Strengthening Liquidity Risk
Management and Supervision –
an international challenge
Financial Regulation Conference, London
3 July 2009
Nigel Jenkinson
Adviser to the Governor
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SERV 9179523
Developing a global framework
“The BCBS and national authorities should develop
and agree by 2010 a global framework for promoting
strong liquidity buffers at financial institutions, including
cross-border institutions.” G20 London Summit
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Containing System-wide risks –
five objectives for consideration
Objective 1: Prudent liquidity risk management by
individual banks (Institutional)
Objective 2: Tougher standards on banks whose distress
has largest system-wide impact (System-spillover)
Objective 3: Tougher overall standards if system-wide
risks are rising (Countercyclical system-wide)
Objective 4: Consistent application internationally
(International)
Objective 5: Central bank facilities should underpin
prudent liquidity risk management (Central bank)
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Objective 1: Institutional
“Liquidity regulation should encourage prudent liquidity risk
management by individual banks. Defences should be
robust to both the crystallisation of firm specific and marketwide stress.”
• Basel Sound Principles (September 08)
• Measurement and calibration (metrics, stress tests, CFPs)
• Links to other risks and defences (eg solvency and capital)
• Usable defences (avoiding adverse spillovers)
• Form of regulatory intervention (liquidity cushions,
insurance, capital?)
• Desired level of resilience?
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Banks economised on cushions of
highest quality assets
Sterling liquid assets relative to total asset
holdings of UK banking sector(a)
Percentage of
total assets
(all currencies)
35
Broad ratio(b)
Reserve ratio(c)
Narrow ratio(d)
Competition &
credit control
1971
Cash ratio deposits
1981
68
73
78
83
88
Sterling stock
liquidity regime
1996
93
98
03
Source: Bank calculations.
(a) 2009 data are as of end-March 2009.
(b) Cash + Bank of England balances + money at call + eligible bills + UK gilts.
(c) Proxied by: Bank of England balances + money at call + eligible bills.
(d) Cash + Bank of England balances + eligible bills.
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US banks holdings of Treasury Bonds
UST / Assets
Avg UST / Assets 1970 - 1992
Percentage of
total assests
(all currencies)
16
14
30
12
25
10
20
8
15
6
10
4
5
2
0
0
66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
Source: FDIC Statistics on Depository Institutions.
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Objective 2: System-spillover
“Liquidity regulation should provide a disincentive for banks
to increase liquidity risk. The disincentive should take
into account the impact of liquidity risk distress at the
bank on the overall financial system.”
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Network of large exposures
between UK banks
Network of large exposures(a)
between UK banks(b)(c)
Source: FSA returns.
(a) A large exposure is one that exceeds 10% of a lending bank's eligible capital
during a period. Eligible capital is defined as Tier 1 plus Tier 2 capital, minus
regulatory deductions.
(b) Each node represents a bank in the United Kingdom. The size of each node is
scaled in proportion to the sum of (1) the total value of exposures to a bank, and (2)
the total value of exposures of the bank to others in the network. The thickness of a
line is proportionate to the value of a single bilateral exposure.
(c) Based on 2008 Q1 data.
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Objective 2: System-spillover
“Liquidity regulation should provide a disincentive for
banks to increase liquidity risk. The disincentive should
take into account the impact of liquidity risk distress at
the bank on the overall financial system.”
• Tougher standards for large banks very active in
interbank markets and as market-makers in capital
markets than for small banks on system periphery
• Measurement and calibration (correlated tail risks,
‘Co-risk’ measures)
• Spillovers depend on system-wide risks
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Objective 3: Countercyclical
system-wide
“Liquidity regulation should guard against the
crystallisation of system-wide liquidity risk.
Disincentives to contain liquidity risk should increase
as system-wide liquidity risk rises.”
• Measures and calibration (interactions between
banks and financial network)
• Endogeneity of market liquidity and impact on
funding liquidity
• Market liquidity most vulnerable when it seems
highest (Borio)
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Vulnerability of banks to sudden
reversal in market liquidity
Decomposition of sterling-denominated
high-yield corporate bond spreads
Financial market liquidity(a)
Liquidity index
1.0
Ba sis point s
Res id ual (includ ing co mp ens atio n fo r illiq uid ity)
3200
Co mp ens atio n fo r uncertainty ab o ut d efault lo s s es
3000
0.5 +
0.0 0.5
1.0
Co mp ens atio n fo r exp ected d efault lo s s es
2800
Actual
2600
2400
2200
2000
1800
1.5
2.0
1600
1400
1200
2.5
3.0
1000
800
600
3.5
4.0
400
200
0
4.5
92
94
96
98
00
02
04
06
08
Sources: Bank of England, Bloomberg, Chicago Board Options
Exchange, Debt Management Office, London Stock Exchange,
Merrill Lynch, Thomson Datastream and Bank calculations.
(a) The liquidity index shows the number of standard deviations
from the mean. It is a simple unweighted average of nine liquidity
measures, normalised on the period 1999-2004. The series shown
is an exponentially weighted moving average. The indicator is more
reliable after 1997 as it is based on a greater number of underlying
measures.
-200
98
99
00
01
02
03
04
05
06
07
08
09
Sources: Bloomberg, Merrill Lynch, Thomsom Datastream and
Bank Calculations.
(a) Webber, L and Churm, R (2007), 'Decomposing corporate
bond spreads', Bank of England Quarterly Bulletin, Vol 47, No. 4,
pages 533-41.
(b) Option-adjusted spreads over government bond yields.
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Indicators of system-wide liquidity
risk
Important area for future research: Some ideas:
• Banking system-wide maturity mismatch with non-banks
• Leverage indicators
• Pressures for central bank refinancing
• Market measures of illiquidity premia
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Proxies for system-wide funding
liquidity risk
UK banks' leverage ratio(a)(b)
Maximum-minimum range
Per cent
70
Interquartile range
60
Chart 7: Illiquidity premia in sterling and
US dollar-denominated corporate bond
spreads(a)(b)
Illiquidit y premia (c)
Full sample average
Average t o end Jun 07
Basis point s
500
450
400
Median
50
350
40
300
250
30
200
150
20
100
10
0
87 89 91 93 95 97 99 01 03 05 07 09
Source: Thomson Datastream, published accounts and Bank
calculations.
(a) Gross leverage measured by total assets divided by
shareholders equity minus minority interests.
(b) Due to the mergers and acquisitions of banks, the chart
includes data for the bank peer group as used in ' A new peer
group to analyse large UK-owned banks resilience over time',
Financial Stability Review, Box 7, December 2004, page 68.
50
0
98 99 00 01 02 03 04 05 06 07 08 09
Sources: Bloomberg, Merrill Lynch, Thomsom Datastream
and Bank Calculations.
(a) Webber, L and Churm, R (2007), 'Decomposing corporate
bond spreads', Bank of England Quarterly Bulletin, Vol 47, No.
4, pages 533-41.
(b) Option-adjusted spreads over government bond yields.
(c) Average of sterling and dollar IG/HY illiquidity premia,
weighted by market value of bonds outstanding.
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Objective 4: International
“Regulatory standards should be applied consistently
internationally, to prevent regulatory arbitrage and
leakage.”
• Regulation developed and implemented nationally
• Similar high level objectives
• But many differences of application:
– Some reflect structural differences (eg, Deposit insurance,
Insolvency/Crisis resolution regimes, Central Bank frameworks)
– Other do not
• Common metrics, benchmarks and standards
• Extending ‘system-wide’ approaches to take account of
international ‘system’ is very challenging!
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Objective 5: Central bank
“The design and operation of central bank facilities should
underpin incentives for banks to manage liquidity risk
prudently, in the long-run interests not only of the
banking system but of the wider economy.”
• No buffer proof against all events
• Central banks provide valuable liquidity insurance
• But may encourage excess risk-taking (moral hazard)
• Design facilities to limit moral hazard
• But cannot fully offset through lending terms ex-post
• Need for regulation to correct incentives ex ante
• Clear principles for public safety nets
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Public safety nets
• Central bank liquidity insurance
• Market maker of last resort
• Capital provider of last resort
• General principles:
– Avoid incentivising imprudent behaviour
– Clear and time-consistent
– Well-defined exit strategy
(See Paul Tucker ‘The repertoire of official sector interventions in the
financial system: last resort lending, market-making, and capital’ May 2009
and Bank of England Financial Stability Report June 2009)
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Issues for further research and
analysis
• Measuring (system-wide) liquidity risk
• Interconnection between market and funding liquidity
• Optimal form of regulatory intervention
• Desired level of resilience
• Role and design of central bank insurance
• Promoting international consistency given differences
in drivers
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