognize the benefits of liquidity risk The report highlights the differences between cash regulations, both for the public at large and firms in management and long-term structural balance-sheet the financial industry,5 and certain jurisdictional con- management. It focuses on both the short-term need to straints faced by the official sector, failing to adapt reg- survive the initial period of a crisis as well as structural ulatory and supervisory structures to more integrated long-term liquidity management. In the context of the and responsive markets may increase the chance of report, liquidity-management issues include business- firm-specific or systemic cross-border problems. as-usual and anticipating stressed conditions. Scope of the Inquiry. The report begins with a section The report does not, however, address the intraday li- on “Emerging Liquidity Issues in a Changing Interna- quidity issues that have recently attracted the attention tional Environment” that offers a brief review of market of the world’s central banks, for example, those concerns developments and other environmental factors. This addressed by the Board of Governors of the Federal Re- section sets the stage for the analysis in the balance of serve System in its consultation paper “Intraday Liquid- the report. The report also includes Analytical Discus- ity Management and Payment System Risk Policy,” June sions on “Reliance on Secured-Financing Sources” and 15, 2006.6 “The Impact of Complex Financial Instruments upon Liquidity-Management Policies and Practices.” The scope of the report is not so wide as to address busi- ness continuity issues. The link between a pure liquidity It should be noted that the members of the Special crisis and a business continuity problem is shown within Committee were drawn from internationally active the report, but the main focus is on managing a liquidity banks, including large and medium-sized, or regional, crisis regardless of its origin. banks, but not from small, local, or primarily domestic banks. We acknowledge the report’s focus and also note Focus on Funding Liquidity Risk. The report distin- that there are liquidity issues with respect to smaller, guishes between the risk to funding the firm, which is noninternationally active banks that need to be ad- referred to as “funding liquidity risk,” and the risk that dressed separately. Furthermore, the report addresses a particular on- or off-balance sheet market or prod- liquidity issues as confronted by commercial and in- uct is illiquid, which is referred to as “market liquidity vestment banks, not other sectors of the financial in- risk.” As noted in the May 2006 Joint Forum document dustry such as the insurance industry or hedge funds. entitled “The Management of Liquidity Risk in Finan- This narrower scope does not suggest that firms with cial Groups,” funding liquidity risk is “the risk that the insurance as well as commercial or investment bank firm will not be able to efficiently meet both expected platforms should manage liquidity in their insurance and unexpected current and future cash flow and col- platforms completely separately from the other plat- lateral needs without affecting either daily operations forms or that liquidity-management principles for the or the financial condition of the firm.” The same docu- insurance platform should necessarily differ materially. ment describes market liquidity risk as “the risk that a This report recommends a central liquidity-manage- firm cannot easily offset or eliminate a position without ment oversight function for firms with multiple plat- significantly affecting the market price because of inad- forms and legal entities, irrespective of whether firms equate market depth or market disruption.” The close have chosen a decentralized or centralized liquidity- link between these two risks is recognized both by the management structure, so that such potential issues as industry and the Joint Forum, including the fact that contagion risk can be identified and addressed early. common events may trigger both. This report primarily Other Recommendations in this report may also ap- addresses funding liquidity risk. ply to firms with no commercial and investment bank 5 Firms draw some comfort in knowing that their counterparts have to meet sound minimum regulatory standards, provide disclosure of their practices, and are subject to regulatory oversight. 6 In order to avoid duplication of work we have also referenced within the report studies by other parties. 11
    • Range of Practices. The responses to the questionnaire differences. This would help supervisors and regulators reflected a range of practices. To some degree, these to understand that the differences between the entities differences reflect firms’ assessments of suitable ap- justify the range of practices. Furthermore, it would proaches to unmitigated liquidity risk tolerance, and help supervisors and regulators understand the differ- some firms believe that it is important to strike a bal- ences, identify the outliers, and make informed deci- ance between an appropriate level of funding liquidity sions, as opposed to requiring conformity. risk and mitigation costs. Fundamentally, firms need to define and manage their own risk appetites within The Special Committee hopes this report contributes to basic prudential limits that take into consideration the understanding of liquidity risk and its management their current and prospective financial conditions.7 and that the proposed Recommendations contribute to Banks may with perfect reason conclude as a matter better management and supervision of liquidity risk. of business strategy that total risk elimination would be too costly and then manage their liquidity risks ac- General Notes: cordingly. The term “firm” is used in this report as a generic term In addition to differences deriving from varying risk and may refer to the group, the parent firm, or an in- appetites and risk profiles, many legitimate differences dependent subsidiary. Whenever pertinent, specific result from firms’ histories, cultural traditions, legal references are made to these entities or others, such as structures, markets in which they operate, complexity, “branches.” or management philosophies. This report encourages embracing these differences across firms, which de- References in this report to the “board of directors” of pend on diverse business models, such as those result- a firm should be read with reference to the context of ing from centralization or decentralization of manage- each firm. In some countries, this term may refer to the ment. most senior level of management, in which case “super- visory board” corresponds to what other countries refer The intent of this report is to encourage an overall to as “board of directors.” raising of expectations while not imposing a rigid template on a rapidly changing industry. We recog- In addition, references to the “board of directors” should nize that firms must manage their own risks and needs always be understood to include a committee, properly and develop tailored models and approaches within an constituted under the firm’s charter and applicable law, acceptable range. It should also be kept in mind that to which relevant authority has been delegated by the the theoretical best may be the enemy of the practical full board. good and that firms need to be prudent and thought- ful given their particular needs. What might have been Where local law permits and it is customary to do so, bright lines in the past may now be best addressed on a and if appropriate internal authority exists, the Special “comply or explain” basis. Committee believes it is acceptable for senior manage- ment to approve policies or take other actions that may, The report also encourages firms to increase transpar- in other firms, be reserved to the board or a committee ency and to provide additional information in their fi- of the board. nancial statements to increase understanding of such Risk-appetite considerations are covered at several points in this report, notably in Recommendation 8. 7 12
    • Emerging Liquidity Issues in a investors. In reaction to these events, there were with- drawals of liquidity from the global financial system by Changing International Environment investors as the appeal of carry strategies declined and economic fundamentals came into question in high- This study addresses liquidity questions at a time of ex- yield markets. Thus, at the global investor level, some traordinary change. Recent economic conditions have tightening of liquidity occurred in emerging markets, been benign, yet the implications of rapidly chang- and the period of May–June 2006 exhibited increasing ing markets and technologies, cross-border financial volatility compared to previous low levels. system consolidation, growing interdependencies of markets, new market infrastructures and participants, The one thing that is certain is that the recent benign regulatory and accounting change, and even improve- markets are unlikely consistently to characterize fu- ments in the sophistication of liquidity risk manage- ture periods. Indeed, the USD has exhibited signs of ment, merit thoughtful attention by both the private weakness since the latter part of November 2006 as and the public sectors.8 As is often noted, develop- investors’ concerns have risen over the willingness of ments that generally strengthen liquidity in the system countries with large current account surpluses to con- may shift risks or create new risks in ways that are not tinue to accumulate substantial USD assets. Hence the yet fully understood. need to take a fresh look at liquidity issues, taking into account market changes over the past decade, particu- To some degree, the greatest liquidity risk to global larly during the low-volatility period. financial stability may be the pace of change and the need to understand what is new, modified, or inter- Globalization Context. The increasing consolidation acting differently. The private sector perspective pro- and centralization of financial groups with the grow- posed here has been developed with an eye toward ing integration of financial markets means that firms these developments, but also with an appreciation of will increasingly have dispersed, multilateral obliga- what remains to be well understood. tions, commitments, and assets that they will need to subject to coherent risk management. Globalization Background and Context of the financial system collides with the policies and procedures of traditional home and host supervisors This section offers a brief review of environmental fac- and local supervision of international payment and tors to set the contextual stage for the analysis in the settlement systems. This divergence from traditional balance of the report. jurisdiction-circumscribed regulatory, monetary, and political management constitutes a profound policy Economic Context. The fundamental background fact challenge for public and private sectors alike. to this report is that the past few years have been a time of benign markets, resulting in compressed risk pre- Technological Context. The acceleration of communi- mia, when there has been pressure on investors and as- cations and the vastly increased power of firms to col- set managers to press the “search for yield” into poten- lect and analyze data are well known. These changes tially riskier territory. At the same time, there has been underpin much of the present discussion, but also are concern among economists that a sudden unwinding worth mentioning independently. of global imbalances could result in a weakening of the U.S. dollar (USD), and, with higher U.S. interest rates, Similarly, market developments, such as the continuous that could lead to reduced global liquidity. In the recent linked settlement system (CLS) and greater reliance on past there have been indications that concerns about real-time gross settlement (RTGS) of payments, have global growth and inflation and the ability of industri- very substantially reduced settlement risk in important al countries to manage monetary policy effectively in segments of payments and foreign exchange, albeit at a an uncertain environment will lead to higher volatility price of perhaps moving liquidity stress points to other in financial markets and a new risk aversion among The May 2006 Joint Forum paper has been important in catalyzing discussion, but other public-sector agencies, including the IMF, European Central Bank, European 8 Commission, Federal Reserve Bank of New York, and many others have addressed aspects of the issues raised here. 13
    • parts of the system. Securities settlement systems have the private and public sectors. This report provides a also reduced their internal risks, at a cost of increasing general discussion of this topic as well as a series of collateral requirements. Recommendations. The Bank of England’s introduction of fundamental Derivatives/Structured Transactions. The development reforms in the sterling money market9 to reduce po- of credit derivatives has given banks greater freedom tential liquidity bottlenecks, the U.S. Federal Reserve’s to manage their balance-sheet constraints and risks. continuing long-term process of close study of and Moreover, credit derivatives have enabled banks to take improvement to the functioning of the USD intraday a more market-driven view of credit in general. Like markets, and the introduction of the euro and the Eu- securitization transactions, credit derivatives allow the ropean Central Bank’s development of margin lending shift of longer-term risk to other market players who in a large Eurozone all change the picture from what seek to hold and manage it because of their desired it was a few years ago and reflect policy attention to risk profiles. In addition, the new risk markets allow multinational liquidity issues. a greater degree of market-based pricing of credit, al- though post-transaction marking to market remains Finally, Internet banking is developing rapidly, even highly problematic for many areas of lending. (or especially) for small retail customers. While Inter- net banking changes delivery channels, it may also af- There is also a significant argument to be made that fect the nature and behavior of products, as discussed more liquid bond markets, securitization, and credit below. These changes allow corporate and retail cus- derivatives are reducing the traditional pro-cyclical- tomers to more easily compare product offerings and ity of bank lending by creating more market transpar- economics and make rational decisions. ency, which allows both earlier identification of credit issues for specific debtors and the market as a whole Issues Arising from Changes in Banking Funda- and more diversification of the investors in the market. mentals This yields better market pricing and more flexible re- sponses to cycle dynamics.11 The following observations are broad generalizations that apply unevenly across firms and countries but re- Credit derivatives markets have faced certain infra- flect fundamental developments. structure issues, which are now being resolved, albeit at a substantial cost in Information Technology (IT) Securitization.10 While market developments over investment and personnel.12 More basically, these mar- many years have led banks to be more dependent on kets have developed rapidly against the background of secured finance, regulatory developments, including what could have been a systemically serious issue born Basel II, have been significant in spurring further de- of the Long-Term Capital Market incident of 1998, velopment of asset-backed (including covered-bond) which required concerted private-public sector efforts channels. Securitization has a long and deep history in to resolve a serious liquidity problem. Since then, the certain products and markets, but the pace of devel- markets have weathered such substantial storms as opment appears to be accelerating. These are positive the downgrading of General Motors’ and Ford’s debt trends for market liquidity and for the reduction in in 2005 and the Amaranth failure of 2006 relatively funding liquidity risk, as are recent advancements in smoothly, in part because the developing depth and secured-funding markets. However, there are risks in- diversification of investors provided market flexibility. volved in these trends, which have been noted by both 9 “Reform of the Bank of England’s Operations in the Sterling Money Markets: A paper on the new framework by the Bank of England,” April 2005. 10 See the Analytical Discussion 1: Reliance on Secured-Financing Sources. 11 See “The Influence of Credit Derivative and Structured Credit Markets on Financial Stability,” Global Financial Stability Report, IMF, April 2006. The alleged procyclicality of Basel II would also be somewhat mitigated by this effect. 12 As is well known, back-office and market-practice questions about confirmation and novation of credit-derivative transactions caused considerable concern over the past year; however, a concerted effort by the private sector, with helpful catalysis by the Federal Reserve Bank of New York, the Financial Services Authority, and other public- sector authorities, has substantially reduced the problems. Back-office, technological, and market-discipline approaches have all contributed to reducing the problem. 14
    • Much of that market capacity has been provided by The more equity-like tranches of both securitization hedge funds. Substantial concerns about the potential and credit derivative transactions, which have often behavior of these funds in a market crisis have been been retained by originating institutions, also may expressed by some central banks. What is the true im- create exposures that could weaken an institution in a pact of hedge funds or similar actors, particularly non- time of stress; new opportunities to off-load such expo- regulated ones, on the markets? Can they be counted sures have developed but could dry up in such times. on to continue to participate, or will they “rush for Market developments, improved internal economic the exits”? Other official observers, although cautious capital analysis, and the more risk-sensitive regula- about the limitations of current knowledge, have been tory approach of Basel II should reduce such risks, al- more sanguine about the role of hedge funds noting, though prudence suggests that they will be least liquid for example, that managers of these funds quickly en- (or most expensive to dispose of) in difficult markets. tered the market to seize perceived opportunities at the time of the 2005 downgrades. Many observers have found grounds for optimism in the fact that some investors, such as hedge funds, have Insurance companies and pension funds have longer been willing to take on more risk, even in moments of liability horizons and avoid the classic bank mismatch market uncertainty. Still, it is notable that a substantial problem. They are better placed in some respects to part of the liquidity resilience of these new markets acquire and hold risk transferred by banks via securiti- (and of their ability to shift risk away from banks to zation transactions or credit derivatives. Such institu- other sources of capital) depends on the opportunistic tions sometimes face legal-investment or capital con- behavior of a relatively new, unregulated class of insti- straints that may limit their ability to participate in the tutions whose strength is its readiness to change form new markets, and, a few years ago, their understanding and pursue new strategies opportunistically.14 Liquid- of credit derivatives and other new instruments was ity also depends to some extent on insurance compa- sometimes questioned. If there was an issue with the nies and pension funds that, for many good reasons, sophistication of such investors, it is now much re- approach the markets with caution. duced, at least for the major firms. In addition, the in- terpretation of ratings of nontraditional instruments, The financial system ultimately cannot reduce actual such as collateralized debt obligations (CDOs), is now economic risk, but can only transfer it to parties with better understood than even a short time ago.13 different time horizons and risk appetites and dilute it by diversification. A good deal of firms’ examination However, questions still arise about the willingness of liquidity issues against the foregoing market devel- of such investors to participate in markets in stressful opments has to do with hedging against the behavior times, especially when one-way markets occur, even of institutions that have generally done a good job of if some have argued in parallel that high-quality as- providing risk intermediation in the new markets. set-based securitization (ABS) could represent a better refuge than high-quality corporate bonds in times of Thus, there is much to be encouraged about in recent crisis because the specifics of the underlying exposure developments, but experience is limited, and it cannot are more transparent. In addition, as the market de- be said with certainty how the markets will perform in velops, there are more bespoke, illiquid products and severely adverse circumstances. more products with longer time horizons, which are more difficult to price. The willingness of investors Concentration Questions. A further issue is the relative to take on these risks has not been tested outside of concentration of the dealer side of the market (and relatively calm conditions. There is a chance that mar- at a more macro level, the consolidation of the inter- kets that appear to be developing well from a strategic national top tier of firms into large, complex institu- viewpoint may suddenly lack depth at critical points tions). A few large firms provide a large part of the vol- in time. ume and liquidity in certain markets. The prospect of 13 The question has been whether investors fully understood the differing risks and default behavior of instruments, such as CDOs, as opposed to traditional bonds. While some investors may still be uncritically reliant on ratings on their face, there is less excuse for this now that a great deal has been written on the subject. Moreover, the rating agencies are considering new approaches, such as “stability scores” that provide more tailored ways of assessing transactions. 14 This report does not focus on counterparty risk, which has been amply treated elsewhere, but of course, counterparty risk must be part of any institution’s prudent analysis of its participation in the market. 15
    • a significant player disappearing from the market has Greater reliance on secured finance requires a focus been a source of concern, although efforts at modeling on the hierarchy of liquidity characteristics of differ- what would happen have suggested that the market is ent types of collateral. Good collateral (with qual- large enough and mature enough to deal with such an ity obligors, subject to market-appropriate haircuts) eventuality. Originators and dealers in securitization is the best assurance of liquidity and the best assur- markets are less concentrated, at least in the most fre- ance of avoiding moral hazard or inappropriate reli- quently traded instruments. Nonetheless, participants ance on lenders of last resort. Yet regulatory require- in, for example, home-currency mortgage securitiza- ments, jurisdiction-specific central bank expectations, tion markets, can be relatively few, although it would and clearance-system limitations combine to create a be the potential desire of a smaller or less-involved disconnect between collateral sources that remain to player to offload assets in a crisis that would be the a substantial extent compartmentalized on tradition- likely issue rather than the capacity of major dealers. ally defined bases and by the globally driven needs of many firms. In addition, collateral has a cost, and un- A broader question is the interconnectedness of mar- necessarily burdensome requirements not only impose ket participants, especially the largest institutions that costs on firms but also act as a brake on the efficiency participate in many markets across multiple products, of the financial system as a whole. currencies, settlement systems, and jurisdictions. The world’s large and complex financial institutions are Much could be said about the technicalities of collat- deeply and increasingly interconnected, which raises eral questions; however, the basic problems are simple. liquidity issues because they provide so much of the How can a global market find ways to leverage avail- market volume that they – and their clients – rely on. able collateral and remove artificial roadblocks so as to use that collateral to avoid liquidity problems for Collateral Issues.15 Participants in the financial system participants in any local or sectoral market? today are much more reliant on secured finance than in the past.16 This is part of the overall shift away from To some extent, the problem is a technical one of trans- customary banking toward market-based finance, but ferability; however, technical problems should be rela- large commercial banks in general are significantly de- tively easy to overcome since much collateral is held in pendent on their ability to marshal collateral for repur- Central Securities Depository (CSD) or International chase agreements (repos) and other secured-financing Central Securities Depository (ICSD) systems, from vehicles. In this they are like investment banks in that which it could be made available to any pledgee (in- they use wholesale funding sources in largely profes- cluding central banks) on short notice. Direct trans- sional markets. The degree of this reliance on the mar- fers are not yet seamless, but they are continuing to be kets (in addition to wholesale markets for certificates of nudged in at ever greater ease and speed. Legal ques- deposit (CDs) and commercial deposits), rather than tions have been reduced compared to 20 years ago, al- on retail deposits, varies from firm to firm, but the fact though there remain legal doubts and efforts such as is well established, especially for the large, cross-bor- the proposed Hague Convention have become bogged der institutions. down. Thus, the market does need to push to do more to address the problems of international usage of col- Outright disposals of assets are less vulnerable to firm- lateral, but the most fundamental problems are else- specific issues but, of course, raise potentially severe where. business issues if selling into down markets occasions substantial losses. In addition, asset sales, particularly “Interoperability” of collateral is more of an issue than outside of trading and available-for-sale books, can transferability. Progress has been made in this area, but have deleterious tax consequences. more needs to be done to ensure the clear, undisputed availability of government obligations and other high- Traditional secured-lending and repo markets depend quality collateral from national system to national sys- on the ready availability and acceptability of collateral. tem. The restrictions that result in “trapped pools of 15 Please refer to the collateral-marshalling ideas in the document “Managing Payment Liquidity in Global Markets: Risk Issues and Solutions,” Report by the Cross-border Collateral Pool Task Force, The Payments Risk Committee, March 2003. 16 See the Analytical Discussion 1: Reliance on Secured-Financing Sources. 16
    • collateral” need to be lifted. Even if the aggregate of of liabilities and, in many countries, experience sug- collateral anachronistically locked up in national can- gests highly consistent behavior since the beginning of tonments is, as some contend, greater than the amount industrialization. Yet this should not stop firms from that would be maintained by firms if they were free to continually challenging their assumptions, especially use global pools of collateral, the net power of readily in marketplaces in which change is material and oc- transferable, widely accepted collateral across global curring rapidly, as even modest changes to erosion fac- markets to protect against liquidity crises and conta- tors could have a notable impact on liquidity. gion would quite likely be greater.17 How is this experience affected by technological change Although it is not the purpose of this report to address and the large intergenerational wealth transfer cur- intraday mechanics, the shift toward real-time gross rently underway? Where firms are becoming increas- settlement of payments moves the burden away from ingly reliant on on-line deposits, are past assumptions credit toward liquidity risk. Central banks typically about the stickiness of consumer funds still holding? make intraday secured credit available for liquidity Are customers with only an on-line relationship, who purposes. And central banks should have an incentive can more easily move funds electronically, significant- to accept as wide a collateral range as possible to re- ly more prone to changing firms to obtain better rates duce collateral costs and prevent settlement delays or or to react to negative news about their current firm? blockages. But restricted eligible collateral remains a What are the practical obstacles to closing out on-line problem for firms, especially those that must manage relationships that may restrain transfers? Firms that obligations in a number of payment and settlement focus on on-line business are cognizant of these issues systems. and approach them conservatively. But how conserva- tive to be about such assumptions remains somewhat A situation could arise in which a house is highly liquid speculative and varies by the market. Even outside overall but could still face a difficult situation in one of the “e-banking” sphere, well-informed consumers system because of restrictions and transfer problems. may prefer not to deal with a bank whose reputation is This risk is compounded by the fact that collateral may questioned, simply to avoid the frictions of recovering become more difficult to move in a crisis, which could funds if a failure occurs, even if their funds are fully exacerbate risks or create unnecessary liquidity block- covered by deposit insurance.18 ages. Obstacles to effective access to collateral, based on outdated market models, may deepen a crisis rather Beyond these simple but basic questions, big-picture than alleviate it. This potential problem is on top of the questions can also affect these issues. Changes in in- day-to-day fact that firms must finance and warehouse ternational capital flows and in global liquidity affect liquidity (i.e., cash and collateral positions) on the bal- each other and may in turn be affected by political ance sheet on a basis that is suboptimal from a global motivations, especially where global imbalances are perspective. concerned. Such macro effects may then affect the be- havior of professional investors and their willingness Behavior of Liabilities. Behavior of demand and un- to deploy liquidity and accept risk. restricted savings deposits, and of retail instruments such as short-term certificates of deposit, remains Concluding Remarks highly predictable and easily modeled under most cir- cumstances. The effects of deposit guarantees and the There is an argument that market innovations may inertia of consumer behavior are well known. This is tend to smooth out cyclicality and provide liquidity. hardly surprising given that banks have literally hun- On the other hand, the argument is also made that the dreds of years of experience with the most basic types overall effects of recent innovations in instruments 17 This is a separate point from the equally important point that well-managed firms that are diversified across multiple markets should generally be stronger for the diver- sification. 18 Quite apart from the question of “stickiness,” when a bank’s name comes into question, the volatility of consumer funds may be increased by on-line competition both among banks and with highly liquid money market funds, or, where permissible, by third-party brokering of insured deposits. 17
    • and diversification of participants in markets may be The point of this section is not to be alarmist. Quite a shift to less-frequent but higher-impact crises.19 The the contrary. There are substantial indications that the concern would be that all of these innovations are ef- resilience of markets that are wider, deeper, and more fective so long as participants can see opportunities in diverse on the investor side, and vastly larger than ever difficulties, which has been the case recently; however, before, has increased, thanks to technology, financial it is not clear how these new market factors would per- innovation, and interconnectedness, and that this re- form in a crisis that appears extraordinarily difficult to silience outweighs the vulnerabilities created by the participants. Furthermore, many of these market in- same factors. But we cannot know for sure. That is the novations have existed only during periods of relative reason for the industry’s reflections in this report, the calm in the markets. Difficulty with a few key players reason for very substantial investments in risk man- could have a profound impact on the functioning of agement and stress testing, and the reason for the these markets. Recommendations for greater transparency and incre- mental collaborative mechanisms between the public and private sector in contingency planning. See, for example, Sir John Gieve, “Financial System Risk in the UK - Issues and Challenges,” Bank of England Web site, speech to the Center for the Study of Financial 19 Innovation, July 25, 2006. 18
    • Recommendations on Industry Practice The following Recommendations refer to liquidity management under both normal circumstances and for Liquidity Risk stressed conditions. The previous section provides the context from which A. Governance and Organizational Structure for the IIF Special Committee on Liquidity Risk concluded Managing Liquidity: that it would be time well served to examine interna- tional liquidity issues. New instruments, newly global Liquidity Risk Definition competition, reliance on secured-funding alternatives, and the rapidly increasing sophistication of risk man- Recommendation 1: Firms should define the differ- agement require a new perspective on liquidity ques- ent forms of liquidity risk to which they are exposed tions. (including relevant subsets within each form defined); identify where they fit in their enterprise risk universe; This is very much a private sector discussion, and it is and communicate these definitions across their groups intended to be useful to private sector executive man- so that a common understanding is applied when iden- agement and liquidity-management departments in tifying and evaluating liquidity risk related to existing evaluating their risk-management efforts for liquidity. businesses, business reviews, new businesses, products The report is intended to suggest food for thought rath- or initiatives, and acquisitions and alliances. er than categorical prescriptions. It outlines reasonable practices on many aspects of liquidity management, Recommendation 2: Firms should distinguish be- but one of the conclusions of the Special Committee tween funding liquidity risk and market liquidity risk is that firms vary considerably in their needs, their in their enterprise risk universe. Within funding li- management styles, and their risk appetites. There is quidity risk, firms should address their practices re- little scope for single-answer solutions and consider- lated to the management of the following (on a time able need for flexibility within prudentially reasonable continuum for the first two subsets): parameters, given that decisions about how to man- age liquidity often reflect basic business strategy over • Structural liquidity risk (over one year – long- which the firm must retain control in an increasingly term, or strategic gap, ratios and funding mix; competitive and globalized market. cash capital; survival horizon), • Tactical liquidity risk (similar concepts as long- The report’s Recommendations, therefore, should be term but for shorter terms; operational, cash considered just that: directional suggestions of issues flow), intraday (cash and collateral manage- that good risk managers should think about, not for- ment), and mulae or prescriptions for what they should do. With- • Contingency liquidity risk (stress testing, i.e., in the scope of the principles suggested here, there is a sensitivity analysis and scenario testing, special considerable range of reasonable responses. Moreover, liquidity asset pools, contingency plans, ratios, it should always be understood that a firm may, on and earmarked liquidity asset pools). the basis of its business mix and strategy, decide that a Recommendation is better disregarded than followed, Discussion: even within the usual range of flexibility. Therefore, to the extent that the market or a supervisor might ques- Firms generally make a clear distinction between fund- tion any firm’s response to any Recommendation, the ing liquidity risk and market liquidity risk.21 In defin- “comply or explain” principle always applies: the firm ing these risks, firms can be influenced by regulatory should be able to provide a good explanation of its definitions. Market liquidity risk is usually considered strategic or tactical choices, on the one hand, and, on a form of market risk. the other, the market or the supervisor should accept a firm’s well-grounded rationale for the way it chooses to proceed.20 The Special Committee recognizes that the level of flexibility available to each firm for choosing not to comply may vary by Recommendation. 20 For definitions, differences, and links between these two forms of liquidity risk, see the Preface to this document. 21 19
    • In defining funding liquidity and/or market liquidity Recommendation 4: A firm’s board of directors (or a risk, firms make reference to how issues with the man- committee thereof under delegated authority) should agement of this risk may affect financial performance approve the strategy and significant policies related to and to wanted and unwanted outcomes of liquidity the management of funding liquidity risk under both management. Issues typically considered include: normal and stressed conditions and review and ap- prove these policies annually. Board-approved docu- • Risk to earnings and capital of a significant im- ments should identify key funding liquidity limits and pairment in the ability to meet on a timely basis approval levels, as well as those authorities delegated any financial on- or off-balance sheet obligations to senior management committees or those executives as they fall due; accountable for approving detailed strategies, goals, • Material, sudden, and unexpected increases in procedures, limits, and exceptions. The board should funding costs and liquid asset price discounts/ also ensure that senior management takes necessary collateral margins; steps to appropriately manage, measure, monitor, and • The inability to achieve an optimal and cost-ef- control funding liquidity risk in an integrated fashion ficient liability structure; with other closely associated risks to facilitate enter- • The inability to monetize assets due to loss in prise-wide risk-management solutions. The board market access or insufficient market depth; should be informed regularly of the funding liquidity • The inability to conduct business as a result of position of the firm (metrics, indicators, and outlooks), reduced secured- or unsecured-funding capac- and immediately notified if there are any material ity and/or liquid assets or as a result of a lack of changes in the firm’s current or prospective funding these; and liquidity positions. • The need to meet requirements in normal and stressed conditions. Recommendation 5: Firms should have a manage- ment structure in place to effectively execute their In general, regulators are more interested in short-term funding liquidity strategies. Roles and responsibilities and intraday liquidity-management practices under of various board and senior management committees stressed conditions, whereas rating agencies are more in the funding liquidity-management structure, as interested in structural liquidity under stressed condi- well as those of different functional and business units, tions. Because funding liquidity risk can manifest itself should be documented, and these roles and responsi- in a number of different ways with varying degrees of bilities should demonstrate appropriate segregation of complexity, different firms use various metrics to de- duties between the execution, design, and oversight fine and measure this risk. and monitoring roles within the firm. This structure should include the ongoing involvement of members Roles and Responsibilities, Integrated Risk Manage- of senior management, who must ensure that funding ment, and Limit Setting liquidity is effectively managed on a regular and timely basis and that appropriate policies and procedures are Recommendation 3: Firms should have an agreed- established to limit and control material sources of upon strategy for the day-to-day management of funding liquidity risk. funding liquidity risk that takes into consideration their business models and legal structures (e.g., mix of Recommendation 6: Firms should have adequate in- foreign branches versus foreign operating subsidiar- formation systems for measuring, monitoring, control- ies), complexity (the breadth and diversity of markets/ ling, and internally reporting their funding liquidity products, geographies, and legal entities), key lines of risk positions. Management should be able to prepare business, home and host regulatory requirements and these reports in times of firm-specific and systemic environments, marketplaces, and risk materiality in business contingencies. the context of the firm-wide risk-management strategy and appetite. The rationale for this strategy should be explained, and the strategy should be communicated throughout the organization. 20
    • Discussion: The day-to-day transactional implementation of these strategies typically occurs in either the func- Board and senior management committees are in- tion with overall responsibility for funding liquidity volved in reviewing funding liquidity-management management, in the Capital Markets/Trading divi- strategies and performing risk oversight on a regular sion of the firm, or in both, in which case each group basis. Consistently with common practice, signifi- has distinct responsibilities (e.g., term funding and cant policies (such as the liquidity framework, fund- capital issuance in Treasury, collateral/liquid asset ing liquidity strategy, and contingency plan) need to trading in the trading division, and short-term un- be reviewed and approved annually by the board (or secured funding and securitization in either one). a committee thereof). The boards of some firms del- These transactional groups manage financing and egate authority to approve various policies, limits, and rollover risk. Funding relationships with liquidity related exceptions for specified entities and items to providers are managed by the Treasury function, the management committees or functions. In such in- sales force of the trading division, and/or by credi- stances, authority is clearly highlighted in board-ap- tor relations groups (dealers). There are a number proved policies. While the board of directors of a few of acceptable variations, especially for decentralized firms may review the funding liquidity position of the firms. firm as often as once a month, we believe that quar- terly reviews are acceptable practice. Typically, the main function with firm-wide re- sponsibility for funding liquidity management is Key management committees and functions involved independent of the financing, lending, and trading in funding liquidity management include the Asset Li- functions. Independent oversight, reporting, and ability Committee (ALCO), Risk Committee, Finance monitoring are provided by Risk and/or the func- Committee, Treasury, Risk Management, Finance, and tion with primary responsibility for funding li- Trading. Some ALCOs meet weekly, although month- quidity management (e.g., Treasury and Finance). ly is the norm. Many firms have separate ALCOs for Some firms separate the function responsible for subsidiaries, business divisions, and countries, in compliance and limit monitoring from the one that which group functions participate. Subsidiaries con- performs firm-wide analyses and reports. In other sider both regulatory and group requirements in man- firms, these responsibilities may be located in differ- aging their funding liquidity and related governance ent functions for different subsets of funding liquid- processes. Some subsidiaries have separate internal ity risk. Irrespective, most firms emphasize the need frameworks and policies that the parent firm reviews for proper segregation of functions in the funding to provide advice and counsel. The strength of links liquidity-management process, especially between between subsidiary and group ALCOs (and between execution and the other roles (design, monitoring, treasury functions) varies, reflecting firms’ preferences and oversight of policy, strategy, and limits). If some for centralized versus decentralized structures. execution is conducted by the function that plays the latter roles, the execution and the governance pro- There are almost an equal number of firms in which cesses are overseen by senior management commit- the boards approve the most senior limits and those tees. in which senior management committees or group executives do so, typically on an annual basis. Either Other noted related practices include: board or senior management limit approval is consid- ered acceptable, provided that key limits are included • Funding liquidity reports reviewed as often as in board-approved documents. Based on materiality, intraday or daily (based on type, materiality, within board-approved guidelines it is viewed as satis- and volatility of the metric) by businesses, and factory for more detailed strategies, limits, and proce- functions with direct responsibility for fund- dures to require approval only by senior management ing liquidity management; and committees or an executive in the function responsible • Increased reporting frequency and level of de- for liquidity management. In some firms, limits are set tail from board to senior management to busi- by Risk Management while the goals, strategies, and nesses and functions with direct responsibility procedures are set by Treasury. for funding liquidity management. 21
    • Recommendation 7: Firms should ensure that fund- ity. Management responses to estimated P&L Effects ing and liquidity risk management practices are in- and estimated cash flows are quite distinct as well. Of corporated within a firm-wide, integrated risk-man- course, VAR-type statistical techniques are often ap- agement framework that also includes market, credit, plicable in analyses ancillary to liquidity risk analy- operational, and other appropriate risks. sis, such as estimating the marked-to-market value of marketable assets, including the likely volatility of Discussion: market values within relevant time frames (e.g., one day, one week, or one month). See also the discussion The degree to (and manner in) which funding liquid- of Recommendation 15. ity risk is integrated with credit, market, and opera- tional risk varies greatly between firms. Integration Recommendation 8: Having identified the liquid- can take the following forms: full/partial integration ity risks and specific vulnerabilities that each firm is of funding liquidity risk control with market or group subject to, firms should describe in their policies and risk control; funding liquidity risk management func- strategies their overall tolerance for unmitigated fund- tion reporting to Risk Management; Treasurer and ing liquidity risk, the factors that may affect choices Chief Risk Officer (CRO) being key members of se- of strategies and limits, the desirable (or, alternatively, nior management committees with oversight of fund- unwanted) outcomes and key objectives of funding ing liquidity; market liquidity risk being considered in liquidity-management strategies, and the key drivers value at risk (VAR) measurement (with as output P&L and stakeholders influencing risk appetite, policies, Effects — as defined in the discussion below — that and strategies. Firms should implement a framework could be combined with other risk models measur- of limits, targets, or triggers to ensure that they operate ing P&L Effects) and funding liquidity risk measures within these specified tolerances. Potential cash out- (with a potential cash outflow output that could be flow and the ability to generate liquidity should be the combined with inflows and outflows for other on- or basis of calculation of liquidity risk tolerance and feed off-balance sheet items); integration between funding into limit setting. liquidity and structural interest rate risk; coordination between the heads of different risks at the functional Discussion: level, informally or through committees, to review all risk aspects of new business proposals; participa- Firms stress the need for sound and prudent approach- tion of other risk managers in liquidity crisis teams; es to funding liquidity management. This is reflected in integrated risk reporting for senior management and their risk profiles, assumptions, and risk measurement board committees; and integration of market, credit, techniques. Firms want to convey to stakeholders their and operational risk considerations in liquidity stress strong funding liquidity profile, their preparedness and testing assumptions. ability to withstand stressful/unexpected events, their management expertise and responsiveness to changing In discussing risk measurements applied to liquidity internal and market conditions, and the very low like- issues it is important to distinguish models and analyt- lihood that the firm’s funding liquidity position could ical approaches, such as VAR, that are focused on as- negatively impact their reputation, earnings, capital sessing potential effects on profitability, in other words base, financial strength, credit ratings, client business, potential losses (“P&L Effects”), from liquidity risk and strategic objectives. models and measures that aim at assessing cash flows. Processes aimed at delivering estimated P&L Effects Other firms define their risk appetites in terms of al- as outputs (applied to credit, market, and operational ways meeting regulatory and internal requirements, risk) are quite different in their means and ends from not having to rely on unsecured (versus secured) fund- processes aimed at delivering estimated cash flows as ing for a set period of time, and being able to survive a outputs (applied to liquidity risk). Estimated changes defined firm-specific crisis. in P&L Effects help manage businesses and product lines and can be taken through to show ultimate effects Some firms strike a balance between an appropriate on capital, whereas cash-flow estimates have as their level of funding liquidity risk and mitigation costs, purpose assessing needs and risks of funding liquid- as total risk elimination is considered too expensive. 22
    • Other firms have a much lower risk appetite and, for Discussion: example, avoid using short-term wholesale funding to fund illiquid assets and have no unmitigated fund- Based on their own sets of circumstances, “centraliza- ing liquidity risk. Within reasonable and acceptable tion” may mean different things to different firms. For boundaries that reflect various business models, con- example: ditions, capabilities, and capacities (e.g., funding ca- pacities), and provided that this Recommendation is • Centralization of the responsibility for group- adhered to, there is no right or wrong choice on the wide governance, policy and oversight process- level of funding liquidity risk that a firm may decide es; to take. • Centralization of the booking of all flows through one or a few parts of the firm; and/or Stakeholders and drivers influencing strategies and • Centralization of roles and responsibilities policies include regulators, central banks, external au- within one business unit for executing funding ditors, rating agencies (and credit ratings), best practic- liquidity-management strategies across multiple es, business/economic/market environment, operating legal entities and jurisdictions. plans, business models, a firm’s overall risk appetite, other risk-management frameworks within the firm, Some firms emphasize the importance of decentral- market share targets, unsecured- and secured-funding ized management at each principal subsidiary, where- access at various stress levels, and competitive bench- as others emphasize the importance of centralized marking. management across the group, sometimes with the caveat that decentralization is tolerated for less mate- Centralization versus Decentralization of Liquid- rial currencies if warranted by local regulation. Driv- ity-Management Practices ing factors include applicable jurisdictions, an organi- zation’s structure (predominance of branches versus Recommendation 9: Given the premise that there is subsidiaries), business lines, fungibility of currencies no right or wrong choice between a centralized or de- within and between legal entities and markets, sys- centralized liquidity-management structure (or a mix tem capabilities, regulatory and tax constraints, and thereof), the Recommendations put forward in the management culture. The degree to which regulations previous section should be applied to each applicable affect this choice differs among firms. The level of so- subsidiary for which detailed strategies and signifi- phistication of some regulators, not necessarily just cant policies for principal operating subsidiaries of the the magnitude and type of operations in that country, group are in place either to meet regulatory require- can also be a driver. ments or to accommodate a preferred decentralized structure. Where a decentralized structure leads to key Generally, firms appear to prefer centralization even funding liquidity metrics being different or not consol- as they recognize that hurdles exist that make it dif- idated at the group level, processes should be in place ficult to achieve fully. Some firms are centralized by to ensure that the group’s board and senior manage- types of activity (e.g., term funding, unsecured bor- ment are made aware of material developments in key rowing); others are focused along legal entities or lines subsidiaries. Irrespective of management structure, a of business. The importance of a centralized oversight group Treasury or Risk function should be responsible function is recognized under both approaches. for central oversight of these subsidiaries. The group’s strategy and policy documents should describe the Under a centralized structure, firms need to be par- structure for managing enterprise-wide funding li- ticularly diligent in ensuring that all local regulatory quidity risk and for overseeing operating subsidiaries requirements are met and that due process is followed and foreign branches. before funding lines are arranged between group enti- 23
    • ties (head office, branches, and subsidiaries). Under a quests, with a dedicated team handling the approval decentralized structure, firms should ensure that there process and pricing on an arms-length basis for statu- is strong centralized oversight as well as efficient pro- tory reporting. cesses and suitable coordination of the firm’s access to unsecured-funding markets under various names. Recommendation 11: Senior management within firms should ensure that the right incentives, policies, The specific market characteristics and risks of non- and procedures are in place to elicit appropriate be- global and emerging-market currencies need to be havior within each business that incurs liquidity costs taken into account. Where there are no reliable foreign (e.g., collateral, term funding), in order to consider and exchange (FX) markets for such currencies, they must manage such costs effectively. Where applied, transfer be managed from an essentially local-market perspec- pricing should be closely aligned with the liquidity of tive, with funding managed through the local market the underlying asset or structural nature of the under- (subject, of course, to firm-wide policies and risk- lying liability. management oversight, and regardless of the physi- cal location of the managers). Where well developed Discussion: FX markets exist, a more global approach to manage- ment of the currency can be taken, including use of Businesses that cause a firm to incur liquidity costs swaps, though careful assessment must be made of the should effectively consider and manage these costs risk that the ability to swap into the currency might through mechanisms such as limits and transfer pric- be eroded, perhaps rapidly, under stressed conditions. ing. Where applied, liquidity costs need to be charged See the further discussion at Recommendation 18. to those businesses that consume liquidity. Proper alignment of the liquidity risk profile of an asset or Intragroup Liquidity Transfers liability and the associated pricing creates a feedback mechanism, as the change in funding cost becomes an Recommendation 10: Firms should have policies, lim- important part of product pricing decisions. This aligns its, and processes in place to control the flow of funds the cost of funding with performance measurements, (related to intraday, tactical, structural, or stressed ensures that the appropriate incentives are in place for liquidity) between branches, between branches and the efficient management of liquidity in a business- subsidiaries, and between subsidiaries that consider as-usual situation, and provides a mechanism to alter regulatory, legal, accounting, credit, and tax restric- this pricing based on market conditions in a liquidity tions as well as the strategies and goals of their funding event. This dynamic then becomes part of an overall liquidity-management framework. liquidity risk management process. Discussion: Additionally, the costs of funding should be made transparent within a firm, which will not only improve In their governance of intragroup liquidity transfers, the quality of liquidity management, but also will pro- firms focus on a variety of different funding restric- mote the efficient use of liquidity as a scarce resource tions, including upstream funding restrictions, down- within the firm. stream restrictions, and internal restrictions, that force each legal entity to attain funding sufficiency indepen- Internal Controls dently. Additionally, a number of firms monitor senior debt funding, capital funding, and double leverage Recommendation 12: Firms should have effective sys- separately. In the case of some firms, credit lines to tems of internal control over their liquidity risk man- subsidiaries have to be approved by regulators. agement processes, including regular independent reviews and evaluations of the effectiveness of these Where applicable, functional responsibility for ap- systems. Firms should ensure that the frequency and proving credit lines primarily rests with Risk with, in scope of these reviews are consistent with, and sup- certain cases, the involvement of Treasury. In some in- ported by, their internal risk assessments. stances, firms treat the requests for credit lines from subsidiaries in the same manner as third-party re- 24
    • Discussion: these plans. In regard to the development of liquid- ity plans, disclosures generally contain a variety of li- Consistent with the Basel Principles that call for inde- quidity risk measures, including business and liquidity pendent review of liquidity risk management by both needs, regulatory requirements, rating agency criteria, internal parties and supervisors, nearly all firms are taxes, prevailing interest rates, and other market con- subject to some form of regular internal review, most ditions. Most firms’ disclosures also indicate the types often in the form of an annual review performed by in- of liquid instruments that their liquidity pools or re- ternal audit. In addition, most firms undergo a review serves are primarily invested in. by external audit. The internal reviews are generally based on adherence to policies, processes, and limits. Firms’ disclosures also contain information on their liquidity risk measurement, management, and moni- Public Disclosure toring techniques, which generally include utilizing liquidity limits, a range of liquidity ratios, market Recommendation 13: Firms should ensure that there triggers, periodic stress tests of temporary and long- is appropriate disclosure of qualitative and quantita- term stress scenarios, cash flow projections, analysis tive information about each firm’s liquidity position of liquid assets, term liquidity gaps and mismatches, and liquidity risk management practices. Mandat- and cash capital measurements. Although most firms’ ing quantitative disclosure would not be meaningful analyses utilize various liquidity ratios, the actual ra- or comparable across firms given that firms’ liquidity tios are generally not disclosed. Instead, firms provide practices vary significantly, as do their internal and ex- components of the balance of their liquidity sources or ternal environments. disclose the minimum result they strive to maintain. Discussion: Most firms include information on their contingency funding strategies and the risks that their contingency Firms provide varying degrees of liquidity informa- liquidity planning frameworks take into account (i.e., tion to market participants. Information provided to general market disruptions, adverse economic devel- creditors, investors, and other counterparties princi- opments, etc.). While most firms disclose that they pally references firms’ public disclosures and annual undergo some type of stress testing to ensure they can reports. Regulators and credit rating agencies are ex- meet funding requirements in even the most unfavor- tended a much wider range of information but typi- able conditions, for the most part, they do not disclose cally receive this information only on an as-requested the types of stress tests performed. Of those firms that basis. The decision regarding what to disclose is driven do disclose such information, examples include one- by legal and regulatory requirements and the attempt or two-notch rating downgrades, withdrawals of cus- to strike a balance between providing useful disclosure tomer deposits, deterioration in asset liquidity, and and confusing external constituents as well as by the limited to no access to unsecured funding. desire to provide transparency and to respond to in- vestor and rating agency demands. Given the range of practices, there is some room for improvement in qualitative public disclosures. In many Although most firms provide liquidity information in cases, discussions about liquidity structure and gover- their quarterly and annual reports, the level of detail nance could be expanded to better describe liquidity- varies significantly, given that firms’ liquidity-manage- monitoring practices and the timeframes and groups ment practices differ considerably and that disclosure in which these practices take place. Firms should pro- practices differ across businesses and jurisdictions. vide detail on key metrics used in their analyses and Firms’ disclosures generally indicate that they manage on the types of stress tests they perform. In addition, liquidity with the goal of ensuring that they have suf- firms should describe the general nature of contingen- ficient funds available to meet known and anticipated cy funding plans and the internal governance involved cash funding requirements. Disclosures tend to focus in overseeing these plans and in setting and monitor- on qualitative descriptions of funding and liquidity ing limits. plans but provide little quantitative detail to support 25
    • Owing to the number of very real constraints faced by ity to provide quantitative liquidity risk measures, par- firms, relatively little quantitative data are disclosed. ticularly if such information is not based on account- Disclosure practices are not only guided by each firm’s ing concepts. Among other things, firms are obliged to philosophy about disclosure, but also by key legal and take into account restrictions on disclosure of poten- compliance considerations, which impact firms’ abil- tially price-sensitive information. 26
    • B. Analytical Framework for Measuring, Monitoring, Common practices include: and Controlling Liquidity Risk: • Analyzing gap breakdowns by products, organi- Forecasting, Measuring, and Monitoring Funding zational units, or business areas, with limits on Requirements the gaps; • Forecasting liquidity needs in various stress sce- Measurement and Monitoring Tools narios; and • Updating daily the volatility of metrics with the Recommendation 14: Firms should establish well values observed last day. reasoned, robust, and documented methodologies to measure and monitor funding liquidity risk. Firms Real-time monitoring of liquidity positions is primar- should forecast future cash flows of assets, liabilities, ily used for intraday cash and collateral management, and, if material, off-balance sheet items over appropri- especially by investment banks or at the level of the ate timeframes. Where appropriate, they also should Treasury department. consider employing liquidity ratios as well as measures for monitoring concentration and diversification. Estimation of Funding Capacity Recommendation 15: Firms should ensure that meth- Recommendation 16: Firms should establish well- odologies for forecasting the future cash flows of assets, reasoned, robust, and documented methodologies to liabilities, and off-balance sheet items are regularly val- manage different components of their funding strate- idated to confirm that they continue to be appropriate gies, including diversification of liabilities by types of and to identify the main assumptions and/or param- depositors, investors, products, marketplaces, and cur- eters to which net funding requirements are sensitive. rencies; relationship with investors; and financing and selling of assets. These components should be regular- Discussion: ly reviewed to determine whether they continue to be adequate and to identify the main assumptions and/or To measure and monitor their liquidity risks, firms use parameters to which the net funding is sensitive. Firms various measurement techniques, time frames, and should measure and/or estimate their secured- and levels of granularity.22 The firms’ primary funding li- unsecured-funding capacity (at the aggregate and in quidity risk measurement models quantify cash flows meaningful subsets) to better understand their current not potential P&L Effects.23 and prospective funding liquidity risk under varying conditions. Most firms use a “cash flow mismatch/liquidity gap” metric,24 produced at least weekly for horizons extend- Discussion: ing from a few days to a few months and at least annu- ally for longer horizons ranging from a few months to In normal conditions, most firms manage funding many years. Short-term forecasts are produced as of- risk by using different sources of funding, which helps ten as daily, while long-term forecasts can be produced prevent an adverse development in their funding posi- as often as weekly, although monthly or quarterly is tions. typical. Balance-sheet ratios are frequently used for firm-specific and industry analysis. Most firms’ base case estimates of their funding ca- pacity in normal conditions are derived from past 22 “The working group found a greater range of practice within the banking sector than within the securities and insurance sectors in areas such as liquidity risk measures and limits.” “The Management of Liquidity Risk in Financial Groups,” The Joint Forum, Basel Committee on Banking Supervision, May 2006. 23 As explained in the discussion of Recommendation 7, measures of potential cash flows must be distinguished from measures of P&L Effects. The outputs of “Liquidity at Risk” models that generate cash-flow estimates cannot be combined with the outputs of other “at risk” models (e.g. VAR for market risk) that measure P&L Effects. Because the terminology is not necessarily uniform, there may be models referred to as “Liquidity at Risk” models that generate P&L Effects, but these focus on market-liquidity risks (of liquid assets) and not funding-liquidity risk, which is assessed by cash-flow measures. Of course, estimating the marked-to-market value of marketable assets is relevant to, but needs to be distinguished from, estimating cash flows for funding-liquidity purposes. 24 The May 2006 Joint Forum paper also indicates that the banking and insurance sectors prefer the cash flow analysis of the liquidity of assets. 27
    • observations of their different sources of secured and eration market liquidity as well as name-specific unsecured funding. Haircuts are also derived from concerns; and past observations. When necessary, such estimates are • Identification of funding strategies under each complemented by the judgments of those in charge of scenario. maintaining the different funding sources as well as by third-party dealers familiar with a firm’s name in Asset and Funding Diversification Practices the wholesale markets. The factors taken into consid- eration when estimating funding capacity may vary Recommendation 17: Firms should have asset and materially between firms depending on the types of funding diversification strategies commensurate with markets and jurisdictions in which a firm operates. the nature of their businesses, the environment in which they operate, and the types of products and Within their funding sources, some firms distinguish markets in which they are active. These strategies between what they estimate to be “reliable,” or core should be adjusted as changes occur in the internal or funding, capacity and the “surplus” portion of this ca- external environment. pacity, which they view as excess buffer. The surplus capacity above the reliable portion is then analyzed Discussion: and measured, taking into account lenders’ appe- tite for a firm’s name, its unused credit lines, and the Most firms monitor depositor concentration. unutilized documented program size for each of the firm’s programs. Diversification of funding sources is usually accom- plished by having: Reliability is in some instances determined from the results of stress testing analyses and scenarios in which • A reliable and diversified retail and commercial some funding sources are assumed to at least partially deposit franchise; disappear. For instance, in the case of wholesale fund- • Maturity dates that are spread out through tar- ing capacity, most firms assume that their unsecured gets or limits on predefined periods; capacity would disappear or be significantly reduced. • Varied funding programs, including an internal The extent of this assumption varies based on both infrastructure built and maintained to support the level of severity of the scenario being considered these programs (e.g., securitization); and the current credit rating of a firm. Similarly, some • Assorted funding products, such as commercial firms are cautious in assuming that committed liquid- paper (CP), CDs, prospectus-based debt pro- ity lines would be made available to them in the event grams, and securitization; of firm-specific liquidity events. • Different types of wholesale investors, e.g., cen- tral banks, pension funds, money market funds, Reliability can also be determined by undertaking a and money managers; thorough analysis of different sources of funding, clas- • Diversification of depositors; sified by counterparty, market liquidity, creditor sur- • Investors in different geographies, countries, re- vey, and product, including pledgeable assets and un- gions; and encumbered liquid assets. • Multiple currencies in which to issue. Practices for estimating and managing funding capac- Liquid assets could be diversified by using the follow- ity include: ing attributes: • A dedicated desk responsible for strengthening • Pledgeable assets (depending on central banks the relationships with main funding providers and industry criteria); and central bank discount windows; • Repoable assets; and • Estimates of unfulfilled appetite/surplus capac- • Securitizable assets (retail consumer loans, retail ity for the group’s name; mortgage loans, corporate loans, etc.) with cash • Haircuts calculated for each scenario based on structures or with synthetic structures (credit stressed market conditions that take into consid- default swap). 28
    • Alternatively, firms could have notional limits by type necessary. Convertibility risk appears not to be a major of liquid asset, issuer type, issuer name, credit rating, issue for most firms, as this risk is often taken into ac- and other meaningful criteria, and/or longer liquida- count through stress testing and contingency planning tion timeframes/larger haircuts as inventory in a spe- and/or in the limits. cific product grows. Liquidity Position by Maturities Liquidity Position by Currency, Cross-Border, and Legal Entity Recommendation 19: Firms should choose the spe- cific time horizons over which they measure, monitor, Recommendation 18: Firms should have in place a and control their funding exposures based on the na- system to measure, monitor, and control their liquidi- ture of the exposure. At minimum, short-term hori- ty positions for all material legal entities, jurisdictions, zons should include a period from the next few days foreign branches, and subsidiaries in the significant to the next few months; long-term horizons should at major currencies in which they are active. In addition least go out to one year. Measurement should be per- to assessing aggregate foreign currency liquidity risk formed using, as appropriate, contractual or effective commitments, firms should also undertake separate maturity dates as well as known and forecasted flows analysis of their strategies for each material currency (e.g., taking into account assumptions with respect to individually, outlining as appropriate how strategies changes in loans, assets, core deposits, etc.). for established currencies with liquid markets and di- verse funding alternatives may be different from those Retention Rates on Nonmaturing Assets and Liabilities for non-global or emerging market currencies. Firms and on Assets and Liabilities with Contractual Maturi- should identify the extent to which fungibility among ties pools of currencies25 (e.g., USD, EUR, JPY, GBP, and CHF), legal entities, and jurisdictions can be relied on, Recommendation 20: Firms should use a robust and this should be reviewed regularly. Firms should qualitative and quantitative analytical framework that assess, monitor, and, where appropriate, limit accept- considers all relevant internal and external factors be- able mismatches between foreign and domestic cur- fore assigning liquidity values to nonmaturing assets rency in light of various internal and external factors. and liabilities. The same process should be followed for other categories of assets and liabilities for which Discussion: contractual maturity dates may not be good indicators of liquidity value. The metrics used by most firms generally take into account the ability to shift liquidity surplus from one Recommendation 21: Firms should understand the currency to another and across jurisdictions and legal characteristics of their funding instruments and eval- entities. Firms usually quantify their liquidity expo- uate the effective cash flows under business-as-usual sure by currency and use various criteria, such as con- and stressed conditions. At minimum, retention rates vertibility, swap market depth, and the ability to lend for nonmaturing liabilities should be viewed different- funds between group entities in the normal course of ly for retail and commercial deposit liabilities. Firms business without triggering any internal or external should analyze retention rates for nonmaturing liabili- concerns, to determine fungibility. Some firms con- ties by domicile, investor type, product, currency, and sider pools of fungible currencies, whereas other firms scenario. consider major currencies, such as USD, EUR and GBP, on a consolidated basis to determine their short- Discussion: term liquidity position. Most institutions consider a portion of their nonma- Most firms apply adjustments to currency exposures turing liabilities, such as demand deposits and capi- to take into account the liquidity of the FX markets tal, as core in their liquidity positions. In the case of and the settlement conventions of spot FX trades when demand deposits and other types of nonmaturing See the discussion of Recommendation 9. 25 29
    • deposits, statistical analyses usually enable a firm to surance either is offered only to domestic institutions distinguish between a volatile part, considered short- or may have different terms for foreign and domestic term funding, and a stable part, considered middle- to institutions. These facts need to be taken into consid- long-term funding. eration when determining the behavior of depositors in a liquidity event and the resultant impact of this be- The scheduling through time of the stable part of these havior.27 Please refer to Behavior of Liabilities in the deposits takes into account decay factors that reflect section on “Emerging Liquidity Issues in a Changing the assumptions and models used by an institution to International Environment.” analyze its data. The use of different assumptions may reflect different levels of risk aversion. Sources of Contingent Liquidity Demand and Related Triggers Decay factors may depend on the type of clients26 (re- tail, large corporates, small and medium corporates) Recommendation 23: Firms should ensure that li- and type of funding instruments (interest bearing de- quidity risk measures take into account the potential posits, noninterest bearing deposits, insured depos- liquidity consequences of undrawn commitments its). and triggering events. A distinction should be made between different types of commitment (e.g., revoca- Some institutions assign decay factors to nonmatur- ble and irrevocable, conditional and nonconditional, ing assets and liabilities by using only qualitative judg- purpose of facility, and types of customers and their ment without reference to quantitative models. Some respective credit ratings). Liquidity risk consequences may also apply judgment to the results of their statisti- should be modeled by applying drawdown probabili- cal analyses by adjusting core values as circumstances ties under various stress scenarios. warrant. Discussion: Recommendation 22: In countries where there is de- positor insurance, this insurance should, subject to For most firms, unutilized commercial loan commit- appropriate judgmental analysis, be considered when ments and commercial paper back-up lines are key modeling depositor behavior. In general, deposits sources of contingent liquidity demand. Other key covered by insurance may be considered to be more sources depend on the nature of the institution. “sticky” in a crisis than other deposits. When applying this concept in practice, consideration should be given Potential triggers for draws include economic cycles, to whether there are any indications that recent devel- systemic crises, credit rating downgrades (with differ- opments may require prudent adjustment of historical ent degrees of severity expressed in terms of numbers patterns. of notches lost), country crises, specific market disrup- tions (e.g., CP market disruption, credit crunch), and Discussion: International Swaps and Derivatives Association, Inc. (ISDA) collateral agreements. Firms appear to be divided as to whether depositor Practices include: insurance should be a consideration in modeling de- positor behavior. In certain country-specific events, • Triggers estimated with different degrees of se- deposit insurance can be viewed as a competitive dis- verity, and advantage to certain banks in that it limits a flight to • Estimated impact of triggering events in scenar- quality. In addition, in certain countries deposit in- io analysis. 26 The May 2006 Joint Forum paper indicates that banks should “assign the timing of cash flows for each type of asset and liability by assessing the probability of the behavior of those cash flows under the scenario being examined.” Investor type will be an important determinant of behavior. 27 In analyzing depositor behavior, the May 2006 Joint Forum paper suggests that in some countries retail and small depositors may rely on public-sector safety nets to shield them from loss. 30
    • Cash Flow of Financial Derivatives a secured basis. The loan (“collateral”) value of its un- encumbered portfolios is reviewed daily. Haircuts on Recommendation 24: If material, firms should con- these securities need to be reviewed regularly with sider cash flows related to financial derivatives (net the funding desks, and consideration must be given flows, where supported by legal frameworks, that oc- to any concentration of positions and risk effects that cur at the repricing or maturity date of contracts, as would affect the prudent level of haircuts in a crisis. well as those covering exchange of margin or collat- This process should be consistently applied to trading eral during the life of these contracts) and interest rate and banking books. The treatment should differenti- flows in their liquidity risk analyses. ate between use of assets as collateral for borrowing and for generation of cash by sales of such assets, and Discussion: also take into consideration the business strategy for the assets in question, the potential P&L impact of any Most firms consider cash flows of financial derivatives disposition, and whether management would be will- in their liquidity risk analyses, although material ex- ing to absorb potential losses, taking into account tax pected cash flows appear to be monitored more than effects. In determining the appropriate haircut for sale potential cash flows related to uncertain outcomes. purposes, the business environment in which the firm Most firms do not include interest cash flows associ- operates and potential stressed volatility of markets ated with on-balance sheet instruments when measur- need to be considered over the determined liquidation ing liquidity demand and supply. There are a number horizon. Haircuts for repo purposes should be based of practical challenges in forecasting derivative flows on an evaluation of the markets’ ability to absorb the related to uncertain outcomes (i.e., options), and each level of positions, at proposed haircut levels. This firm needs to make an informed judgment as to the evaluation should be performed on securities held for materiality of these challenges. To that effect, it is not clearance and for other regulatory or legal purposes to the gross amount of derivative or interest rate cash determine whether they are encumbered or otherwise flows originating from each contract of a particular unavailable for liquidity purposes. business/activity that should drive the determination of materiality; rather, it should be the net amount of Liquidity value needs to be given to other asset classes all contracts within each period being measured that in which liquidity has been demonstrated through an should be the driver for firms to determine whether active and ongoing sales or securitization program. more resources should be dedicated to their measure- Central bank/government repo facilities should only ment in light of the relative materiality of these interest be used if they have been tested and would be available and/or derivative cash flows vis-à-vis typical total net in a name-specific event. flows that firms experience for these periods. • Firms could base haircuts on prior experience, Measuring and Monitoring Asset Liquidity best-practice assumptions, liquidation scenarios, regulatory requirements, practices adopted in Recommendation 25: Firms that rely on secured- market or credit risk, or market liquidity models. funding sources to a significant extent should have ro- A comparison of various models would provide bust processes in place to evaluate asset liquidity under a range of results from which firms could select a variety of business-as-usual and stressed conditions. an appropriate model. It should be recognized that liquidity values of similar assets may vary across firms depending on the nature • Securities need to be grouped by their liquidity of their business and their respective market capabili- value. High values, for example, would apply to ties. eligible central bank holdings. Other criteria to be included in considering liquidity values and Discussion: categorization are rating/credit quality, market It is standard practice for securities firms and large price availability, maturity, type of security, rea- banks with capital market platforms to assess the son for holding (trading, investment, hedge), ac- ability of a firm to convert its unsecured funding to cess to secured funding for the security, issuer 31
    • type/country, currency, size of position (e.g., to be limited because they are already included in oth- relative to issue size, daily traded volume), and er market risk metrics. Hence, these firms believe that time to settlement. Liquidity categories can be liquidity risk metrics do not have to take these move- grouped into high, medium, and low liquidity or ments into account. by the likelihood that the action will be taken. If large liquidity demands were to occur, a decision Most firms use haircuts or volatility analyses to de- would need to be made as to holdings that could be termine the liquidity value of assets. In general, firms shed with the least detriment to business relationships evaluate the value and timing of their actions based on and to perceptions about a firm’s soundness while tak- the scenario that is being addressed. ing into account business economics (profit and loss). Firms that are active in secured-lending markets could Recommendation 26: Firms should ensure that asset use assets to generate liquidity through repos rather liquidity is assessed based on a demonstrated ability to than through outright sales, should markets permit. obtain liquidity, and firms should only take credit for active and ongoing programs for sale, securitization, Most firms rely to some extent on the ability to gen- or secured borrowings. Consideration should be given erate liquidity from securities positions in normal to adjusting haircuts if the state of markets (stressed) course and emergency conditions; others reduce cash during the specified scenario warrants it. holdings or interbank deposits. Recommendation 27: Firms with significant reliance Sources of liquidity generally are weighted based on on asset liquidity should evaluate haircuts and the tim- their degrees of liquidity. When analyzing the liquidity ing of cash flows from these sources. In determining value of a portfolio, time to liquidity must be consid- the amount of available liquidity and the liquidation ered (i.e., how long it takes to move the firm’s assets horizon, the evaluation should include a determina- to the right place at the right time so that the firm can tion of whether the asset is encumbered as well as an generate liquidity in time to cover its needs). assessment of market haircuts, market capacity con- straints, access to central bank facilities, concentra- Liquidity Risk Metrics and Limits tions in collateral, potential name-specific concerns, and the operational ability to complete the transac- Recommendation 28: Firms should use metrics that tion. In particular: are relevant to the nature of the business they under- take. Firms that engage in a broad range of activities • Encumbered assets should be excluded from in- would be expected to use a similarly broad range of cremental liquidity value; liquidity metrics. • Haircuts should be evaluated in business-as- usual as well as in stressed conditions; Recommendation 29: For each selected metric, firms • The capacity of the markets for a particular asset should decide whether they will impose a prescriptive class should be evaluated; and limit or a preferred target/range or just monitor the • Operational capability to facilitate the transac- metric for historical trends. Not all metrics need to be tion should be in place and tested. assigned limits, and firms could make different choices for the same metric, bearing in mind their respective Discussion: internal and external environments. When metrics are based on the market values of assets Discussion: and liabilities, market price movements are mechani- cally taken into consideration. Some firms take market No simple, convenient and predetermined metric or price movements into account in their normal course quantitative measure with prescribed assumptions of business and stress/scenario analyses, for example, would work to provide either adequate liquidity safe- by using haircuts. Other firms consider the impact of guards or truly useful management information. Al- market price movements on their liquidity positions though the idea of imposing simple metrics across 32
    • institutions may have some immediate appeal, differ- Recommendation 30: Firms should ensure that li- ences in institutions are likely to make the results not quidity risk limits are only set on a consolidated basis truly comparable, even if superficially similar. In fact, when it is practicable to do so given the regulatory, le- lack of comparability may render the information at gal, accounting, credit, tax, and internal constraints on best not useful and at worst potentially deceptive. the effective movement of liquidity. Firms’ risk toler- ance should be evaluated at the individual entity level The diversity of activities undertaken by firms, as well unless there is an unrestricted ability to transfer funds as their size, complexity, demonstrated capabilities, between entities and across borders. If such an unre- and financial conditions, effectively means that the li- stricted ability does exist, then consolidated limits that quidity risks arising in each firm may be different in encompass these entities and geographic areas may be nature or magnitude. Therefore, a list of prescriptive appropriate. metrics and/or limits would be neither appropriate nor sufficient to address the source and nature of the Discussion: liquidity risk that may occur in each firm. The metrics that a firm uses need to be relevant to the key liquidity In times of financial distress certain regulatory and in- risk vulnerabilities that it has identified. A firm that ternal constraints have been relaxed (as was the case, uses a small number of specific metrics designed to for example, in the 9/11 crisis) depending on the source cater to identified vulnerabilities will be more effective and nature of the distress. However, it is also conceiv- in its liquidity risk management endeavors than a firm able that certain regulatory requirements could be- that produces a longer but less tailored set of metrics come more severe. Firms need to manage their liquid- and limits. ity based on thorough assessments of the likelihood of central bank actions or statutory requirements. For A robust liquidity-management framework should example, if particular assets are not eligible as collat- identify the potential sources of liquidity risk arising eral with the central banks, the working assumption from such activities and establish a range of metrics. should be that such assets will remain ineligible during Refer to Appendix 1 for a list of possible sources of li- a liquidity event. quidity risk vulnerabilities and metrics. 33
    • C. Stress Testing and Contingency Planning: debt and capital, most investment banks use a longer benchmark assumption, with many using one year. Stress Testing (Sensitivity and Scenario Analysis)28 Short-term funding sources for investment banks tend to be supported with unencumbered securities that Recommendation 31: Firms should analyze liquidity can be sold or repoed. Thus, these institutions ensure using a variety of firm-specific and market-related sce- that short-term, unsecured obligations can be funded narios and/or sensitivity analyses, or a combination of with secured sources. This is a standard benchmark the above. Stress testing may be appropriate at a group in the industry that is accepted by rating agencies and level, by geographic region, and at a subsidiary level. regulators. The rationale behind the choice of time horizons over which a crisis is to be measured and the severity lev- Firms may elect to consider types of events that can lead els of crises considered should be appropriately docu- to liquidity risk in order to identify liquidity exposure. mented. For example, it could be useful to integrate market risk metrics to provide a measure for asset liquidity. An- Discussion: other consideration is the practice of reducing credit exposure for derivative transactions through adding Most firms employ scenario analysis as part of their downgrade triggers or provisions to deliver funding or liquidity risk measurement. Examples of market stress collateral should predefined events occur. scenarios include a general regional crisis, such as an emerging markets crisis or country crisis; the failure Recommendation 32: Firms should ensure that stress of a clearing and settlement system; a systemic shock, tests are used to measure the behavior of all sources such as 9/11, that leads to an inability to fund/reduced of cash inflows and outflows that could potentially be access to wholesale money markets; or a major disrup- material to the firm under various sets of assumptions. tion in financial markets. Firm-specific scenarios usu- To the extent that these tests indicate an unwanted ally test the impact of downgrading (1-4 notches); rep- shortage of funding over the time horizon over which utation risk driving deposit withdrawals; a shock to the they are conducted, consideration should be given, in clearing/settlement system (internal system outage); light of the probability of the scenario, to modifying the default of a major counterparty or funding source, underlying normal course of business limits to address market player, or obligor; differing levels of ability to this shortfall. borrow in unsecured and secured markets; and loss of CP rating (could also be a market-specific CP crisis). Discussion: Per the Joint Forum paper, two-thirds of firms simu- late firm-specific and market events separately. The level and timing of cash inflows and outflows may differ quite sharply between scenarios and from one Many firms run several scenarios that cover a range of firm to another depending on each firm’s historical ex- crisis durations and levels of severity. Some firms may perience. The level and timing may also reflect reputa- test the same scenario at different points in the crisis tion, market presence, current credit rating, or other event and may include the point in time when busi- factors. Judgment will play a large role if recent histori- ness returns to normal. cal experience is not available. Most commercial banks use relatively short time ho- Each scenario contains assumptions about behavior rizons. Since these firms tend to be more reliant on under stress, and the run-off profile of each balance- short-term, unsecured funding, surviving a disruption sheet and nonbalance-sheet item is considered. The in this funding source is emphasized. On the other assumed behavior can be objective and/or subjective hand, since the funding profile of broker-dealers tends in nature. For those that are subjective in nature, firms to be longer-term with an emphasis on long-term can elect to use a more or less conservative approach. 28 Stress testing is a risk-management technique used to evaluate the potential effects on an institution’s financial condition of a specific event and/or movement in a set of financial variables. The traditional focus of stress testing relates to exceptional but plausible events. Sensitivity analyses are generally less complex to carry out since they assess the impact on an institution’s financial condition of a move in one particular risk factor, the source of the shock not being identified, whereas scenario tests tend to consider the impact of simultaneous moves in a number of risk factors, the stress events being well defined. 34
    • Based on the type and severity of the stress test con- Discussion: templated, potential sources of inflows could include raising incremental core customer deposits, using Most firms employ a business-as-usual approach to unused unsecured and secured wholesale funding ca- the balance sheet while stress testing. This assumes pacity, selling unencumbered liquid assets, increasing that the balance sheet is “evergreen,” with assets rolled securitization of assets for which programs already ex- over at maturity. However, a significant minority of ist, drawing on committed lines, borrowing from cen- firms attempt to forecast changes in the balance sheet, tral banks, calling client loans where legally possible, with some assuming there would be reductions based making illiquid asset sales, and maximizing internal on the severity of the scenario and others assuming funding between the firm’s various legal entities. Many growth in line with their business forecasts. scenarios could involve a firm’s still being able to bor- row from the market, even unsecured funds, possibly Recommendation 34: Firms should ensure that the at reduced levels, shorter maturities, increased cost, or results of key stress tests are periodically communi- some combination of such effects. cated to senior management and, as appropriate, to the board. Firms should have an understanding of the Potential sources of outflows could include loss of core worst-case scenarios that may trigger implementation deposits, inability to rollover wholesale deposits, in- of contingency plans. The assumptions and parameters creased collateral requirements from payment/settle- underlying these tests and resulting cash flows, includ- ment systems and derivatives transactions, normal ing funding capacity assumptions, should be regularly course of business loan drawdowns, committed li- reviewed and challenged. quidity line drawdowns, higher haircuts for securities finance transactions and asset sales, increased cash or Discussion: collateral postings as a result of a downgrade, and loss of deposit with credit rating triggers. The results of key stress tests provide management with a range of liquidity gaps that could open up; this In performing stress tests, firms need to take into ac- could be the starting point for designing a contingency count both the level of severity of a crisis and their plan or survival strategy. Potential liquidity gaps iden- position (on a standalone basis and relative to their tified in these tests, and the firm’s capacity to generate peers) at the onset of the crisis before they decide how liquidity, can provide the cornerstones for a liquidity to measure exposures and react to the results of these limit framework, after taking into account the firm’s tests. In the case of potentially less disruptive stress appetite for liquidity risk. The discussion with senior scenarios, such as a ratings downgrade, firms need to management will generally include: the extent to which review several stages of the crisis; this allows them to stress-test assumptions can be considered realistic; the test assumptions about changes in assets and liabilities complexity and precision of the models and the need over time. to assess models critically (precision and complexity not being guarantees of accurate outputs); and an es- Recommendation 33: The appropriate starting point timate of the probability of occurrence of each stress for stress testing assumptions for firms should be a situation. Senior management will not and should not business-as-usual approach with clients. This approach respond to stress tests mechanistically, but must make assumes that the entity will continue to operate as a appropriate strategic decisions based on sound busi- going concern and that the franchise has significant ness judgment, taking the tests but also many other value. Different scenarios should be used to evaluate considerations into account. how various events may impact the firm, including the point at which growth plans may need to be curtailed Contingency Planning - Governance if the severity of the crisis warrants such an action. This should then be used to plan the evolution of the Recommendation 35: Firms should have contingency balance sheet in a crisis. plans in place that address potential early warning sig- 35
    • nals of a crisis, the strategy and tactics used in normal Firms manage their various funding needs and main- course of business to prevent escalation of liquidity tain diverse funding sources that can help avoid dis- concerns, and the possible strategies for dealing with ruption or, alternatively, can be used during a fund- different levels of severity and types of liquidity events ing disruption. One option is to hold excess liquidity that cause liquidity shortfalls. The breadth and depth in a portfolio of high-quality assets in local currency of these strategies should incorporate recovery objec- and, as appropriate, foreign currencies that can either tives that reflect the role each firm plays in the opera- be sold in the market or used in repos to generate ad- tion of the financial system (e.g., provision of collateral ditional liquidity. to payment/settlement systems) such that these strate- gies enable a firm to continue to play its role, even in Consistent with this Recommendation is that firms times of major operational disruptions. Firms should should assess the effectiveness of their contingency make efforts to assess the effectiveness of their contin- plans. Contingency tests, as an example, are used by gency plans. some firms to ensure the effectiveness of contingen- cy plans when stress situations are simulated. If these Discussion: tests do not meet predefined minimum threshold standards, firms generally take action. Regular con- Some firms define stages of a crisis and define appro- tingency tests could be conducted to ensure that key priate measures to mitigate a crisis. Generally, firms exposures are understood and that contingency pro- distinguish among orderly market conditions, a liquid- cedures are known and understood in areas critical ity squeeze during which unsecured funding may be during a liquidity crisis. The scope of contingency tests partially inaccessible and steps are taken to strengthen can span from testing the availability of crisis contacts liquidity, and a severe liquidity squeeze or shock, in- to discussing the policies and procedures to be fol- cluding a firm-specific crisis when unsecured funding lowed during a liquidity crisis to simulating a crisis, is not accessible and access to secured funding may with the focus placed on managing a liquidity crisis also be limited. rather than on business continuity or operational pay- ment or settlement issues. At this last stage a liquidity crisis committee could convene to take appropriate measures. Such measures Recommendation 36: Firms should ensure that con- would be based on expected liquidity positions, es- tingency plans are proportionate to the size and com- timates of how cash might be generated through the plexity of the firm and involve input from senior man- market, and projected outflows from deposit run-offs agement. Contingency plans should be reviewed as or reduced wholesale funding. Firms can, and general- business or market circumstances change. ly do, identify early warning signals of a liquidity crisis (both firm-specific and market-wide) and the operat- Discussion: ing procedures to be activated in the event of progres- sive deterioration. The level of organization involved in a contingency plan may differ depending on business activities, Market participants should explicitly consider and whether liquidity is managed centrally or not, and plan for major operational disruptions, developing re- whether liquidity pressures are managed locally in the covery objectives that reflect the risk they represent to first place. Reporting as a group, reporting for material the operation of the financial systems in which they subsidiaries, or reporting on a regional basis could all participate. Those who provide more critical services be appropriate. need to target higher standards. Contingency plans need to involve Treasury, Risk, and Firms may consider limiting the provision of commit- business areas, and could include IT, operations/settle- ted funding lines as the crisis escalates, and they may ments/payments, communication, and Finance units, need to carefully consider the value of purchasing ac- among others. Often a member of Treasury or Risk is cess to committed lines of funding. assigned the role of contingency coordinator to ensure 36
    • that working groups understand their tasks and that Many firms also have coordination between their li- decisions and actions are logged and communicated quidity crisis teams and business continuity manage- as appropriate. ment. Recommendation 37: Firms should ensure that con- Recommendation 38: Firms should outline in their tingency planning includes establishing policies and liquidity policies the benchmark periods that require procedures and clear divisions of roles and responsibili- evaluation for whether liquidity needs can be met. Se- ties for liquidity events so as to avoid confusion or lack lection of these benchmark periods should be based of clarity of roles during a crisis. This should include on a number of qualitative factors. strategies and procedures for timely, clear, consistent, and uninterrupted internal and external communica- Discussion: tion flows to ensure timely decisions, to avoid undue escalation of issues, and to provide adequate assurance The quality of a firm’s underlying assumptions and the to market participants, employees, clients, creditors, robustness of its funding and liquidity risk manage- regulators, and shareholders. This would include the ment process should be prime considerations in the designation of leadership roles in a liquidity crisis and determination of a benchmark period. Other deter- may include the designation of a formal crisis team mining factors should include the type of entity and that would be a contact point for senior management. whether the firm has access to the central bank/lender The planning process should include the designation of last resort. Firms that have access to nonwholesale of back-ups for key functions and the assurance that sources of funding that tend to be more stable may key systems and processes have been considered in the have shorter benchmark periods (subject to the analy- firm’s business continuity planning. sis suggested at Recommendation 22). Firms may also choose to have multiple benchmark periods.29 Discussion: Asset Reduction and Financing Strategy Most firms have a liquidity crisis team in place that is chaired by the Treasurer or CFO. Alternatively, an Recommendation 39: Firms should have in place an effective ALCO or another similar forum with repre- asset reduction plan and financing strategy for both sentation from senior management, Treasury, Finance, firm-specific and market-related liquidity events. Risk Management, representatives responsible for as- set-liability management (ALM), members of the fund- Recommendation 40: Back-up plans may involve in- ing desks, and significant businesses could serve such voking unused credit facilities granted to a firm; how- a function. In many firms, this function also reviews ever, firms should not rely excessively on such lines as various scenarios as part of the normal ALM moni- counterparties could elect not to honor their obliga- toring process. The frequency of team meetings differs tions to provide funding if a firm is in trouble. from firm to firm, reflecting the fact that in many cases such teams meet on a regular basis to review stress sce- Discussion: narios in business-as-usual conditions. An agenda for a crisis team would generally include a liquidity crisis Firms consider the loss of access to funding sources scenario simulation, market reports, liquidity moni- under certain scenarios such that one source may be toring and analysis, and liquidity strategy. The team completely eliminated. Secured funding and asset liq- should also ensure that the plan is adequately tested uidation should be available against higher haircuts (or on a regular basis. The May 2006 Joint Forum paper indicates that the first few days in any liquidity crisis are crucial to maintaining stability and that the appropriate time frame will depend 29 on the nature of the bank’s business. In the context of collecting data related to the bank’s liquidity, the paper goes on to suggest the benchmark period is highly dependent on the bank’s reliance on short-term money markets. Banks that are reliant on short-term funding should concentrate primarily on managing their liquidity in the very short term (out to five days) whereas banks less dependent on short-term money markets might manage their net funding requirements over a slightly longer period, per- haps one to three months ahead. However, the paper also suggests that institutions should collect data and monitor their liquidity positions in more distant periods. 37
    • premiums), although access to secured funding might questions asked” basis; the latter may be available only be limited during a market crisis or if a firm does not to market participants deemed significant for the fi- have a demonstrated market presence in a liquid prod- nancial stability of a currency. In some cases, lender uct category in business-as-usual conditions. During of last resort facilities, or emergency funding, are truly a disruption asset liquidation would be possible for meant to be a last resort and as such, the firm may high-grade paper (in particular, eligible central bank have to comply with conditions that change the busi- assets), but again, higher haircuts would be applied ness model significantly if it wishes to obtain funding. based on liquidity quality. During general market crises, access to central bank funding could be expected to be generally more forth- Cushion of Liquid Assets coming against high-quality collateral for standing facilities. During a name-specific event, using central Recommendation 41: Firms should develop method- bank funding could send out negative signals to the ologies and policies to determine the level of specifi- market, and central bank eligibility criteria could be cally earmarked liquid assets that they should maintain stricter. at all times to meet immediate liquidity needs when faced with adverse conditions. These policies should Recommendation 43: Firms can include standing also include criteria for asset composition. central bank facilities that are granted on a “no ques- tions asked” basis in their contingency plans. The in- Discussion: clusion of such funding should be consistent with the timing of the availability of the respective collateral at Firms maintain a cushion of eligible central bank or the central bank. highly liquid assets to generate liquidity through re- pos, through asset sales, or through central bank Discussion: pledges. The calculation of such a cushion can be based on stress simulation, a requirement to cover In Europe some central banks provide lending facilities short-term liabilities (wholesale funding), or histori- to market participants. Under these standing facilities, cal analysis. Firms need to introduce a minimum level participants can raise liquidity on demand, usually for such a cushion of liquid assets. They also should against high-quality collateral already pledged to the consider whether different haircuts should be used for central bank, sometimes at a market rate and some- different/stressed scenarios and factor this into their times at a penalty rate. Some examples include the stress testing. A stressed scenario is generally expected European Central Bank, the Bank of England (stand- to lead to increased collateral demands in response to ing facilities), and the Swiss National Bank (Liquidity reduced access to unsecured funding. Shortage Financing Facility). Central Bank Facilities In 2006 the Bank of Japan removed the maximum number of times a month that banks may go to the Recommendation 42: Firms should ensure that as- discount window. In fact, banks with high-quality col- sumptions regarding potential funding from central lateral are encouraged to use it to increase the liquidity banks are evaluated taking into account the level of in the market during times of tightness, particularly severity and type of crisis. Firms should differentiate when market rates rise above the central bank lending between different types of central bank facilities (e.g., rate. “standing” facilities and “emergency” facilities). In all of these cases, approaching the central bank for Discussion: economic reasons is deemed prudent and takes place on a “no questions asked” basis whereby firms are not In considering the use of central bank facilities, some asked to explain what circumstances led to the liquid- central banks differentiate between standing facilities ity shortage. and emergency lending (often referred to as lender of last resort facilities). The former might be set at pre- In the United States, discount window facilities should agreed levels and often may be granted under a “no not be considered available in a name-specific event, 38
    • as this could signal to the markets that the firm is in In a general market crisis, market participants assume dire straits and could exacerbate the crisis. The Fed- access to central bank funding is possible against high- eral Reserve publishes statistics related to the use of grade collateral. the discount window by district. Although the name of the borrower is not disclosed, if there were concerns The availability of central bank funding depends on about a particular institution there would be specula- the circumstances at the time of the crisis: Are markets tion about its borrowing that could lead to reputation operating normally, or is there a firm-specific, con- issues. However, if the scenario is such that access to tained (product, region), or market-wide disruption? unsecured funding is assumed to be lost, then using Availability of central bank funding (and conditions to these facilities as a last resort is an acceptable alterna- be met for funding to be forthcoming) needs to be as- tive. sessed prior to making assumptions for stress testing purposes. Some firms eliminate this source of funding The Web site of the Bank of Canada details the Bank’s as it could send out negative signals to the market if policies and procedures as a lender of last resort, which used. includes both standing and emergency facilities. One document outlines the policies governing the Bank’s Recommendation 44: Emergency lending facilities lending activities, including the terms and conditions (lender of last resort facilities) should be considered of its two lender of last resort programs and the eligi- in firms’ stress testing. When implementing firms’ bility criteria that a financial institution must meet to “what-if ” scenarios, the potential use of these facilities receive a loan.30 Another document provides an over- should be dimensioned under each scenario. However, view of the Bank of Canada’s lender of last resort role, in terms of dimensioning risk (and establishing liquid- discusses the policy framework that guides the lender ity risk limits), emergency facilities should only be of last resort function, and addresses the potential considered available in extreme events subject to con- provision of liquidity to major clearing and settlement ditions under which the facility can be used legally and systems.31 under conditions that would not exacerbate a liquidity event for the institution. Most firms currently consider the impact of standing and emergency lending facilities in their stress scenar- Discussion: ios. A limited number of these firms plan to rely on and use these facilities only in limited circumstances Access to emergency lending facilities under the des- (i.e., severe stress events or to cover liquidity needs in ignated scenario should be confirmed in order to es- honoring credit facilities to other financial intuitions). tablish that local rules and regulations allow for such borrowing and that the prerequisite operational as- pects have been demonstrated. Assumptions generally should be conservative. Please refer to www.bankofcanada.ca/en/financial/llr.html. 30 Please refer to www.bankofcanada.ca/en/review/winter04-05/daniel.html#box2. 31 39
    • Considerations for the Official Sector tive approach to assessing the adequacy of a firm’s global liquidity risk management. That is, supervisors The following Considerations are targeted at public- need to focus on the overall effectiveness of each firm’s sector authorities as well as at firms. In these cases, it process, rather than expecting the risk-management is hoped that the suggestions will help inform a con- framework at each firm to have similar components. structive public policy discussion that will both make Often, such differences as legal structure, complexity, the system stronger and reduce regulatory rigidities risk-management approach, centralized versus decen- or uneconomic cross-border obstacles to good liquid- tralized management, key lines of business, and risk ity management. New technologies, new instruments, materiality justify differences in firms’ management and new risk-management capabilities have created structures and strategies (i.e., risk measurement and more integrated and responsive markets that cannot mitigation). be contained in old regulatory forms that may actually increase, rather than decrease, the chance of interna- To enable such reviews, firms need to assist supervi- tional systemic problems. sors to understand where and why differences in prac- tices across sectors and/or jurisdictions are acceptable Roles of Supervisors and lead to more efficient and effective risk-manage- ment solutions that are tailored to a firm’s individual A: Home and host supervisors should work together circumstances. to conduct an independent evaluation of a firm’s inte- grated liquidity positions as well as strategies, policies, Liquidity Risk Regulation procedures, and practices related to the management of global liquidity. Supervisors should ensure that the B: Regulators should seek to harmonize, or at least to firm has an effective system in place to measure, moni- promote greater consistency of, liquidity concerns, tor, and control liquidity risk and has an appropriate definitions, and standards among regulators so that liquidity contingency plan on a consolidated basis and, firms are better prepared to address regulatory consid- where required by regulation or deemed appropri- erations when constructing liquidity risk management ate by the board of directors, for each legal entity. As policies and practices for firm-wide implementation needed, supervisors should leverage the firm’s internal across multiple legal entities and jurisdictions. risk reporting to obtain sufficient and timely informa- tion to evaluate the firm’s level of liquidity risk. C: Liquidity regulations should be based on qualita- tive (Pillar 2) risk-management guidance, not specific Discussion: quantitative (Pillar 1) requirements. Host regulators should put more uniform reliance on home regulators Consistent with the Basel Core Principles, firms are and regulation to ensure adequacy of enterprise-wide generally subject to regular reviews on a consolidated management of liquidity. More effective global man- basis by a firm’s home supervisor and on a legal entity agement of liquidity by large firms should reduce sys- basis by each host or legal entity regulator. The criteria temic liquidity risk, even if at times this may mean that for these overlapping reviews, however, are not formal- the national interests of individual regulators are not ized or consistent, with some regulators focusing on maximized. qualitative assessments while other reviews are more quantitative in nature. Similarly, supervisory guidance Discussion: and regulation are a mix of qualitative and quantita- tive requirements. Quantitative information reported For most firms regulatory requirements directly related to supervisors varies, but tends to include gap reports, to liquidity and other prudential requirements are key liquidity position, and liquidity ratios. considerations in their global liquidity risk manage- ment frameworks. In fact, the need to meet legal entity While it is recognized that supervisors have certain requirements is one of the main drivers of the design legal constraints, home country supervisors need to of such frameworks. Quantitative legal entity require- consider taking a more holistic rather than compara- ments, however, may impinge on the ability to man- age liquidity on a group-wide basis, especially where 40
    • host country currencies are very liquid currencies and liquidity problems are most likely to spread through when the firm has a preference for a centralized liquid- reputational contagion that, by definition, cannot be ity-management structure, by creating liquidity pools prevented by the presence of trapped liquidity in a maintained at subsidiaries that are restricted from subsidiary in which problems did not originate. In- lending to the holding company or sister subsidiary. stead, such trapped liquidity may have the unintended This trapped liquidity could severely exacerbate the consequence of exacerbating the problem by limiting group-wide liquidity situation should a crisis arise. In access to these assets. addition, different regulatory requirements in various jurisdictions force firms to provide a number of dif- It is important that the issues of depositor and creditor ferent reports that are not based on internal models, protection and those of liquidity not be confused. The duplicating work and approval processes and creating more mobile and fungible liquidity is across locations distortions between internal and regulatory liquidity and currencies, the less likely it is for liquidity risks to reports. This inconsistent regulatory framework and crystallize and eventually become a question of solven- these restrictions on transferring liquidity between cy. Ensuring consumer/creditor protection would be entities in a group limit the ability of groups to man- better addressed by implementing harmonized bank- age firm-wide liquidity efficiently and have led many ruptcy laws across various jurisdictions and allowing groups to monitor and manage liquidity on a legal en- for a free flow of liquidity from locations where excess tity basis. liquidity exists. Should regulators relax some of the restrictions on the free movement of funds between Regulators need to give further consideration to the affiliates (e.g., large exposure regulation), the liquidity benefits of taking a more qualitative, consolidated situation would be less vulnerable to liquidity crises, as (rather than national) view when overseeing fund- firms could more freely move liquidity around when ing liquidity management of firms’ subsidiaries and and as needed instead of having to keep certain pools branches in their jurisdictions. To this end, host and of local liquidity merely to comply with local regula- legal entity regulators need to rely less on rules that tions. Fast access to liquidity is key to a liquidity crisis might trap liquidity and rely more on internal policy not developing into a solvency crisis that could affect frameworks and models reviewed by home regula- the stability of the rest of the financial system. tors and on information sharing and cooperation with home regulators. This will lead to more effective and Role of Central Banks efficient global management of funding liquidity risks and reduce systemic liquidity risk. Regulators are right- D: Central banks should seek to expand and harmo- ly concerned that financial difficulties encountered in nize eligibility of central bank collateral, enabling firms one entity could adversely impact the financial stabil- to maintain a common collateral pool. ity of the entire group, or even the markets in which they operate. Therefore, close monitoring of the rela- Discussion: tionships between regulated entities and all other enti- ties is of utmost importance. The regulatory require- Central banks, payment and settlement systems, and ment to maintain separate pools of liquidity, however, public exchanges should harmonize and expand the need not lead to the conclusion that a firm can con- types of acceptable collateral (especially for crises for sistently distance itself from a troubled affiliate, since which the financial industry is not the root cause) as large firms would suffer quite serious damage to both well as take steps to permit cross-border collateraliza- their reputations and their liquidity positions should a tion. Such a move would allow firms to manage liquid- material subsidiary become troubled. ity risk more effectively and more efficiently, in part by enabling firms to maintain a common collateral pool. The May 2006 Joint Forum paper made similar obser- Central banks in particular need to consider including vations, noting that regulations impede the movement less-liquid, but high-quality, assets as eligible collateral of liquidity and could force firms to hold liquid assets for their RTGS payment systems and normal course of in a number of jurisdictions and currencies. The paper business liquidity facilities. also stated that most firms believe that firm-specific 41
    • E: Central banks should provide greater clarity on not, the public sector would have regulatory and leg- their roles as lenders of last resort in both firm-specific islative means available to bring to order firms that and market-related crises. do not meet minimum risk-management standards (following the incremental clarity provided by central F: The official sector, including central banks, should banks). As a principle, central banks should be more be willing to actively participate in a firm’s contingen- willing to intervene to support the market and its par- cy planning, including periodic testing of lender of last ticipants and be more lenient as to the type of collat- resort facilities. eral they are willing to accept, if the crisis originates outside the financial industry. Discussion: Interaction of Liquidity Risk and Central banks should be more transparent about the Capital Adequacy process to be followed during extraordinary events, for example, the types of additional collateral that could G: Regulatory and economic capital should not be di- be pledged, haircuts that could be applied, limits by rectly tied to funding liquidity risk. The Basel II re- asset type (if any), and the delivery form of such assets. quirement to take liquidity into consideration for pur- This would include the questions that would be asked poses of Pillar 2 (Supervisory Review Process) should related to the borrowing and whether the borrowing be met through a regulatory assessment of firms’ li- would be public information. quidity positions and risk-management practices that considers each firm’s various liquidity risk metrics and As the IIF Special Committee on Effective Regulation levels of acceptable risk tolerance in light of its inter- notes in its Proposal for a Strategic Dialogue on Effec- nal and external environment and circumstances. tive Regulation, there is a fear that greater transparency on the part of central banks would lead to moral haz- Discussion: ard. It is the Special Committee’s belief, however, that the benefits of increased clarity on how central banks The Special Committee recognizes that there is some would respond to different types of crises outweigh intellectual appeal to trying to attribute capital to all this risk. In times of crisis involving multiple jurisdic- risks, including funding liquidity risk. However, the tions and regulators, there will always be challenges in use of a simple, standardized measure of liquidity the coordination of information collection, sharing, risk to derive capital requirements would be unlikely and decision making. To the extent possible, the more to yield a result that would be truly risk based. De- protocol that is established prior to such an event, the veloping and implementing a capital requirement for better prepared both firms and supervisors will be to liquidity risk would be not only costly and complex, address a crisis. but also would result in little additional capital. As noted throughout this report, the most effective un- Publishing the criteria about how a central bank derstanding of liquidity risk is developed through an would determine which firms would qualify for ad- evaluation of firms’ liquidity positions and risk-man- vances against “special” collateral is not the only way agement practices. Therefore, metrics should be tai- to increase transparency. Central banks could provide lored to market- and firm-specific characteristics. a collateral list and the circumstances under which such collateral would be accepted and could advise Funding liquidity risk is mainly a second-order risk. firms of the procedures for collateralizing advances That is, material liquidity risk issues typically arise as a so that banks could be better prepared. Central banks result of problems with the management of other risks. also need to provide the ability for business-as-usual Although liquidity risk could accelerate the downfall testing of these facilities so that operational details are of a firm, particularly if it initially had a high level of arranged in advance. For their part, firms are respon- unmitigated liquidity risk, it will almost never be the sible for acknowledging and managing the moral haz- root cause of a bank-specific crisis. Assigning capital ard risk as well as for maintaining adequate liquidity to cover funding liquidity risk would be adding to to respond to firm-specific liquidity shocks. If they do capital already allocated to other first-order risks, in- 42
    • cluding credit, market, business, and operational risks. preted in markets in which the capacity to close these There would inevitably be a duplication of capital re- gaps in term funding markets does not exist? In cases quirements if this were mandated. in which the capacity exists to mitigate the risk fully but firms choose not to, would the spread a firm could There are more efficient and effective ways to offset li- pay to close this gap be a reasonable proxy for what the quidity risk than using capital (e.g., increase core de- firm would have to pay in short-term markets in times posits, securitization, term funding, and pools of liq- of crisis? In other words, would the short-term pre- uid assets) if liquidity risk reduction is required. mium the firm has to pay in a crisis be as large as the long-term premium the firm would have had to pay Even if regulators or firms were to try to implement at the onset, especially in the case of lower-rated firms a capital framework, there are a number of more de- for which long-term spreads can be very wide and can tailed conceptual challenges to developing a robust vary materially between firms with the same rating? and meaningful methodology. One question that would need to be addressed is how to incorporate in In addition to the modeling challenges outlined above, the capital measure the impact of important off-bal- there is also a public policy aspect. Before consider- ance sheet liquidity risk mitigants, such as different ing any capital charges for liquidity risk, and in light of levels of unused funding capacity between different the important “maturity transformation” role financial firms, existence of deposit insurance programs, and firms play in the economies of all countries, regulators differences among various jurisdictions. Another would need to assess and understand the impact these question is how to choose business environment as- charges could have on financial firms, on their busi- sumptions for measuring liquidity risk and, therefore, ness franchises, and on other participants in capital capital requirements and corresponding confidence markets. Failure to do so could result in unintended intervals, when firms are not operating in a uniform consequences, such as diminishing financial firms’ environment and the risk of liquidity shocks to various maturity transformation role (especially in markets firms may vary greatly. These challenges may lead to in which gaps cannot be fully closed) or imposing a a significant divergence between institutions in their higher entry barrier for new competitors, who would adopted measurements, diluting the comparability of have to pay more to close these gaps if they are not well the outcomes and undermining the objectivity of the rated. framework itself. Given the practical, conceptual, and policy challenges, Challenges also exist in applying to liquidity risk the we believe that the industry’s resources would be bet- concept of unexpected loss, which is the basis for most ter spent improving capital measures related to other, economic and regulatory capital measures. If unex- more material risks and on strengthening liquidity pected loss were to be determined by looking at struc- risk management. Pursuing a costly solution to an im- tural liquidity gaps and the incremental cost that firms material problem is inconsistent with risk-based regu- could pay to close these gaps, how should this be inter- lation. 43
    • Analytical Discussion 1 be to provide funding to the institution. For example, securitization offers the opportunity to correct a sub- stantial part of the classic banker’s mismatch between Reliance on Secured-Financing Sources short-term deposits and other obligations and long- term assets by converting those assets into more read- Background ily tradable form, getting them off the balance sheet, and allowing banks to diversify risk and concentrate on As a general principle, liquidity derived from assets, as originating and managing credit rather than solely on opposed to incremental liabilities, is the most reliable warehousing risk. Conversely, capital relief and reduc- source of funding in a liquidity event. Thus, a signifi- tion of credit risk are often primary considerations for cant aspect of the liquidity risk management process securitizing assets. of a financial institution involves the assessment of its ability to access secured-financing sources. The most The Special Committee on Liquidity Risk noted that significant forms of secured-funding sources relate to there is a general assumption among financial institu- securities portfolios (Trading and Available for Sale) tions that incremental liquidity can be generated from and loans for which there are active markets for their unencumbered qualifying assets and that there is a securitization (mortgages, credit cards, and others). significant, increasing trend in their reliance on this The principles delineated in this report are equally ap- funding source. This mirrors market developments in plicable to asset sales and to secured funding. the secondary market for various asset classes and is a positive trend for the financial community. However, As noted above, the most reliable form of funding in along with assessing the liquidity value of the assets of a a liquidity event is derived from assets as opposed to particular firm, this raises more general market-related raising unsecured incremental liabilities. As financial questions about the availability of this funding source markets evolve, a significant trend impacting the li- in stressed market conditions. In particular, the con- quidity of financial institutions relates to the increased cerns relate to the availability of this funding source in availability of secured-financing sources. During 2006, a general market event or in a systemic event impacting in the U.S. alone, issuance of asset-backed securities more than one financial institution relying on the same exceeded $809 billion.32 Individual firms rely on bil- liquidity sources. A fundamental question is whether lions of dollars of secured funding on a daily basis to a firm that appears to be sliding into trouble would be finance their securities portfolios and to facilitate cus- able to have access to this market on reasonable terms, tomer transactions. and if so, to what extent? Even if able to offer high-qual- ity collateral, a firm might find that the market is in- The markets for secured financing fall into several cat- creasingly closed to it because counterparties (and tri- egories: party repo providers) may simply not want to face the potential difficulties of dealing with a failing firm, even • Securities financing arrangements, such as re- if they are confident under the applicable legal regime purchase/reverse repurchase agreements and that the collateral is fully secure and available to them. stock borrow/stock loan; The regulatory community shares these concerns. The • Asset-backed commercial paper (ABCP); May 2006 Joint Forum paper notes this trend, and fur- • Securitization of loans, such as ther discussions with regulators indicated particular º Credit Cards, concern about assumptions that central banks would º Mortgages, and provide a “backstop” in a market disruption. º Autos; and • Covered bonds. Securitization gives tremendous flexibility to firms and to the markets, but securitization (including cov- The primary purpose of some of these transactions ered-bond) transactions require expert personnel and in business-as-usual environments may or may not substantial infrastructure. There are highly technical UBS Investment Research, January 2, 2007. 32 44
    • questions regarding how to value securitized assets, uate the haircuts and timing of the cash flows including what liquidity haircuts to apply to even the from these sources. most widely understood assets, such as mortgages. Moreover, the market standing required for doing A3. In determining the amount of available liquid- such deals successfully cannot be overlooked. It is ity and the liquidation horizon, the evaluation highly unlikely that a firm that is not in the business should include a determination of whether the could use such transactions to unload assets if it began asset is encumbered as well as an assessment of to encounter liquidity or other financial difficulties. In market haircuts, market capacity constraints, ac- addition, although markets for many securitized assets cess to central bank facilities, concentrations in are broad and deep and regularly absorb large issuanc- collateral, potential name-specific concerns, and es, market capacity cannot be assumed, and if several the operational ability to complete the transac- firms attempted to dispose of large amounts of assets tion. Please see Recommendation 27. at the same time, especially under conditions of broad- er market stress, that capacity could be challenged. In º Encumbered assets should be excluded from short, securitization is strong strategically but may not incremental liquidity value; be available tactically in times of stress. º Haircuts should be evaluated in business-as- usual as well as in stressed conditions; These concerns can be partially alleviated by strong º The capacity of the markets for a particular policies and procedures at individual firms. The regu- asset class should be evaluated; and latory community needs to provide additional support º Operational capability to facilitate the trans- by providing clarity about its role, allowing broader action should be in place and tested. eligibility of collateral, and facilitating cross-border collateralization. A4. Liquidity value should only be given to those asset classes for which their liquidity has been Recommendation: While there is a need to continue demonstrated through active and ongoing sales, to look for ways to address the potential risk of liquid- secured funding, or securitization programs. ity drying up in secured-finance and liquid-asset mar- Please see Recommendation 26. kets, the Special Committee believes that: A5. In determining the available liquidity from A1. The main focus should be to take steps, through these sources, the depth of the markets should collaborative mechanisms between the industry be evaluated in business-as-usual and stressed and the official sector, to reduce the probabilities conditions. Capacity can be evaluated by asset that such events will occur, and if they do oc- class/security type through discussions with cur, to reduce their impact. The qualitative and customers regarding their available credit fa- quantitative measurement of this risk in liquidi- cilities, capacity, and pricing. Please see Recom- ty stress tests conducted by various firms remain mendation 25. speculative and arbitrary and would in the ex- treme produce results that senior management A6. Business strategy should be considered in evalu- would consider impractical to remedy. Rather, ating the liquidity of an asset class. For example, firms should continue to refine their risk-man- if a liquid asset is held as a hedge of another as- agement practices and focus on risk mitigation. set or derivative transaction as part of an overall business strategy, consideration should be given Recommendations – Financial Institutions to the impact on that business strategy, even as- suming such assets could, in light of existing A2. Firms that rely on secured-funding sources to a business or regulatory requirements or obliga- significant extent should have a robust process tions, be sold or pledged. Please see Recommen- in place to evaluate asset liquidity under a vari- dation 27. ety of business-as-usual and stressed conditions. Please see Recommendation 25. Firms with sig- A7. To the extent practicable, firms should test their nificant reliance on asset liquidity should eval- ability to access lender of last resort facilities. 45
    • This test should be coordinated with the central Liquidity value should only be given to asset classes for bank. Please see Recommendation 25. which liquidity has been demonstrated through an ac- tive and ongoing sales or securitization program. The Discussion: availability of central bank/government repo facili- ties should be used only if they have been tested and It is standard practice of securities firms and many would be available in a name-specific event. Consider- large commercial banks to assess the ability of a firm to ation should be given to whether use of these facilities convert its unsecured funding to a secured basis. The would exacerbate a crisis. loan (“collateral”) value of its unencumbered portfo- lios is generally assessed on a daily basis. Haircuts on Firms could base haircuts on prior experience, best- these securities are reviewed on a regular basis with practice assumptions, liquidation scenarios, regulato- the funding desks and consideration is given to the ry requirements, practices adopted in Market or Cred- concentration of positions, the level of haircuts in a it Risk, or market liquidity models. A comparison of crisis, and the operational capability to complete the various models would provide a range of results from transaction. Acceptable practice for a bank’s trading which firms could select an appropriate model. and banking books should be consistent with the pro- cess above. Securities should be grouped according to their li- quidity value. High values, for example, would apply If liquidity problems occur, a decision would need to to eligible central bank holdings. Other criteria to be be made as to which holdings can be shed that are least considered when assessing liquidity values and catego- detrimental to business relationships and to percep- rization are rating/credit quality, frequency of mark- tions about the firm’s soundness, taking into account to-market, market price availability, maturity, type business economics (profit and loss). Firms that are of security, reason for holding (trading, investment, active in secured-lending markets could use assets to hedge), access to secured funding for the security, is- generate liquidity through repos rather than through suer type/country, currency, size of position (e.g., rela- outright sales, should markets permit. tive to issue size, daily traded volume), and time to settlement. Liquidity categories can be grouped into Some central banks offer limited overnight funding high, medium, and low liquidity or by the likelihood against high-quality collateral (usually pledged in ad- that the action will be taken. vance) on a “no questions asked” basis. Most firms use haircuts or a volatility analysis to de- The evaluation of the liquidity value should differenti- termine the liquidity value of assets. In general, firms ate between use of assets as collateral for borrowing evaluate the value and timing of their actions based on and for generation of cash by sales of such assets, and the scenario that is being addressed. also take into consideration the business strategy for the assets in question, the potential P&L impact of Considerations for the Official Sector any disposition, and whether management would be willing to absorb potential losses, taking into account A8. Central banks should seek to expand and har- tax effects. In determining a haircut for sale purposes, monize eligibility of central bank collateral, en- stressed volatility of markets should be considered abling firms to maintain a common collateral over the projected liquidation horizon. Haircuts for pool. Please see Consideration D for the Official repo purposes should be based on an evaluation of Sector. the market’s ability to absorb the level of positions, at proposed haircut levels. An evaluation should be per- A9. Central banks should provide greater clarity formed of securities held for clearance and for other on the role of the central bank as lender of last regulatory or legal purposes to determine whether resort in both firm-specific and market-related they are encumbered or otherwise unavailable for li- crises. Please see Consideration E for the Offi- quidity. cial Sector. 46
    • A10. The official sector, including central banks, ard. It is the Special Committee’s belief, however, that should be willing to participate actively in firms’ the benefits of increased clarity on how central banks contingency planning, including periodic test- would respond to different types of crises outweigh ing of lender of last resort facilities. Please see this risk. In times of crisis involving multiple jurisdic- Consideration F for the Official Sector. tions and regulators, there will always be challenges in the coordination of information collection, sharing, Discussion: and decision making. To the extent possible, the more protocol that is established prior to such an event, the Central banks, payment and settlement systems, and better prepared both firms and supervisors will be to public exchanges should harmonize and expand the address a crisis. types of acceptable collateral (especially for crises for which the financial industry is not the root cause) as Publishing the criteria about how a central bank well as take steps to permit cross-border collateraliza- would determine which firms would qualify for ad- tion. Such a move would allow firms to manage liquid- vances against “special” collateral is not the only way ity risk more effectively and more efficiently, in part by to increase transparency. Central banks could provide enabling firms to maintain a common collateral pool. a collateral list and the circumstances under which Central banks in particular need to consider including such collateral would be accepted and could advise less-liquid, but high-quality, assets as eligible collateral firms of the procedures for collateralizing advances for their RTGS payment systems and normal course of so that banks could be better prepared. Central banks business liquidity facilities. also need to provide the ability for business-as-usual testing of these facilities so that operational details Central banks should be more transparent about the are arranged in advance. For their part, firms are re- process to be followed during extraordinary events, for sponsible for acknowledging and managing the moral example, the types of additional collateral that could hazard risk as well as for maintaining adequate liquid- be pledged, haircuts that could be applied, limits by ity to respond to firm-specific liquidity shocks. If they asset type (if any), and the delivery form of such assets. do not, the public sector would have regulatory and This would include the questions that would be asked legislative means available to bring to order firms that related to the borrowing and whether the borrowing do not meet minimum risk-management standards would be public information. (following the incremental clarity provided by central banks). As a principle, central banks should be more As the IIF Special Committee on Effective Regulation willing to intervene to support the market and its par- notes in its Proposal for a Strategic Dialogue on Effec- ticipants and be more lenient as to the type of collat- tive Regulation, there is a fear that greater transparency eral they are willing to accept, if the crisis originates on the part of central banks would lead to moral haz- outside of the financial industry. 47
    • Analytical Discussion 2 difference in the way in which income is recognized. The margin on a secured loan in the commercial bank is accrued over the life of the contract. The margin on a The Impact of Complex Financial Instru- derivative financing trade can often be present valued ments upon Liquidity-Management Poli- and recognized into income immediately upon com- cies and Practices pletion of the transaction. Some firms may regard this as an incentive to develop their derivatives’ financing Introduction activity. Some firms may not have fully recognized the impact this will have over time on their own balance The growth in the use of Complex Financial Instru- sheets. ments (CFIs) over the past decade requires us to con- sider the extent to which developments in the man- This report attempts to illustrate the ways in which ufacturing, warehousing, and distributing of such CFIs can affect a firm’s liquidity. The report does not products can affect the liquidity of a firm and should attempt to quantify the scale of the risk or vulnerabil- affect its related policies and practices. At first glance ity created. What it does aim to do is provide partici- this may not seem to be an obvious question. After all, pants with an insight into how liquidity vulnerabilities derivatives have historically been off-balance sheet and may arise and what drivers are behind activities that unfunded commitments. When we think of funding create such vulnerabilities; finally, it suggests how to liquidity risk our thought process rarely begins with best monitor and mitigate the liquidity risks arising. the derivatives arena. Reviewing the vulnerabilities and ways to mitigate the risks is considered a higher-return activity than scal- So why should we consider this question? Firstly, little ing the exposure. Because of the differences between has been written to date on this specific subject. There firms owing to the differences in jurisdictions, mar- are good reasons for this. The subject is not simple, kets, businesses, and structures, there is no simple set and few market practitioners are experts in both the of metrics that can be used to gauge the aggregate size fields of derivatives and balance-sheet/liquidity man- of this exposure. agement. The process by which this report has been produced Secondly, derivatives have flourished in an environ- began with the formation of a Task Force operating ment in which regulatory prescription and industry under the auspices of the IIF Special Committee on practices are not very consistent and in which opacity Liquidity Risk. governs the way in which some prices are determined and some transactions are reflected in financial state- The Task Force developed an analysis, based on the ex- ments. The fact that different firms may measure and periences of each member’s respective firm, of the ways attribute different economic values to “liquidity” for in which CFIs could impact the liquidity of a firm. This these transactions may create pricing discrepancies analysis was distilled into this summary report. that are not warranted. Our analysis revealed that the liquidity impact of CFIs The third (and perhaps most specific) reason that we can be categorized under four headings: should consider this question requires an acknowledg- ment that many firms may not have yet fully transi- 1) Documentation Risk tioned their liquidity policies and practices from being The challenge of ensuring that all the critical terms of primarily concerned with core commercial lending ac- structured transactions are adequately captured and tivity out of the commercial banking areas into giving made visible to those responsible for maintaining an derivatives areas the attention they deserve. Aspects of entity’s liquidity is substantial. CFI transactions are financing (typically, secured lending) are increasingly often bespoke transactions governed by bespoke doc- being structured as derivative financing trades under umentation. Certainty in respect to the contractual an ISDA contract. The drivers behind this change are terms of the transactions and the legal enforceability several; however, perhaps the most important is the 48
    • of the contracts are key aspects of ensuring liquidity in facilities constitutes contingent liquidity risk. This risk the markets and the predictability of cash flows. Firms arises in the event of disruption in the ABCP markets, that are active in this area need to satisfy themselves an issue with funded assets, or an issue with the pro- that all material liquidity risks, in addition to the cred- vider of the liquidity line. In effect, if the ABCP mar- it, counterparty, and market risks embedded in such kets are not able to fund the conduit, the obligation to documentation, are both understood and visible. fund the assets passes to the provider of the backstop liquidity facility. While the risk of draw on liquidity 2) Liquidity of Assets lines is a low probability event, firms should consider A common presumption is that highly rated assets what their obligation would be under such circum- are inherently liquid (either from the perspective of a stances and ensure that they are properly mitigating firm’s ability to refinance using the secured markets or this risk. in terms of a firm’s ability to sell the assets in the mar- ket). This presumption needs to be confirmed. In times Analysis of the likelihood of drawdown based on his- of distress there may be an inverse correlation between tory may lead to a false level of comfort. Firms need the complexity of an asset and its true liquidity. to acknowledge that “black swans”33 may exist and ensure that the quantum of facilities extended makes 3) The Total Return Swap (TRS) sense in the context of their overall liquidity planning, The Total Return Swap is a critical mechanism within including both legal and practical obligations. Analy- the broader structured-asset market. The TRS is used sis of the liquidity of the assets pledged to the conduit, by some firms to take advantage of the differential in alternative funding arrangements available for these funding costs that exists between firms. Firms with a assets, and protections provided by the nature of the low cost of funds can finance assets on-balance sheet underlying customer relationship are important con- and transfer the economics of these assets via a TRS siderations in determining the extent of the liquidity to a firm with a higher cost of funds. The differential risk. in funding costs is shared between the firms and may in some cases be recognized into income immediately In the pages that follow we provide further detail on upon completion of the transaction how best to monitor and mitigate the risks described under the headings above. As the use of the TRS as a financing tool has grown, so too have instances of the use of mismatches in the Descriptions and Recommendations term structure of the TRS warehouse books in which some firms seek to benefit from the term structure of 1) Documentation Risk financing costs by providing long-term financing via a TRS hedged with a TRS of a shorter duration. Firms Overview of Vulnerabilities: may therefore be exposed to the risk that the “hedge” TRS does not roll over at its maturity. This creates an The increasingly unique and bespoke nature of struc- open market risk and liquidity position, which is di- tured transactions and derivative trading documen- rectly relevant to a firm’s liquidity if consideration is tation has resulted in a variety of contractual ar- given to hedging the open position with the purchase rangements that could expose a firm to a variety of on-balance sheet of the reference assets. vulnerabilities, including: 4) Conduit Financing • Contingent liquidity risks, and It is an increasingly common practice for firms to • Misstatement in liquidity profile, i.e., lack of clar- finance assets (both client and proprietary) via con- ity regarding the pay-off profile of a structured duits. Conduits may be used to finance assets that arise investment product, any embedded derivative from the provision of CFIs to a firm’s clients. The con- features, and event triggers that could result in duits issue ABCP for which repayment is supported a misstatement of the liquidity characteristics of by a backstop liquidity facility. The provision of these such products. A black swan is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations. 33 49
    • Insufficient management information on the nature of party while the client covers its exposure via a general such contractual arrangements may mean that these deed of pledge on its assets. issues and their liquidity impact may not be visible to a firm and, consequently, may not be adequately in- 2. Call Features Embedded in Structured Investment cluded in liquidity planning and contingency plans. Products Structured investment products are common de- How the vulnerabilities may occur: rivative products through which predominantly retail and high net worth individuals are provided Such vulnerabilities may occur through a variety of with structured investment exposure to a range of common arrangements, several of which are detailed asset classes in a variety of forms. below: The pay-off features of such products can vary con- 1. Credit Rating Downgrade Language siderably. Some structured products, while issued Certain clients may be required, through internal with, for example, a ten-year term, have embed- board policies or legal charters, to ensure that all ded features allowing the issuer to call the prod- transactions/trading activities are executed with uct from customers on a regular basis, i.e., every the most highly rated institutions. As a conse- three months, if certain market-based triggers are quence, such clients may require that Credit Rat- breached. A product area may treat and book these ing Downgrade Language be included in bilateral transactions as ten-year term deposits, whereas counterparty documentation. The consequences of from a liquidity-management perspective the call a credit downgrade can vary: feature necessitates that these types of products should be treated as three-month rolling deposits. • Under trading documentation, such as ISDA, A lack of clarity regarding the pay-off profile of a a common consequence of breaching a credit structured investment product, and specifically rating trigger includes the termination of the any embedded derivative features, could result in a transactions by the nonaffected party or, if a misstatement of the liquidity characteristics of such Credit Support Annex (or equivalent) has been products. executed, requirement of the delivery of collat- eral in a specified amount and quality by the af- Recommendation B1: The function within a firm that fected party to the nonaffected party. is responsible for liquidity risk should receive regular • Under bespoke liquidity arrangements the en- management information or have access to informa- tity being downgraded may be required to col- tion on the nature and profile of all material arrange- lateralize its commitment within a specified ments that expose the firm to a contingent liquidity period (i.e., placing cash on a specified escrow risk. Any material negative liquidity implications re- account within 30 days). In certain transactions, lated to these arrangements should be captured in the particularly some conduit liquidity facilities, firm’s liquidity measures. the amounts that may be required to be placed as collateral can be significant. Recommendation B2: All transactions that expose a firm to a material-contingent liquidity risk should be The occurrence of a credit rating downgrade event subject to pre-approved business limits or be report- represents a liquidity risk for a firm, a contingent li- able and subject to pre-approval and, where appropri- quidity risk that Treasury will have to recognize and ate, conditions of sanction by Treasury management. manage. Lack of management information on the issue may mean that the issue and its impact (and the timing Recommendation B3: The function within a firm that thereof) may not be visible to Treasury and thus not is responsible for liquidity risk should be actively en- included in liquidity plans and stress tests. gaged in the evaluation of new product offerings to en- sure that liquidity issues are adequately addressed and Mismatches may also exist between treatment of coun- appropriate actions taken to report and mitigate such terparties’ collateral support agreements, putting some risks as appropriate. risk on the firm to provide collateral to the counter- 50
    • Recommendation B4: The function within a firm that However, TRS transactions increasingly reference is responsible for liquidity risk should have a detailed complex and unique underlying assets (e.g., CDOs, understanding of the nature of the structured invest- hedge funds, funds of hedge funds), and while ment product business undertaken and the way in some of these assets may be highly rated there is which such products are booked and reported in li- not, at present, a deep and liquid cash and deriva- quidity reporting frameworks. tive market for them. In reality, the ability of the trading desk to: 2) Liquidity of Assets Overview of Vulnerabilities: a) Quickly and easily sell the cash hedge may be low, and oftentimes the desk will be unwilling By financing a trading desk on an overnight basis, to sell due to the creation of an open risk posi- rather than based on the expected liquidity profile of tion and doubts as to whether the asset hedge its underlying assets or asset packages, a firm could be can be reacquired at a later date. Some assets exposed to a potentially unrecognized liquidity mis- are unique and bought by buy-to-hold inves- match. tors; consequently, secondary liquidity can be sparse. Liquidity issues could be further exacerbated when b) Quickly sell the cash hedge and substitute it the assets are held as a hedge to a derivative transac- with a derivative alternative may be doubtful; tion and profit is booked on the derivative transaction in reality such a transaction would often take upfront. In such circumstances, the liquidation of the months to arrange. asset position may trigger the booking of a loss in the relevant trading book. 2. Negative Basis Transactions A proprietary desk may seek to realize a “riskless” How the vulnerabilities may occur: profit by capturing differentials in the pricing of a credit between the cash and derivative market. The vulnerabilities may occur through a variety of Typically, a transaction involves: transactions; two common derivative transactions in which such vulnerabilities may arise include: a) The purchase of a credit asset, funded via Trea- sury; and 1. Total Return Swaps b) The hedging of the associated credit risk through A trading desk will often provide a client with syn- the purchase of credit default swap (CDS) pro- thetic exposure to an asset via a term TRS and then tection. hedge the client transaction by buying the underly- ing asset and holding it on-balance sheet using fi- Assets purchased will typically be held on-balance nance provided by Treasury. On the basis that the sheet and funded via Treasury. transaction is originated and booked by a trading desk and the asset may be highly rated, Treasury While the credit asset may be liquidated in a short pe- may assume that the underlying asset is liquid and riod of time, this is not the correct liquidity bench- readily tradable and, consequently, fund the un- mark for anything other than a stressed liquidity situa- derlying asset on a short-term (typically overnight) tion. By buying a concomitant CDS hedge the trading basis. This may be appropriate where a deep and desk has created a “negative basis” package. If the asset liquid cash and derivative market exists for these element of the package were to be liquidated in isola- assets, allowing the trading desk to easily substitute tion, the trading desk would be left with the CDS posi- its hedge by selling the underlying reference assets tion, which would be difficult to unwind and would, in (e.g., government securities) and entering into a the meantime, expose the trading desk to a potentially derivative hedge (e.g., an interest rate swap) with a unwelcome synthetic short position in the underlying market counterparty. credit. 51
    • For liquidity risk management purposes, the liquid- liability. Liquidity costs should be charged to those ity of the “negative basis” package should be analyzed. businesses that consume liquidity. There are three alternative ways in which the package could be funded: 3) Use of Total Return Swaps to Fund Directly from the Market a) A back-to-back TRS with a third party, where- by the trading desk would sell the asset and Overview of Vulnerabilities: provide the purchaser with credit protection. b) Novation of the package in which the trading Total Return Swaps can be regarded as off-balance desk sells the assets to a third party and trans- sheet funding arrangements. Unless Treasury ensures fers its CDS. that appropriate controls are in place over such trans- c) Repo or secured funding of the underlying as- actions, a structuring desk by using a TRS may: set so that the position is maintained but the underlying asset is repoed into the market to • Utilize the capacity of an entity to raise fund- raise funding. ing in the market; and • Create and run funding mismatches, exposing In reality, the repo market for some of these as- a firm to tactical and structural liquidity risk. sets may lack depth while the back-to-back TRS or Novation could take several months to ar- How the vulnerabilities may occur: range. A common derivative transaction is for a trading or Recommendation B5: The function within the firm structured product desk to provide a client with syn- that is responsible for liquidity risk should have a de- thetic exposure to an asset via a TRS. The trading desk tailed understanding of the asset profile of each trading can hedge this exposure by either: desk, including access to information on the estimated period of time to liquidate, substitute via derivative, or a) Buying the asset and holding it on-balance repo the assets held on such books. sheet (using finance provided by Treasury); or b) Entering into a hedge TRS with a market coun- Recommendation B6: As part of the new business terparty. approval process for material transactions involving highly structured assets as underlyings, trading desks The hedge TRS can be regarded as an off-balance sheet should clarify how they aim to fund these positions, funding arrangement. If a trading desk uses a TRS in what the potential alternatives for liquidating these this way to raise funding in the market without Trea- positions are, and the expected timescales to achieve sury’s and/or the main funding desk’s awareness that such exits. this is taking place, it is: Recommendation B7: Firms should consider whether • Utilizing the firm’s capacity to access the a policy ought to be established requiring that assets wholesale markets, potentially and perhaps and asset packages be funded for a tenor equivalent unknowingly restricting the firm’s ability to to their expected liquidity profile and/or limits placed access liquidity when it may really need it. on ensuing funding gaps, or alternatively, whether • Possibly sending an inconsistent message to processes should be implemented to recognize these the market regarding the price and form in gaps in firm-wide liquidity reports and allocate, where which a firm raises debt if pricing levels are applicable, related term funding costs that may be in- not coordinated. curred. If the client TRS and the hedge TRS are not contractu- Recommendation B8: As stated in Recommendation ally identical, the trading desk is running a funding 11 of the main report, where applied, transfer pricing mismatch. While running interest rate mismatches is should be closely aligned with the liquidity of the un- normal in the course of trading desk or Treasury busi- derlying asset or structural nature of the underlying ness, running a funding mismatch is generally not. For 52
    • example, if a trading desk provides a five-year TRS to a ther impede the ability of a firm to effectively client and hedges it via a six-month TRS from the mar- manage the associated liquidity risks; and ket, in the event that the hedge TRS cannot be rolled • Contingent liquidity risks, if material and not over at maturity, the firm may be exposed to a tactical included within internal and regulatory li- and structural liquidity risk (“roll risk”). quidity reporting requirements, would lead to a potential misunderstanding of a firm’s true Without proper recognition of the liquidity risk in this liquidity risk. Consequently, the firm may not example, the financial performance of the structuring be maintaining sufficient liquidity to deal with desk may be overstated. This issue can be further com- conduit based contingent liquidity events. pounded when this benefit is not accrued but instead is taken upfront as a structuring fee. How the vulnerabilities may occur: Recommendation B9: A firm’s policies on the man- To facilitate client transactions, structured product ar- agement of funding and liquidity risk should incorpo- eas often seek to use conduit vehicles. Such vehicles rate funding gaps arising from the usage of derivative will typically be arm’s-length, special-purpose enter- products within trading areas. prises that acquire assets funded via the issuance of ABCP to third parties. Recommendation B10: The function within a firm that is responsible for liquidity risk should understand The spectrum of assets held by the conduit can vary how structured transactions are booked in legacy and considerably, dependent on its strategy, but could in- risk systems and how they roll up in the balance sheet clude mortgages, car loans, and customer receivables, to ensure that adjustments to automated liquidity risk as well as liquid securities such as ABS. While the as- measurement processes are made where necessary. sets will typically be highly rated by a recognized credit rating agency, their liquidity profile can vary consider- Recommendation B11: Regular management infor- ably from intraday (e.g., central bank repo eligible se- mation should be produced or made available as re- curities) to several years (e.g., an amortising customer quired for Treasury that details the on- and off-balance asset that can not be transferred or sold). sheet funding profile of each trading desk, including any roll risk. The ABCP issued by the conduit will typically have a maturity of one to six months, whereas the asset li- 4) Contingent Liquidity Risk Arising from Con- quidity profile may be significantly longer. As a conse- duits quence the conduit is exposed to a liquidity mismatch. To mitigate this risk and facilitate the short-term credit Overview of Vulnerabilities: ratings necessary for the successful distribution of the ABCP to third parties, a highly rated bank provides a A standby liquidity facility extended to a conduit vehi- liquidity facility to the conduit in the form of a standby cle represents a contingent liquidity risk in that on the liquidity facility. occurrence of specified events a firm may be required to provide funding, potentially immediately, to a con- The occurrence of any of three possible events would duit. From a liquidity-management perspective such a typically cause the drawdown by a conduit of its li- facility represents a number of challenges: quidity facility: • The timing and size of drawdowns may involve 1. A general disruption in the CP market that the interaction of a number of factors that are shuts off the conduit’s access to ABCP fund- difficult in aggregate to assess and often are ing; beyond a firm’s control; 2. A conduit or administrator disruption that • Management reporting of such contingent li- eliminates ABCP market access (e.g., a ratings quidity risk (i.e., scale, sensitivities, and char- downgrade to A-2/P-2 or below of the liquid- acteristics), if not well developed, would fur- ity provider); or 53
    • 3. An issue with a specific transaction that leads dence to support this view, the potential impact that the conduit administrator to fund the transac- these draws could have on a firm’s liquidity could be tion outside the conduit. very material. Therefore the risk has to be proactively understood, managed, and controlled. The materiality of the vulnerabilities to which a firm is exposed will depend on a number of factors: Recommendation B12: The function within the firm that is responsible for liquidity risk should have a de- 1. The nature of the specified event that has oc- tailed understanding of the contingent liquidity risk to curred and the duration over which it occurs; which it is exposed by extending backstop liquidity fa- 2. The quantum of aggregate liquidity facili- cilities to conduits, as well as the events that may trig- ties that a firm has extended that relate to the ger the drawdown of these liquidity facilities. specified events; 3. The other funding options the seller has to fund Recommendation B13: The potential liquidity conse- these assets in light of the expensive costs that quences of the conduit business should be integrated normally apply to drawing these lines; and into the overall liquidity planning of a firm. These 4. The nature of the inherent liquidity mismatch- plans should take into account contingent liquidity es being run by the conduits to which ABCP demands from various businesses. liquidity facilities have been extended, as well as whether the conduit will readily liquidate Recommendation B14: A firm should mitigate the assets on the occurrence of a specified event. contingent liquidity risks arising from the provision • A liquid conduit, being one that invests in of such backstop liquidity facilities by establishing an highly liquid securities that the conduit appropriate strategy, policy, limit framework and oth- can sell or repo within the maturity distri- er mitigants as appropriate for this activity that take bution of outstanding ABCP, exposes the into consideration the types of assets being securitized firm to a low duration of the contingent li- and their degrees of liquidity. Such a framework could quidity risk. include, for example, limits on the size and nature of • An illiquid conduit, being one that invests ABCP facilities offered, limits on the amount of CP in highly illiquid/structured assets that maturing during any one time period (overnight, one cannot be sold within the maturity distri- week, two weeks, one month, etc.), or holding a risk- bution of the CP, exposes the firm to a po- adjusted pool of earmarked liquid assets to mitigate tentially significant duration of the contin- against short-term disruptions. gent liquidity risk. Recommendation B15: Any material transactions that One of the challenges faced when dealing with this incorporate ABCP-based liquidity facilities should be topic is that while the probability that liquidity lines subject to Treasury approval or prior business limit ap- will get drawn is minimal, and there is plenty of evi- proval. 54
    • Appendix 1 The following possible sources of liquidity vulnerabili- ties and potential liquidity metrics have been identified as good examples of what firms may want to consider in Possible Sources of Liquidity Vulnerabili- their liquidity risk analyses. Where these vulnerabilities ties and Potential Metrics are applicable and material, firms may choose to imple- ment these or other similar metrics, bearing in mind the The concept of “liquidity” is complex, and any sugges- context of their own vulnerabilities. This list is neither tion that a single metric will adequately reflect the true exhaustive nor intended to be a prescriptive list of met- liquidity risk of a firm is misguided. A range of metrics rics that each firm should use. Some metrics may be used is therefore required. The range of metrics needs to be to address multiple vulnerabilities. Some firms will natu- customized to meet the needs of the firm.34 rally focus on the vulnerabilities most relevant to their liquidity profiles. These vulnerabilities are focused on As the business mix of each firm differs and does not liquidity outcomes, not necessarily such root causes as fall into simple categories, we refrain from classifying significant credit losses or reputational issues. We have the metrics. The firm should ensure that its choice of grouped them in the following categories, recognizing metrics reflects the business mix and is appropriate for that different firms could group them differently and the liquidity vulnerabilities that exist within the firm. that some vulnerabilities and metrics are more meaning- ful than others. Liability-Related Possible Sources of Liquidity Vulnerabilities Potential Metrics Accelerated withdrawal of relationship-based and Stress testing under various scenarios transactional deposits from banks or dealers Cash capital Core deposits to loans Lack of competitive deposit strategy Deposit profile – by customer type, amount bands, and products product type, currency Ability of liquid assets to cover liquidity gaps More rapid loan than deposit growth (reference to benchmark period discussion) Risk-adjusted models measuring potential exposure Market triggers – to monitor transition from business- as-usual to stressed conditions Core deposit haircuts Loss of access to unsecured wholesale funding or ex- Liquidity stress tests that assume no access to unse- treme increase in cost cured wholesale funding Ability of liquid assets to cover liquidity gaps Material dependence on wholesale short- and long- (reference to benchmark period discussion) term unsecured funding, including from higher-rated Business-as-usual funding gaps counterparties Maximum unsecured unused funding capacity over Failure of major provider of unsecured funds previous periods as a proportion of expected funding requirements Concentration of wholesale funding sources Maximum unsecured used funding capacity over secu- rities available for collateralization Refer to Recommendation 29. 34 55
    • Reduction in the availability of money market lines Unused unsecured funding capacity broken down by available to the firm products, currencies, geographies, etc. Risk-adjusted models measuring potential exposure Reduction in ability to raise term money Diversity of funding programs Market triggers to monitor transition from business- as-usual to stressed conditions, wholesale unsecured funding, and less short-term placements, as compared with third party liabilities Loan to deposit and loan to core deposit ratios Cash capital Survivability horizon Comparative funding costs Cash flow and term mismatches Survey of dealer and counterparts to estimate unused unsecured funding capacity Credit available to firm by counterparties for unsecured funding Proportion of funding from higher-rated counterpar- ties to total unsecured funding Concentration analysis of liquidity providers Debt profile by product, market, investor, currency, and maturity Comparative debt spreads Stress tests Reliance on credit dependent sources of secured fund- Proportion of credit sensitive funding lines to total ing, correspondingly, availability of committed irrevo- funding cable secured-funding lines List of securities categorized by degree of liquidity of secured-funding market Restricted access to secured-funding markets Total and unused secured funding capacity Liquidity stress testing for dependence on secured funding List of commercial and central bank secured lines Reliance on synthetic funding from better-rated coun- Review of concentrations of funding terparties Proportion of funding from higher-rated counterpar- ties to total unsecured funding Technology risk related to funding Stress testing Quantum of funding which is reliant upon the stability of the technology supporting e-channels Ratings downgrade Stress testing Cash capital Sensitivity of funding and collateral needs to ratings changes broken down by number of notches 56
    • Asset-Related Possible Sources of Liquidity Vulnerabilities Potential Metrics Insufficient availability of collateral Maximum collateral usage for each payment system and settlement system Disruption in payment/settlement systems Forecasting models Stress testing Increased collateral requirements due to market risk Impact of ratings changes on collateral requirements losses, ratings triggers, or asymmetric documentation Exclusion in cash flow analysis Pledging limits Special emergency asset pool Inadequacy of a firm’s infrastructure to conduct securi- Securitizable amounts by period, currency, and asset tization transactions class (can be incorporated into scenario analysis/stress testing) Reduced liquidity of outright market for securities Stress scenarios of wider haircuts List of liquid asset holdings by categories, credit rat- ings, and liquidity value Too large a trading position relative to market volume, Size of position compared to open interest and average open interest, and number of market makers daily volume; considered as part of stress tests Failure of specialist liquidity providers in niche secu- Scale of exposure to any given liquidity provider rity markets Unwillingness of counterparties to take settlement risk List of pledgeable collateral by appropriate categories on collateral transfers across time zones Metrics scaled to the entity level, where “entity” is de- fined by the fungibility of liquidity Spurious diversification; while portfolios might be di- List of asset categories across strategies versified strategies may be correlated across counter- parties (like in the case of long-term capital manage- ment) Lack of demonstrable liquidity due to bespoke nature Cash capital of transaction Customer loans to customer liabilities and core liabili- ties Stress testing Generic On- or Off-Balance Sheet Possible Sources of Liquidity Vulnerabilities Potential Metrics Increased drawdown of committed facilities or other Total committed but undrawn facilities broken down contingent funding uses by credit rating of borrower, with different drawdown percentages assumed by ratings Risk-adjusted models measuring potential exposure Scenario analysis based on ratings migration and vari- ance in line utilization by rating Market triggers to monitor transition from business- as-usual to stressed conditions 57
    • Funding transactions structured as derivatives, possibly List of deals with contingent funding by period resulting in contingent funding risks not being identi- Risk-adjusted models measuring potential exposure fied, measured, or managed effectively Structure of group – multiple balance sheets, tax, and Metrics scaled to the entity level, where “entity” is de- regulatory restrictions; ability to transfer liquidity fined by the fungibility of liquidity – amount of liquid- across entities, geographies, currencies efficiently ity that can be transferred must be considered in other metrics Change in regulatory or tax rules Currency mismatch between assets and liabilities Quantify acceptable reliance upon FX swap market or cross-currency for access to funding in specific curren- cies Cross-currency funding measures and limits Concentration and diversification risks of strategy, Concentration and diversification analysis and/or lim- product, industry, currency, counterparty, funding its sources Reduced internal capital generation Cash capital Survivability horizon 58
    • Appendix 2 foreign branches versus foreign operating subsidiar- ies), complexity (the breadth and diversity of markets/ products, geographies, and legal entities), key lines of Recommendations on Industry Practice business, home and host regulatory requirements and for Liquidity Risk environments, marketplaces, and risk materiality in the context of the firm-wide risk-management strategy For purpose of convenience Appendix 2 restates the and appetite. The rationale for this strategy should be Recommendations contained in the main body of the explained, and the strategy should be communicated report. throughout the organization. A. Governance and Organizational Structure for Recommendation 4: A firm’s board of directors (or a Managing Liquidity: committee thereof under delegated authority) should approve the strategy and significant policies related to Liquidity Risk Definition the management of funding liquidity risk under both normal and stressed conditions and review and ap- Recommendation 1: Firms should define the differ- prove these policies annually. Board-approved docu- ent forms of liquidity risk to which they are exposed ments should identify key funding liquidity limits and (including relevant subsets within each form defined); approval levels, as well as those authorities delegated identify where they fit in their enterprise risk universe; to senior management committees or those executives and communicate these definitions across their groups accountable for approving detailed strategies, goals, so that a common understanding is applied when iden- procedures, limits, and exceptions. The board should tifying and evaluating liquidity risk related to existing also ensure that senior management takes necessary businesses, business reviews, new businesses, products steps to appropriately manage, measure, monitor, and or initiatives, and acquisitions and alliances. control funding liquidity risk in an integrated fashion with other closely associated risks to facilitate enter- Recommendation 2: Firms should distinguish be- prise-wide risk-management solutions. The board tween funding liquidity risk and market liquidity risk should be informed regularly of the funding liquidity in their enterprise risk universe. Within funding li- position of the firm (metrics, indicators, and outlooks), quidity risk, firms should address their practices re- and immediately notified if there are any material lated to the management of the following (on a time changes in the firm’s current or prospective funding continuum for the first two subsets): liquidity positions. • Structural (over one year – long-term, or stra- Recommendation 5: Firms should have a manage- tegic gap, ratios and funding mix; cash capital; ment structure in place to effectively execute their survival horizon), funding liquidity strategies. Roles and responsibilities • Tactical (similar concepts as long-term but for of various board and senior management committees shorter terms; operational, cash flow), intraday in the funding liquidity-management structure, as (cash and collateral management), and well as those of different functional and business units, • Contingency (stress testing, i.e., sensitivity anal- should be documented, and these roles and responsi- ysis and scenario testing, special liquidity asset bilities should demonstrate appropriate segregation of pools, contingency plans, ratios, and earmarked duties between the execution, design, and oversight liquidity asset pools). and monitoring roles within the firm. This structure should include the ongoing involvement of members Roles and Responsibilities, Integrated Risk Manage- of senior management, who must ensure that funding ment, and Limit Setting liquidity is effectively managed on a regular and timely basis and that appropriate policies and procedures are Recommendation 3: Firms should have an agreed- established to limit and control material sources of upon strategy for the day-to-day management of funding liquidity risk. funding liquidity risk that takes into consideration their business models and legal structures (e.g., mix of 59
    • Recommendation 6: Firms should have adequate in- group Treasury or Risk function should be responsible formation systems for measuring, monitoring, control- for central oversight of these subsidiaries. The group’s ling, and internally reporting their funding liquidity strategy and policy documents should describe the risk positions. Management should be able to prepare structure for managing enterprise-wide funding li- these reports in times of firm-specific and systemic quidity risk and for overseeing operating subsidiaries business contingencies. and foreign branches. Recommendation 7: Firms should ensure that fund- Intragroup Liquidity Transfers ing and liquidity risk management practices are in- corporated within a firm-wide, integrated risk-man- Recommendation 10: Firms should have policies, lim- agement framework that also includes market, credit, its, and processes in place to control the flow of funds operational, and other appropriate risks. (related to intraday, tactical, structural, or stressed liquidity) between branches, between branches and Recommendation 8: Having identified the liquid- subsidiaries, and between subsidiaries that consider ity risks and specific vulnerabilities that each firm is regulatory, legal, accounting, credit, and tax restric- subject to, firms should describe in their policies and tions as well as the strategies and goals of their funding strategies their overall tolerance for unmitigated fund- liquidity-management framework. ing liquidity risk, the factors that may affect choices of strategies and limits, the desirable (or alternatively, Recommendation 11: Senior management within unwanted) outcomes and key objectives of funding firms should ensure that the right incentives, policies, liquidity-management strategies, and the key drivers and procedures are in place to elicit appropriate be- and stakeholders influencing risk appetite, policies, havior within each business that incurs liquidity costs and strategies. Firms should implement a framework (e.g., collateral, term funding), in order to consider and of limits, targets, or triggers to ensure that they operate manage such costs effectively. Where applied, transfer within these specified tolerances. Potential cash out- pricing should be closely aligned with the liquidity of flow and the ability to generate liquidity should be the the underlying asset or structural nature of the under- basis of calculation of liquidity risk tolerance and feed lying liability. into limit setting. Internal Controls Centralization versus Decentralization of Liquid- ity-Management Practices Recommendation 12: Firms should have effective sys- tems of internal control over their liquidity risk man- Recommendation 9: Given the premise that there is agement processes, including regular independent no right or wrong choice between a centralized or de- reviews and evaluations of the effectiveness of these centralized liquidity-management structure (or a mix systems. Firms should ensure that the frequency and thereof), the Recommendations put forward in the scope of these reviews are consistent with, and sup- previous section should be applied to each applicable ported by, their internal risk assessments. subsidiary for which detailed strategies and signifi- cant policies for principal operating subsidiaries of the Public Disclosure group are in place either to meet regulatory require- ments or to accommodate a preferred decentralized Recommendation 13: Firms should ensure that there structure. Where a decentralized structure leads to key is appropriate disclosure of qualitative and quantita- funding liquidity metrics being different or not consol- tive information about each firm’s liquidity position idated at the group level, processes should be in place and liquidity risk management practices. Mandat- to ensure that the group’s board and senior manage- ing quantitative disclosure would not be meaningful ment are made aware of material developments in key or comparable across firms given that firms’ liquidity subsidiaries. Irrespective of management structure, a practices vary significantly, as do their internal and ex- ternal environments. 60
    • B. Analytical Framework for Measuring, Monitoring, markets in which they are active. These strategies and Controlling Liquidity Risk: should be adjusted as changes occur in the internal or external environment. Forecasting, Measuring, and Monitoring Funding Requirements Liquidity Position by Currency, Cross-Border, and Legal Entity Measurement and Monitoring Tools Recommendation 18: Firms should have in place a Recommendation 14: Firms should establish well- system to measure, monitor, and control their liquidi- reasoned, robust, and documented methodologies to ty positions for all material legal entities, jurisdictions, measure and monitor funding liquidity risk. Firms foreign branches, and subsidiaries in the significant should forecast future cash flows of assets, liabilities, major currencies in which they are active. In addition and, if material, off-balance sheet items over appropri- to assessing aggregate foreign currency liquidity risk ate timeframes. Where appropriate, they also should commitments, firms should also undertake separate consider employing liquidity ratios as well as measures analysis of their strategies for each material currency for monitoring concentration and diversification. individually, outlining as appropriate how strategies for established currencies with liquid markets and di- Recommendation 15: Firms should ensure that meth- verse funding alternatives may be different from those odologies for forecasting the future cash flows of assets, for non-global or emerging market currencies. Firms liabilities, and off-balance sheet items are regularly val- should identify the extent to which fungibility among idated to confirm that they continue to be appropriate pools of currencies35 (e.g., USD, EUR, JPY, GBP, and and to identify the main assumptions and/or param- CHF), legal entities, and jurisdictions can be relied on, eters to which net funding requirements are sensitive. and this should be reviewed regularly. Firms should assess, monitor, and, where appropriate, limit accept- Estimation of Funding Capacity able mismatches between foreign and domestic cur- rency in light of various internal and external factors. Recommendation 16: Firms should establish well- reasoned, robust, and documented methodologies to Liquidity Position by Maturities manage different components of their funding strate- gies, including diversification of liabilities by types of Recommendation 19: Firms should choose the spe- depositors, investors, products, marketplaces, and cur- cific time horizons over which they measure, monitor, rencies; relationship with investors; and financing and and control their funding exposures based on the na- selling of assets. These components should be regular- ture of the exposure. At minimum, short-term hori- ly reviewed to determine whether they continue to be zons should include a period from the next few days adequate and to identify the main assumptions and/or to the next few months; long-term horizons should at parameters to which the net funding is sensitive. Firms least go out to one year. Measurement should be per- should measure and/or estimate their secured- and formed using, as appropriate, contractual or effective unsecured-funding capacity (at the aggregate and in maturity dates as well as known and forecasted flows meaningful subsets) to better understand their current (e.g., taking into account assumptions with respect to and prospective funding liquidity risk under varying changes in loans, assets, core deposits, etc.). conditions. Retention Rates on Nonmaturing Assets and Liabilities Asset and Funding Diversification Practices and on Assets and Liabilities with Contractual Maturi- ties Recommendation 17: Firms should have asset and funding diversification strategies commensurate with Recommendation 20: Firms should use a robust the nature of their businesses, the environment in qualitative and quantitative analytical framework that which they operate, and the types of products and considers all relevant internal and external factors be- fore assigning liquidity values to nonmaturing assets See the discussion of Recommendation 9. 35 61
    • and liabilities. The same process should be followed Measuring and Monitoring Asset Liquidity for other categories of assets and liabilities for which contractual maturity dates may not be good indicators Recommendation 25: Firms that rely on secured- of liquidity value. funding sources to a significant extent should have ro- bust processes in place to evaluate asset liquidity under Recommendation 21: Firms should understand the a variety of business-as-usual and stressed conditions. characteristics of their funding instruments and eval- It should be recognized that liquidity values of similar uate the effective cash flows under business-as-usual assets may vary across firms depending on the nature and stressed conditions. At minimum, retention rates of their business and their respective market capabili- for nonmaturing liabilities should be viewed different- ties. ly for retail and commercial deposit liabilities. Firms should analyze retention rates for nonmaturing liabili- Recommendation 26: Firms should ensure that asset ties by domicile, investor type, product, currency, and liquidity is assessed based on a demonstrated ability to scenario. obtain liquidity, and firms should only take credit for active and ongoing programs for sale, securitization, Recommendation 22: In countries where there is de- or secured borrowings. Consideration should be given positor insurance, this insurance should, subject to to adjusting haircuts if the state of markets (stressed) appropriate judgmental analysis, be considered when during the specified scenario warrants it. modeling depositor behavior. In general, deposits covered by insurance may be considered to be more Recommendation 27: Firms with significant reliance “sticky” in a crisis than other deposits. When applying on asset liquidity should evaluate haircuts and the tim- this concept in practice, consideration should be given ing of cash flows from these sources. In determining to whether there are any indications that recent devel- the amount of available liquidity and the liquidation opments may require prudent adjustment of historical horizon, the evaluation should include a determina- patterns. tion of whether the asset is encumbered as well as an assessment of market haircuts, market capacity con- Sources of Contingent Liquidity Demand and Related straints, access to central bank facilities, concentra- Triggers tions in collateral, potential name-specific concerns, and the operational ability to complete the transac- Recommendation 23: Firms should ensure that li- tion. In particular: quidity risk measures take into account the potential liquidity consequences of undrawn commitments • Encumbered assets should be excluded from in- and triggering events. A distinction should be made cremental liquidity value; between different types of commitment (e.g., revoca- • Haircuts should be evaluated in business-as- ble and irrevocable, conditional and nonconditional, usual as well as in stressed conditions; purpose of facility, and types of customers and their • The capacity of the markets for a particular asset respective credit ratings). Liquidity risk consequences class should be evaluated; and should be modeled by applying drawdown probabili- • Operational capability to facilitate the transac- ties under various stress scenarios. tion should be in place and tested. Cash Flow of Financial Derivatives Liquidity Risk Metrics and Limits Recommendation 24: If material, firms should con- Recommendation 28: Firms should use metrics that sider cash flows related to financial derivatives (net are relevant to the nature of the business they under- flows, where supported by legal frameworks, that oc- take. Firms that engage in a broad range of activities cur at the repricing or maturity date of contracts, as would be expected to use a similarly broad range of well as those covering exchange of margin or collat- liquidity metrics. eral during the life of these contracts) and interest rate flows in their liquidity risk analyses. Recommendation 29: For each selected metric, firms should decide whether they will impose a prescriptive 62
    • limit or a preferred target/range or just monitor the assumes that the entity will continue to operate as a metric for historical trends. Not all metrics need to be going concern and that the franchise has significant assigned limits, and firms could make different choices value. Different scenarios should be used to evaluate for the same metric, bearing in mind their respective how various events may impact the firm, including the internal and external environments. point at which growth plans may need to be curtailed if the severity of the crisis warrants such an action. Recommendation 30: Firms should ensure that li- This should then be used to plan the evolution of the quidity risk limits are only set on a consolidated basis balance sheet in a crisis. when it is practicable to do so given the regulatory, le- gal, accounting, credit, tax, and internal constraints on Recommendation 34: Firms should ensure that the the effective movement of liquidity. Firms’ risk toler- results of key stress tests are periodically communi- ance should be evaluated at the individual entity level cated to senior management and, as appropriate, to unless there is an unrestricted ability to transfer funds the board. Firms should have an understanding of the between entities and across borders. If such an unre- worst-case scenarios that may trigger implementation stricted ability does exist, then consolidated limits that of contingency plans. The assumptions and param- encompass these entities and geographic areas may be eters underlying these tests and resulting cash flows, appropriate. including funding capacity assumptions, should be regularly reviewed and challenged. C. Stress Testing and Contingency Planning: Contingency Planning - Governance Stress Testing (Sensitivity and Scenario Analysis) 36 Recommendation 35: Firms should have contingen- Recommendation 31: Firms should analyze liquidity cy plans in place that address potential early warning using a variety of firm-specific and market-related sce- signals of a crisis, the strategy and tactics used in nor- narios and/or sensitivity analyses, or a combination of mal course of business to prevent escalation of liquid- the two. Stress testing may be appropriate at a group ity concerns, and the possible strategies for dealing level, by geographic region, and at a subsidiary level. with different levels of severity and types of liquidity The rationale behind the choice of time horizons over events that cause liquidity shortfalls. The breadth and which a crisis is to be measured and the severity lev- depth of these strategies should incorporate recovery els of crises considered should be appropriately docu- objectives that reflect the role each firm plays in the mented. operation of the financial system (e.g., provision of collateral to payment/settlement systems) such that Recommendation 32: Firms should ensure that stress these strategies enable a firm to continue to play its tests are used to measure the behavior of all sources role, even in times of major operational disruptions. of cash inflows and outflows that could potentially be Firms should make efforts to assess the effectiveness material to the firm under various sets of assumptions. of their contingency plans. To the extent that these tests indicate an unwanted shortage of funding over the time horizon over which Recommendation 36: Firms should ensure that they are conducted, consideration should be given, in contingency plans are proportionate to the size and light of the probability of the scenario, to modifying complexity of the firm and involve input from senior underlying normal course of business limits to address management. Contingency plans should be reviewed this shortfall. as business or market circumstances change. Recommendation 33: The appropriate starting point Recommendation 37: Firms should ensure that con- for stress testing assumptions for firms should be a tingency planning includes establishing policies and business-as-usual approach with clients. This approach procedures and clear divisions of roles and responsibil- 36 Stress testing is a risk-management technique used to evaluate the potential effects on an institution’s financial condition of a specific event and/or movement in a set of financial variables. The traditional focus of stress testing relates to exceptional but plausible events. Sensitivity analyses are generally less complex to carry out since they assess the impact on an institution’s financial condition of a move in one particular risk factor, the source of the shock not being identified, whereas scenario tests tend to consider the impact of simultaneous moves in a number of risk factors, the stress events being well defined. 63
    • ities for liquidity events so as to avoid confusion or lack Cushion of Liquid Assets of clarity of roles during a crisis. This should include strategies and procedures for timely, clear, consistent, Recommendation 41: Firms should develop method- and uninterrupted internal and external communica- ologies and policies to determine the level of specifi- tion flows to ensure timely decisions, to avoid undue cally earmarked liquid assets that they should maintain escalation of issues, and to provide adequate assurance at all times to meet immediate liquidity needs when to market participants, employees, clients, creditors, faced with adverse conditions. These policies should regulators, and shareholders. This would include the also include criteria for asset composition. designation of leadership roles in a liquidity crisis and may include the designation of a formal crisis team Central Bank Facilities that would be a contact point for senior management. The planning process should include the designation Recommendation 42: Firms should ensure that as- of back-ups for key functions and the assurance that sumptions regarding potential funding from central key systems and processes have been considered in the banks are evaluated taking into account the level of firm’s business continuity planning. severity and type of crisis. Firms should differentiate between different types of central bank facilities (e.g., Recommendation 38: Firms should outline in their “standing” facilities and “emergency” facilities). liquidity policies the benchmark periods that require evaluation for whether liquidity needs can be met. Se- Recommendation 43: Firms can include standing lection of these benchmark periods should be based central bank facilities that are granted on a “no ques- on a number of qualitative factors. tions asked” basis in their contingency plans. The in- clusion of such funding should be consistent with the Asset Reduction and Financing Strategy timing of the availability of the respective collateral at the central bank. Recommendation 39: Firms should have in place an asset reduction plan and financing strategy for both Recommendation 44: Emergency lending facilities firm-specific and market-related liquidity events. (lender of last resort facilities) should be considered in firms’ stress testing. When implementing firms’ Recommendation 40: Back-up plans may involve in- “what-if ” scenarios, the potential use of these facilities voking unused credit facilities granted to a firm; how- should be dimensioned under each scenario. However, ever, firms should not rely excessively on such lines as in terms of dimensioning risk (and establishing liquid- counterparties could elect not to honor their obliga- ity risk limits), emergency facilities should only be tions to provide funding if a firm is in trouble. considered available in extreme events subject to con- ditions under which the facility can be used legally and under conditions that would not exacerbate a liquidity event for the institution. Additional Recommendations regarding Reliance on Secured-Financing Sources and the Impact of Complex Financial Instruments upon Liquidity-Management Policies and Practices are set out in Analytical Discussions 1 and 2. 64
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