Liquidity Risk Management: A
Regulator’s View
Simon Topping
Hong Kong Monetary Authority
16 November 2004
1
Outline
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The concept of “liquidity”
Liquidity crises
– institution-specific
– systemic
“Traditional” regulatory approach
– regulatory liquidity requirements
HKMA’s new guideline: A “risk management”
approach
2
The concept of “liquidity”

“The liquidity of an instrument reflects the ease
with which it can be turned into something else,
usually central bank or commercial bank money.
An instrument can be liquid because it has a
short maturity, & so is due to be turned into
money in the near future, or because it can easily
be sold for money in a market, without turning
the price significantly against the seller.” [BofE]
3
The concept of “liquidity”

“The risk that a bank may not be able to fund
increases in assets or meet obligations as they fall
due without incurring unacceptable losses. This
may be caused by the bank’s inability to
liquidate assets or to obtain funding to meet its
liquidity needs. The problem could also be the
result of market disruption or a liquidity squeeze
whereby the bank may only be able to unwind
specific exposures at significantly discounted
values.” [HKMA]
4
The concept of “liquidity”

“The essence of banking is the ability to provide
payment – whether routinely from management
of cashflows & access to money markets or, in
times of pressure, from a cushion of liquid assets,
or access to central bank facilities – when
contracts are due. Second, liquidity relates to the
depth of markets – the ability to transform assets
into cash without a significant price discount or
“one-way” markets developing”. [BofE]
5
The concept of “liquidity”

“The structure of banks’ balance sheets –
essentially illiquid assets funded by highly liquid
liabilities – leaves them prone to liquidity
shocks. Banks offer liquidity insurance to
customers by taking in money that can be
withdrawn on demand or at very short notice &
providing committed loan facilities at longer
maturities – & in providing this service they
become exposed to significant liquidity risk
themselves.” [BofE]
6
Liquidity crises
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Liquidity problems can have an adverse impact
on a bank’s earnings & capital &, in extreme
circumstances, may even lead to the collapse of a
bank which is otherwise solvent.
A liquidity crisis besetting individual banks that
play an active or major role in financial activities
may have systemic consequences for other banks
& the banking system as a whole.
A liquidity crisis could also affect the proper
functioning of payment systems & other
financial markets.
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Liquidity crises
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In addition to direct knock-on effects – e.g. when
a bank in difficulty fails to honour its obligations
to other banks, thereby causing difficulties for
those banks in turn – there can be serious
indirect knock-on effects – e.g. if there develops a
general loss of confidence in (parts of) the
banking sector.
Sound liquidity management is therefore pivotal
to the viability of every bank & the maintenance
of overall banking stability.
8
“Traditional” regulatory approach
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For authorities, ensuring that banks hold
adequate liquid assets makes banks individually,
& the system as a whole, more robust & better
able to withstand shocks without recourse to
central bank support
But there is an obvious public policy trade-off
between risk & efficiency in the size of the buffer
banks hold.
9
“Traditional” regulatory approach

Broadly, regulators have developed 2
approaches to liquidity regulation:
– The first is to monitor banks’ mismatch between
out-flows & inflows at short maturities (e.g. 1 day,
week or month). Banks should measure the
potential outflows over the period & ensure that
they have sufficient liquidity to meet the funding
requirement.
– The second requires banks to hold, at all times, a
stock of highly liquid assets that can be used in the
event that they encounter problems raising
liquidity.
10
“Traditional” regulatory approach

This approach is fine as a starting point, but it
has a number of limitations:
– It is a broad-brush, “one size fits all”
approach which is not tailored to the
circumstances of particular banks;
– It places insufficient emphasis on qualitative
factors, particularly the adequacy of systems
& controls for managing liquidity risk; &
– It does not reflect the latest liquidity risk
management practices of major banks.
11
“Traditional” regulatory approach
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In Hong Kong, it is a statutory requirement that
banks should maintain a liquidity ratio of not
less than 25%.
This is calculated as the ratio of the sum of the
bank’s liquefiable assets (multiplied by the
relevant liquidity conversion factor) to the sum
of its qualifying 1-month liabilities.
Banks have also generally been required to
maintain mismatch limits within 10% for 7 days
& 20% for 1 month).
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“Traditional” regulatory approach
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Clearly, such an approach is not ideal given the
diversity of banks operating in Hong Kong –
large & small, local & foreign.
Moreover, this approach:
– Focuses overly on contractual maturity (when
experience shows that behaviour may differ
markedly, particularly in a crisis);
– Does not distinguish between liquidity in
different currencies (whereas currencies may
not be fungible in a crisis); &
– Focuses insufficiently on “stress” situations.
13
HKMA’s new guideline
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Reflects recent developments in international
standards and best practices on liquidity risk
management e.g. Sound Practices for Managing
Liquidity in Banking Organisations issued by Basel
Committee in 2000
Draws on study of the practices adopted by a
wide range of banks in Hong Kong.
14
HKMA’s new guideline

The HKMA recognises that the degree of
sophistication of a bank’s liquidity risk
management systems and controls will depend
on the nature, scale and complexity of its
operations as well as the level of liquidity risk
assumed. The focus of the guideline is
therefore on a bank’s ability to apply the
principles & guidance laid down to developing
systems and controls that are appropriate to its
particular circumstances.
15
HKMA’s new guideline

Managing liquidity risk is not simply a matter
of complying with a statutory minimum
liquidity ratio – crucially, it involves
understanding the characteristics & risks of
different sources of liquidity, determining the
appropriate funding strategies (including the
mix of funding sources) to meet liquidity needs
& deploying the strategies in a cost-effective
manner.
16
HKMA’s new guideline
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In managing asset liquidity, AIs are expected to
establish a clear strategy for holding liquid
assets, develop procedures for assessing the
value, marketability & liquidity of the asset
holdings under different market conditions, &
determine the appropriate volume and mix of
such holdings to avoid potential
concentrations.
17
HKMA’s new guideline
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In managing liability liquidity, AIs should be
able to distinguish the characteristics of
different funding sources and monitor their
trends separately.
AIs should also pay particular attention to the
impact of changing market conditions on their
funding structure.
18
HKMA’s new guideline

Central to effective liquidity risk management
is a bank’s ability to maintain adequate
liquidity in the event of a funding crisis. The
HKMA will assess this ability in respect of:
– the amount of high quality liquid assets that
the bank can readily dispose of or pledge for
funding;
– the results of stress tests carried out by the
bank on its cash-flow & liquidity positions
under different scenarios; &
19
HKMA’s new guideline
– the stability of the bank’s funding sources &
its contingency measures for dealing with
crisis situations.

Every bank is expected to document in a policy
statement its policies & strategies for managing
liquidity risk, including how it identifies,
measures, monitors & controls that risk. This
should be approved by the Board of Directors
& agreed with the HKMA.
20
HKMA’s new guideline
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In assessing the overall adequacy of liquidity
of branches or subsidiaries of banks
incorporated outside Hong Kong, the HKMA
will take account of the global liquidity risk
management policies of the head office or
parent bank & the extent to which liquidity is
supervised by the home authority. A more
flexible approach (other than the statutory
requirements) will be adopted for the
supervision of these AIs, provided that their
liquidity is managed, & supervised, on an
integrated global basis.
21
HKMA’s new guideline

The HKMA will monitor the level & trends of
banks’ liquidity positions through their regular
submission of the following statistical returns
and management information:
– the monthly “Return on Liquidity Position –
MA(BS)1E (“Liquidity Return”) – to monitor
banks’ compliance with the statutory
requirements on the minimum liquidity
ratio & analyse other information on
liquefiable assets and funding sources;
22
HKMA’s new guideline
– the quarterly “Return on Selected Data for
Liquidity Stress-testing” (“Liquidity Stresstesting Return”) (only applicable to locally
incorporated banks) – to enable the HKMA
to conduct across-the-board stress tests on
individual banks’ liquidity risk; &
– the cash-flow & scenario analyses conducted
by banks (based on their internal
management reports submitted on a
quarterly basis) – to analyse banks’ ability to
maintain adequate liquidity under normal &
stressed conditions.
23
HKMA’s new guideline

Banks are encouraged to set a target liquidity
ratio at a level above the statutory minimum so
as to provide an early warning signal to the
management.

Banks are expected to adopt a cash-flow
approach to managing their liquidity risk. This
approach complements the legal framework on
minimum liquidity ratio by requiring banks to
measure, monitor & control their cash flow &
maturity mismatch positions under different
operating conditions.
24
HKMA’s new guideline

Under the cash-flow approach, banks should
have in place appropriate systems &
procedures for:
– monitoring on a daily basis net funding
requirements under normal business
conditions;
– conducting regular cash-flow analyses based
on stress scenarios; &
– developing reasonable assumptions for
making the above cash-flow projections.
25
HKMA’s new guideline
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Banks should be able to generate cash-flow
positions by individual currencies & in
aggregate. For those AIs that have significant
foreign exchange business, there should be
separate analysis of cash-flow positions for
individual foreign currencies in which they are
active.
26
HKMA’s new guideline

Banks should set internal limits to control the
size of their cumulative net mismatch positions
for the short-term time bands up to one month
(i.e. “next day”, “7 days” and “1 month”).
Such limits should be realistic & commensurate
with their normal capacity to fund in the
interbank market. Maturity mismatch limits
should also be imposed for individual foreign
currencies in which they have significant
positions.
27
HKMA’s new guideline

In order to provide prudent projections of
expected cash flows, banks should, as far as
possible, incorporate in the maturity profile
realistic assumptions underlying the behaviour
of their assets, liabilities & off-balance sheet
activities rather than relying simply on
contractual maturities.
28
HKMA’s new guideline

The HKMA considers that whether a bank can be
regarded as having sufficient liquidity depends to
a great extent on its ability to meet obligations
under a funding crisis. Therefore, in addition to
monitoring net funding requirements under
normal business conditions, banks should conduct
regular stress tests by applying various “what if”
scenarios on their liquidity positions (for all
currencies in aggregate and significant individual
currencies) to ensure that they have adequate
liquidity to withstand stressed conditions.
29
HKMA’s new guideline

It is important for banks to construct plausible
adverse scenarios & examine the resultant cash
flow needs. While banks are encouraged to
cover stress events of different types & levels
of adversity, they should, at a minimum,
include the following scenarios in their stresstesting exercise:
– an institution-specific crisis scenario; &
– a general market crisis scenario (based on
assumptions prescribed by the HKMA from
time to time).
30
HKMA’s new guideline
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An institution-specific crisis scenario should
cover situations that could arise from the bank
experiencing both real or perceived problems
(e.g. asset quality problems, solvency concerns,
rumours on an AI’s credibility or management
fraud, etc.). It should represent the bank’s
extreme view of the behaviour of its cash flows
in a crisis (i.e. a “worst case” scenario for the
bank).
31
HKMA’s new guideline
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Foreign banks (including branches &
subsidiaries of foreign banking groups) should
consider 2 types of institution-specific crisis
scenario, namely a crisis that is restricted to
their Hong Kong operations & a crisis that
affects the global operations of the banking
group (e.g. with problems originated from the
head office or parent bank).
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HKMA’s new guideline
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A general market crisis scenario is one where
liquidity at a large number of financial
institutions in one or more markets is affected.
Characteristics of this scenario may include a
liquidity squeeze, counterparty defaults,
substantial discounts needed to sell assets &
wide differences in funding access among
banks due to the occurrence of a severe tiering
of their perceived credit quality (i.e. flight to
quality).
33
HKMA’s new guideline
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The HKMA would normally expect a bank to
have sufficient funds to continue in business, at
least under the institution-specific crisis
scenario, for the minimum number of days
necessary for it to arrange emergency funding
support. As the nature and size of business
may differ widely among AIs, the HKMA does
not intend to prescribe a standard minimum
number of days for all.
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Conclusions

In conclusion, under its new guideline, as part
of its review of the banks’ liquidity policy
statement, the HKMA will consider the
suitability & reasonableness of the following
limits & assumptions set by banks, having
regard to the nature and complexity of their
operations:
– maturity mismatch limits & behavioural
assumptions adopted for constructing the
maturity profile under normal business
conditions;
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Conclusions

– the cash flow assumptions for conducting
stress-testing under the institution-specific &
general market crisis scenarios. The HKMA
will provide input on the scope of the general
market crisis scenario; &
– the minimum number of days of positive
liquidity targeted by individual banks under
the institution-specific crisis scenario.
Note, however, that the focus is on the banks’
processes & controls for managing liquidity risk,
& on the suitability & reasonableness of limits &
assumptions.
36
Conclusions


There is no “magic formula” as far as liquidity
is concerned, no magic ratio which, if it is
observed, can guarantee that the institution
will in all circumstances be free from liquidity
problems.
Regulators can provide guidance on sound
systems & controls & limits but it is bank
management’s responsibility to put this into
practice.
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