5.6 Measurement of Liquidity Risk

C 33/2015 STA يسري تنفيذه من تاريخ 3/1/2022

a.IB must be able to measure and forecast its future cash flows arising from all of its positions, whether on or off-balance sheet, over a range of time bands. The IB must use a range of time horizons in order to assess its vulnerability to changes in its cash flows and liquidity requirements over time, given the size and mix of its balance sheet components. These time horizons can range from intraday, overnight, weekly and monthly for short-term liquidity assessments, up to one year for medium term and over one year for longer-term assessments.
b.An IB must have robust, documented and well tested methodologies for measuring liquidity risk, and must make appropriate amendments and revalidation to reflect changing market conditions, so as to ensure that the major assumptions and parameters continue to be relevant and up to date.
c.IBs must also take into consideration the impact of potential payments and commitments arising from off-balance sheet items such as committed lines, guarantees, letters of credit and Shari’ah-compliant derivatives. Particular importance must be paid to covenants that trigger the drawing of liquidity lines or that allow counterparties not to fulfil their obligations. Implicit support to restricted investment accounts or any securitisation vehicles of the IB (held off-balance sheet in most cases) must also be considered in the liquidity analysis. For securitisation vehicles, an IB must also take into consideration the contingent exposure and triggering events stemming from its contractual and non-contractual relationships with special purpose vehicles. (“SPV”).
Undrawn commitments, letters of credit and financial guarantees represent a potentially significant drain of funds for IB. IB may be able to ascertain a "normal" level of cash outflows under routine conditions, and then estimate the scope for an increase in these flows during periods of stress.
d.IBs must recognise that the behaviour of their cash flows can be considerably different from other types of institutions owing to the different nature of the contracts used for their financing and investment products. Cash flows in an IB may be categorised as follows:
1. i.Known cash flows: are those cash flows where the amount and maturities are known in advance, such as receivables from Murabahah, Ijarah, based financing.
2. ii.Conditional but predictable cash flows: are dependent on the performance of commitments or work, and fulfilment of agreed terms and conditions over an agreed period by the counterparties, as in the case of Salam, Istisna` and Diminishing Musharakah.
3. iii.Conditional but unpredictable cash flows: are related to equity participations by the IB where the recovery of invested capital and possible levels of return on investment are conditional on the financial results of the activity in which the funds are invested, as in Musharakah and Mudarabah.
e.For measuring liquidity risk, IB must utilise a range of measurement techniques, time horizons and levels of granularity. Depending upon the nature, size and complexity of operations of an IB, cash-flow forecasts and projections can range from simple spreadsheets to sophisticated modelling techniques, including utilising static simulations, value at risk, liquidity at risk and others. IB may use, for measuring and monitoring liquidity risk, the cash-flow mismatch/maturity gap for calculating the net funding requirement, which is based on an estimation of the amount and timing of future cash flows with respect to contractual or expected maturity.
f.IBs must analyse liquidity gaps, breaking them down by type of product, business unit and currency, with appropriate forecasting of liquidity needs in various stress scenarios. In order to ensure the reliability of the forecasting process, IB must collect and aggregate relevant data, and verify that the data are processed and transferred correctly through various systems and channels. IBs must also validate the forecasted cash flows and ensure that the data are complete and reconciled, with appropriate plausibility checks. The validations and back-testing results must be properly documented and communicated to senior management for their information.
g.The maturity gap approach helps the IB to address the net funding requirement in each time horizon. The analysis of net funding requirements involves the construction of a maturity ladder and the calculation of a cumulative net excess or deficit in funding at a series of points in time.
h.For calculating net funding requirements, the IB must analyse prospective cash flows based on assumptions of the future behaviour of assets, liabilities and off-balance sheet items, and then calculate the cumulative net excess or shortfall over the time frame.
i.Assumptions related to the behaviour of various fund providers and asset classes, or regarding possible triggers of any contingent liability and liquidity disruption, play an extremely important role in measuring and projecting cash flows. IBs must ensure that the assumptions it makes are practical, realistic and properly documented.
j.Assumptions related to the behaviour and stability of investment accounts, current accounts and funds generated from wholesale investors, as well as the volatility of asset portfolios on the basis of investment modes such as Mudarabah and Musharakah, are important. IBs must be able to test various scenarios on the availability of alternative funding sources from Islamic money and capital markets under adverse market conditions, as well as the effects of a deterioration in its asset quality or capital adequacy. An important consideration in such analyses is the critical role that the reputation and creditworthiness of an IB plays in accessing funds from the market on reasonable terms and in time. IB must be aware of any information that may adversely affect its public image and reputation, and hence its access to funds from the Islamic interbank market. Such information includes any negative publicity appearing in the media on the IB’s Shari’ah non-compliance, rating downgrade and fall in earnings.
k.Evaluating the liquidity position and liquidity risk of an IB requires an analysis of the behaviour of different cash flows under various market conditions. This behaviour can be analysed using various stress testing or “what-if” scenarios, to determine what the impact would be on cash stocks (i.e. cash balances) or cash flows. Stress testing helps to quantify potential liquidity gaps in specified stress scenarios using deterministic and stochastic cash flows and, therefore, must be linked with various actions and countermeasures.
l.IBs must also include sensitivity and scenario analyses in their stress testing. While sensitivity analyses test the dependence on a selected risk factor, scenario analyses simultaneously examine the effect of several risk factors on liquidity. The results of stress testing exercises must be the basis of setting limits, preparing the CFP, and revising the strategy, policies and procedures for liquidity risk management in the IB.
m.Stress testing must be conducted on a regular basis and must consider the following:
1. -It must be done on individual entity basis, group basis and across business lines.
2. -It must consider the implication of the scenarios across different time horizons, including on an intraday basis.
3. -The extent and frequency of testing should be commensurate with the size of the bank and its liquidity risk exposures.
4. -IB must build in the capability to increase the frequency of tests in special circumstances, such as in volatile market conditions or at the request of the Central Bank.
5. -Senior management must be actively involved in the stress testing process, demanding rigorous assumptions and challenging the results.
6. -The Board must be informed of the stress testing results and must be able to challenge outcomes, assumptions and actions taken on the basis of the tests.
n.IBs must ensure consistency in the reporting process to allow for comparability overtime and assist in measuring changes in the risk exposure and/or profile.
o.The stress test scenarios must consider the following:
1. -A simultaneous drying up of market liquidity in several previously highly liquid markets (inter-bank money markets, non UAE funding markets, securitisation).
2. -Severe constraints in accessing secured and unsecured wholesale funding.
3. -The run-off of retail funding.
4. -Contingent claims and more specifically, potential draws on committed lines extended to third parties or the IB’s subsidiaries, branches or head office and the liquidity absorbed by off-balance activities.
5. -Severe operational or settlement disruptions affecting one or more payment or settlement systems.
6. -Take into account the link between reductions in market liquidity and constraints on funding liquidity. This is particularly important for IBs with significant market share in, or heavy reliance upon, specific funding markets.
7. -IBs must also consider the results of stress tests performed for various other risk types and consider possible interactions between liquidity risk and these other types of risk (e.g. capital stress tests), and including consistency across stressed credit and liquidity methodologies/metrics.
8. -Tests must reflect accurate time-frames for the settlement cycles of assets that might be liquidated (i.e. time to receive the sale proceeds).
9. -If an IB relies upon liquidity outflows from one system to meet obligations in another, it must consider the risk that operational or settlement disruptions might prevent or delay expected flows across systems. This is particularly relevant for IBs relying upon intra-group transfers or centralised liquidity management.
10. -Additional margin calls and collateral requirements.
11. -The availability of contingent lines extended to the IB.
12. -The impact of credit rating triggers.
13. -The access to Central Bank facilities.
14. -The potential reputational impact when executing contingency /remedial action.
15. -Estimates of future balance sheet growth.
16. -The likely behavioral response of other market participants (similar response to market stress might amplify market strain).
17. -The likely impact of its own behaviour on other market participants.
18. -Where a bank uses a correspondent or custodian to conduct settlement, the analysis must include the impact of those agents restricting their provision of intraday credit.
p.IBs must use various kinds of limits for controlling its liquidity risk. These limits are normally set at the group level and are apportioned downwards to the various entities, including subsidiaries, units/divisions or desks. Through limits, IBs can ensure that it does not have a level of outflows, which cannot be funded in the market, taking account of its risk tolerance and historical record. Overall, IBs must set their limit structure so that it continues to operate in an idiosyncratic stress or market-wide stress, or both.
q.IBs may use internal fund transfer pricing technique for measuring and analysing pricing, profitability and performance of various business lines, products and branches within the IB.
Since the internal prices affect the performance measurement of different functional units, products and lines of business, senior management must assign such responsibility to an independent unit in a transparent manner. It must also uphold the Shari’ah requirements in case IB has different pools of funds. In addition, the internal pricing must be decided after an interactive discourse between the business lines and the unit/s responsible for the fund transfer price and must cover all significant business activities of the IB, including off-balance sheet. This process must take into account different factors related to assets, liabilities and off-balance sheet items, including their expected holding periods and associated changes in liquidity risk, “stickiness” or stability of funding sources, and other related factors. It must also be updated at appropriate intervals.
r.Senior management must appropriately incorporate liquidity costs, benefits and risks in the internal pricing and performance measurement for all significant business activities (both on- and off-balance sheet). The sophistication of the transfer pricing framework must be in line with the bank’s level of sophistication and business complexity. The costs, benefits and risks must then be explicitly attributed to the relevant activity so that line management incentives are consistent with and reinforce the overarching liquidity risk tolerance and strategy of the bank, with a liquidity charge assigned, as appropriate, to positions, portfolios, or individual transactions.
s.This assignment of liquidity costs, benefits and risks must incorporate factors related to the anticipated holding periods of assets and liabilities, their market liquidity risk characteristics, and any other relevant factors, including the benefits from having access to relatively stable sources of funding, such as some types of retail deposits.
The quantification and attribution of these risks must be explicit and transparent at the line management level and must include consideration of how liquidity would be affected under stressed conditions.
The analytical framework must be reviewed as appropriate to reflect changing business and financial market conditions and so maintain the appropriate alignment of incentives.
t.IBs must assess its aggregate foreign currency liquidity needs and determine acceptable currency mismatches. IBs must undertake a separate analysis of its strategy for each currency in which it has significant activity, considering potential constraints in times of stress. The size of foreign currency mismatches must take into account: (a) the IB’s ability to raise funds in foreign currency markets; (b) the likely extent of foreign currency back-up Shari’ah compliant facilities available in its domestic market; (c) the ability to transfer a liquidity surplus from one currency to another, and across jurisdictions and legal entities; and (d) the likely convertibility of currencies in which the bank is active.
IBs must take account of the risks of sudden changes in foreign exchange rates or market liquidity, or both, which could sharply widen liquidity mismatches and alter the effectiveness of foreign exchange hedges and hedging strategies.