Tier I Tier I + Tier 2 + Tier 3
CHIAPTER 8 CHIAPTER 8
8.3 The Regulatory Environment
The most significant development in prudential liquidity regulation in the last 15 years has been the assessment of liquidity needs by calculating expected cash flows based on the maturity structure of a bank's assets and liabilities. However, even regulators that have adopted the cash-flow methodology believe that the stock (of liquid assets) approach has an important, if supplementary, role to play and should not be neglected (see Figure 8.1). This stance is based on the perception that the increasingly important role of liquidity management, in addition to being an asset-lia- bility management tool, has significant implications for the stability of the banking system as a whole. Certain crucial premises influence this stabil- ity, including the confidence of banks in each other, the confidence of major suppliers of funds in banks, and the existence of normal market con- ditions.
Trends in the prudential supervision of liquidity, as in other areas of regulation, have tended to lag behind market trends. In addition, less progress has been made in the international coordination and convergence of liquidity regulation than, for example, in the field of capital adequacy.
Nevertheless, some important changes have taken place, including the fol- lowing:
FIGURE 8.1 STATUTORY LIQUIDITY REQUIRED VERSUS ACTUAL LIQUID ASSETS HELD
Percent Currency
12 25,000
10 8
.. 15,000
-10,000
4 FP
2- _ ,, 0 t '';'..0 t . ' t- . t . 0 .L 0 . i tIm [ 5,000
2
o~~~~~~~~N 1: . ,Ltt*t*,-,-,,EW1EWl 0
1 3 5 8 10 12 14 16 18 20 22 24
Liquid assets held E Liquid assets requirement Cash required as percentage of total liabilities
* a relative decline in the importance of liquid asset requirements as a supervisory tool, in favor of the cash-flow or maturity-pro- file approach;
* emphasis on the continual need for a stock of stable liquid assets as a supplementary method of controlling risk;
* a shift away from statutory requirements toward a more flexible approach to the setting of guidelines and the monitoring of liq- uidity;
* greater emphasis on the evaluation of the liquidity of individual banks, rather than an across-the-board approach;
* greater efforts by supervisors to improve bank standards for the information and control systems that are used to manage liquidity;
* incorporation into the regulatory framework of off-balance-sheet products and new methods of asset-liability management.
Most countries now make a clear distinction between instruments of prudential supervision and monetary control. This applies particularly to the holding of specific liquid assets. In recent years, a greater reliance on control of the money supply as a major policy instrument, together with structural changes in the banking environment, has highlighted the incompatibility of and inconsistency between prudential supervision and monetary control. When banks attempt to circumvent the impact of mon- etary policy instruments such as the cash-reserve requirement, which forms part of the prudential liquid asset requirements (for example, by moving liabilities related to repurchase agreements off the balance sheet), liquidity risk management may be negatively affected.
Banking legislation normally contains specific liquidity requirements that banks must meet. These prudential requirements should not be viewed as the primary method for the management of liquidity risk; the opposite in fact is true. Given the importance of liquidity, a bank with prudent man- agement should establish certain policy guidelines for risk management in addition to determining responsibility for planning and day-to-day fund management. Typical liquidity regulations (or a bank's own liquidity guidelines) are illustrated in Box 8.1.
The approach to supervision is therefore increasingly focused on the independent evaluation of a bank's strategies, policies, and procedures and
LIQUIDITY RISK MANAGEMENT 175
BOX 8.1 TYPICAL LIQUIDITY REGULATIONS OR INTERNAL LIQUIDITY GUIDELINES
* A limit on the loan-to-deposit ratio
v A limit on the loan-to-capital ratio
* Guidelines on sources and uses of funds
* Liquidity parameters; for example, that liquid assets should not fall below
"X" percent or rise above "Y" percent of total assets
E A percentage limit on the relationship between anticipated funding needs and available resources to meet these needs; for example, that the ratio of primary sources over anticipated needs should not fall below "X" per- cent
E A percentage limit on reliance on a particular liability category; for exam- ple, that negotiable certificates of deposit should not account for more than "X" percent of total liabilities
* Limits on the minimum/maximum average maturity of different categories of liabilities; for example, the average maturity of negotiable certificates of deposit should not be less than "X" months
its practices related to the measurement, monitoring, and control of liquid- ity risk. The emphasis increasingly is on the management structures neces- sary to effectively execute a bank's liquidity strategy and on the involve- ment of senior management in the liquidity risk management process.
8.4 The Structure of IFundling: Deposits andrI Market Borrowing
Deposits. Funding structure is a key aspect of liquidity management. A bank with a stable, large, and diverse deposit base is likely to have fewer liquidity problems than a bank lacking such a deposit base. The assess- ment of the structure and type of deposit base and evaluation of the con- dition (i.e., the stability and quality) of the deposits thus is the starting point for liquidity risk assessment. The type of information that is neces- sary to conduct this assessment includes the following:
if Prodluct range. The different types of deposit products available should be noted, along with the number of accounts and the bal- ance raised for each. This information is best presented in a sched-
ule that shows the product type, such as savings or checking account, six-month deposit, or deposit with maturity over six months. (Product types are defined in accordance with a bank's own product range.) The nature of the depositor (e.g., corporate or retail) should also be shown, since each type of depositor has a cer- tain behavioral pattern. Breakdowns by terms of deposit, including currency, maturity, and interest rates, should also be included.
* Deposit concentration, including itemization for all customers with deposits that aggregate to more than a certain amount of total assets, with term and pricing shown on each.
* Deposit administration, including information on the adequacy of the systems that record and control depositor transactions and internal access to customer accounts, as well as on the calculation and form of payment of interest (e.g., average daily or period-end balance).
Because of the competition for funds, most corporations and individ- uals seek to minimize their idle funds and the effect of disintermediation on a bank's deposit base. A bank's management therefore typically will adopt and pursue a development and retention program for all types of deposits. In addition to deposit growth, management also must look at the quality of the deposit structure to determine what percentage of the over- all deposit structure is based on stable or hard-core deposits, fluctuating or seasonal deposits, and volatile deposits. This step is necessary if funds are to be invested with a proper understanding of anticipated and potential withdrawals. Figure 8.2 illustrates the source of deposits (i.e., from whom they have been received, including households and public and private sec- tor enterprises) for the particular bank under observation. Deposit man- agement is a function of a number of variables, some of which are not under the direct control of bank management.
Financial market borrowings. Another key ingredient of a liquidity profile is a bank's ability to obtain additional liabilities (also known as its liquidity potential). The marginal cost of liquidity (i.e., the cost of incre- mental funds acquired) is of paramount importance in evaluating the sources of liquidity. Consideration must be given to such factors as the fre- quency with which a bank needs to refinance maturing purchased liabilities
LIQUIDITY RISK MANAGEMENT 177
FIGURE 8.2 CUSTOMER DEPOSITS BY SECTOR Currency
800,000 700,000 600,000
500,000 ...
400,000 300,000 _ 200,000 100,000
Period 1 Period 2 Period 3 Period 4 Current Period D Due to private sector enterprises fl Due to individuals m Due to public sector enterprises
and its ability to obtain funds through the money market. For a bank that operates frequently in short-term money markets, the crucial determinant of the ability to borrow new funds is its standing in the market.
The obvious difficulty of estimating the ability to borrow is that until a bank enters a market, the availability of funds at a price that will give a positive yield spread cannot be determined with certainty. Changes in money market conditions may cause a bank's capacity to borrow at a prof- itable rate to decline rapidly. In times of uncertainty, large investors and depositors tend to be reluctant to trade with small banks because they are regarded as risky. The same pattern may also apply to larger banks if their solvency comes into question.
8.5 Maturity Structure and lFunding Mismatches
Maturity mismatches are an intrinsic feature of banking, including the short-term liability financing of medium-term and long-term lending. The crucial question is not whether mismatching occurs - because it always does - but to what extent, and whether this situation is reasonable or potentially unsound. Put another way, one can ask how long, given its cur-
rent maturity structure, a bank could survive if it met with a funding cri- sis, and what amount of time would be available to take action before the bank became unable to meet its commitments. These questions should be asked by banks, regulators, and, ultimately, policymakers. This aspect of liquidity risk management also implies that access to the central bank, as the lender of last resort, should be available only to solvent banks that have temporary liquidity problems.
Figure 8.3 provides a view of a bank's maturity ladder. The trend toward a short-term mismatch is reviewed over time to determine whether or not the mismatches are increasing. An increased mismatch could be due to problems in obtaining long-term funding for the bank or could reflect a deliberate decision based on the bank's view of future interest rate move- ments. For example, banks tend to increase their short-term mismatches if they expect interest rates to fall.
The focus of such an analysis is not only the size of the mismatch but also its trends over time, as these could indicate if the bank has a potential funding problem. When reviewing the short-term mismatch as a percent- age of total liabilities, an analyst will need to determine the proportion of the total funding that has to be renewed on a short-term basis. Liquid
FIGURE 8.3 MATURITY MISMATCH
Currency Period 1 Period 2 Period 3 Period 4 Current Period
100,000 200,000 300,000
400,000 -
500,000 600,000 700,000 800,000 1900,000 1,000,000 1,100,000 1,200,000 1,300,000 1,400,000 1,500,000 1,600,000 1,700,000 1,800,000 1,900,000 \ 2,000,000 2,100,000
- Short-term cumulative mismatch Medium-term cumulative mismatch
LIQUIDITY RISK MANAGEMENT 179
assets actually held can then be compared to the value of the short-term mismatch, to assess how much of the latter is in fact covered by a buffer stock of high-quality liquid assets. In addition, other readily marketable securities should be considered.
The contractual maturity-term structure of deposits over time can be used to ascertain if a funding structure is changing. If it is, the analyst should determine whether the bank is experiencing funding shortages or is deliber- ately changing its funding structure. Figure 8.4 provides a trend analysis of the maturity profile of the deposit base. This analysis can be used to evalu- ate whether a bank's policy change is of a permanent or erratic nature, as well as to assess the regularity of funding problems (i.e., the amount of funding that has to be renegotiated contractually on a short-term basis).
While it is apparent that the maturity structure of deposits for the observed bank has changed, the reasons are not straightforward or easy to determine. For example, in volatile economies characterized by high infla- tion and in countries where the public lacks confidence in the banking sys- tem, the maturity of deposits tends to be much shorter than in stable economies. The shortening of maturities could have been triggered by the worsening of the observed bank's economic environment. At the same time, it is apparent that the bank's source of deposits changed during the period, with individual household deposits (see Figure 8.2) as a percent- age of total deposits increasing, and private enterprise deposits decreasing.
The change in average maturity could therefore be at least partly attributed to changes in funding sources.
Once the contractual mismatch has been calculated, it is important to determine the expected cash flow that can be produced by the bank's asset-liability management model. Neither the contractual nor the expect- ed mismatch will be accurate, but both will indicate the amount of fund- ing that a bank might be required to obtain from nonclient sources. The sources available to banks could include the central bank's liquidity sup- port facilities (geared toward liquid assets held by the individual banks) and money market funding. The amount remaining for utilization of cen- tral bank facilities indicates the size of the expected money market short- age. This critical variable is used by the money market committees of cen- tral banks to determine the monetary policy options that are available to them for market interventions.
Currency
180,000 160,000 140,000 120,000 100,000
80,000 60,000
40,0001/ ~ Wit a With original matuIty of one month or less
With original maturity of one month to three months With original maturity of more than three months to one year Period 3 Per od 4 / With original maturity of more than one year
Current Period
LIQUIDITY RISK MANAGEMENT 181
An additional aspect that should also be assessed is the potential impact of credit risk on liquidity. Should large exposures or excessive sec- tor risk materialize, there could be significant consequences for liquidity.
The type of credit risk exposure, especially sector concentration, should be considered and specifically evaluated. For example, many banks in the United States have become insolvent due to poor real estate and oil sector lending practices.
8.6 Deposit Concentiratiorn and VoRatility of IFudiniig
Another critical aspect of liquidity risk management is dependence on a single source of funding (also known as concentration risk). If a bank has a few large depositors and one or more withdraw their funds, enormous problems will occur if alternative sources of funding cannot quickly be found. Most banks therefore monitor their funding mix and the concen- tration of depositors very closely, to prevent excessive dependence on any particular source. The sensitivity of banks to large withdrawals in an uncertain environment cannot be overemphasized. Regulators increasing- ly are focusing on mismatches in liquidity flows and on the ability of banks to fund such mismatches on an ongoing basis, rather than on statu- tory liquid assets and traditional access to the central bank.
An appraisal of a bank therefore must give adequate attention to the mix between wholesale and retail funding and, in connection to this, to the exposure to large depositors and whether or not an undue reliance on indi- vidual sources of funds exists. Figure 8.5 illustrates an assessment of con- centration in the bank under observation. The aim of such an assessment is to establish if the bank is exposed to a creditor large enough to cause a liquidity crisis if it were to withdraw its funding.
By calculating the percentage of the short-term mismatch that large deposits represent, an analyst can obtain a picture of the sensitivity of the bank or of the banking sector as a whole to withdrawals by large suppli- ers of funds. The proportion of wholesale funding to retail funding is another means of measuring sensitivity to large depositors. Overall, the increasing volatility of funding is indicative of the changes in the structure and sources of funding that the banking sector is undergoing.
FIGURE 8.5 TEN LARGEST SOURCES OF DEPOSITS AS PERCENTAGE OF TOTAL CUSTOMER DEPOSITS
Percent 80 70 60 50
40 25.23
30 14.26
20 2.69
10 9S0 _ ''''6'.6'1 '''' 24.39
0
Demand less than one month One to three months More than three months Total
* Local currency E Freely convertible currency 3 Nonconvertible currency
To assess the general volatility of funding, a bank usually classifies its liabilities as those that are likely to stay with the bank under any circum- stances - for example, enterprise transaction accounts - and those that can be expected to pull out if problems arise. The key issues to be deter- mined for the latter are their price sensitivity, the rate at which they would pull out, and which liabilities could be expected to pull out at the first sign of trouble.