According to the Bank of International Settlements, liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The term bank generally refers to banks, bank holding companies or other companies considered by banking supervisors to be the parent of a banking group under applicable national law as determined to be appropriate by the entity’s national supervisor.
The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk, both of an institution-specific nature and that which affects markets as a whole.
Virtually every financial transaction or commitment has implications for a bank’s liquidity. Effective liquidity risk management helps ensure a bank’s ability to meet cash flow obligations, which are uncertain as they are affected by external events and other agents’ behaviour.
Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management.
The market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector. In advance of the turmoil, asset markets were buoyant and funding was readily available at low cost.
The reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in a few cases, individual institutions.
Many banks had failed to take account of a number of basic principles of liquidity risk management when liquidity was plentiful. Many of the most exposed banks did not have an adequate framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines, and therefore incentives at the business level were misaligned with the overall risk tolerance of the bank.
Many banks had not considered the amount of liquidity they might need to satisfy contingent obligations, either contractual or non-contractual, as they viewed funding of these obligations to be highly unlikely.
Many firms viewed severe and prolonged liquidity disruptions as implausible and did not conduct stress tests that factored in the possibility of market wide strain or the severity or duration of the disruptions.
Contingency funding plans (CFPs) were not always appropriately linked to stress
test results and sometimes failed to take account of the potential closure of some funding
In order to account for financial market developments as well as lessons learned from the turmoil, the Basel Committee has conducted a fundamental review of its 2000 Sound Practices for Managing Liquidity in Banking Organisations. Guidance has been significantly expanded in a number of key areas.
In particular, more detailed guidance is provided on:
1. The importance of establishing a liquidity risk tolerance
2. The maintenance of an adequate level of liquidity, including through a cushion of liquid assets;
3. The necessity of allocating liquidity costs, benefits and risks to all significant business activities;
4. The identification and measurement of the full range of liquidity risks, including contingent liquidity risks;
5. The design and use of severe stress test scenarios;
6. The need for a robust and operational contingency funding plan;
7. The management of intraday liquidity risk and collateral; and
8. Public disclosure in promoting market discipline.
Guidance for supervisors also has been augmented substantially. The guidance emphasises the importance of supervisors assessing the adequacy of a bank’s liquidity risk management framework and its level of liquidity, and suggests steps that supervisors should take if these are deemed inadequate.
The principles also stress the importance of effective cooperation between supervisors and other key stakeholders, such as central banks, especially in times of stress.