34)Liquidity measurement involves assessing a bank’s cash inflows against its outflows and the liquidity value of its assets to identify the potential for future net funding shortfalls. A bank should be able to measure and forecast its prospective cash flows for assets, liabilities, off-balance sheet commitments and derivatives over a variety of time horizons, under normal conditions and under a range of stress scenarios, including scenarios of severe stress. It should also consider funding needs in currencies in which the bank is active and liquidity needs arising from correspondent banking and settlement activities. Below is an overview of what is expected under the above mentioned risk drivers.
Future cash flows of assets and liabilities
35)A bank should have a robust liquidity risk management framework providing prospective, dynamic cash flow forecasts that include assumptions on the likely behavioral responses of key counterparties to changes in conditions and are carried out at a sufficiently granular level. A bank should make realistic assumptions about its future liquidity needs for both the short- and long-term that reflect the complexities of its underlying businesses, products and markets. The Central Bank reporting format attached to this manual can provide a good starting point.
36)A bank should analyze the quality of assets that could be used as collateral, in order to assess their potential for providing secured funding in stressed conditions. A bank should also manage the timing of incoming flows in relation to known outgoing sources in order to obtain an appropriate maturity distribution for its sources and uses of funds.
37)In estimating the cash flows arising from its liabilities, a bank should assess the “stickiness” of its funding sources. In particular, for large wholesale funds providers, both secured and unsecured, a bank should assess the likelihood of roll-over of funding lines and how the r fund providers are likely to behave under stress - and therefore consider the possibility that secured and unsecured funding might dry up in times of stress. For secured funding with overnight maturity, a bank should not assume that the funding will automatically roll over. In addition, a bank should assess the availability of term funding back up facilities and the circumstances under which they can be utilized. In assessing the ‘stickiness’ of retail deposits a bank should also consider factors such as size, interest-rate sensitivity, geographical location of depositors and the deposit channel (e.g. short term high interest rate promotion).
38)Regarding the time horizons over which to identify measure, monitor and control liquidity risk, a bank should ensure that its liquidity risk management practices integrate and consider a variety of factors. These include vulnerabilities to changes in liquidity needs and funding capacity on an intraday basis; day-to-day liquidity needs and funding capacity over short and medium-term horizons up to one year; longer-term liquidity needs over one year; and vulnerabilities to events, activities and strategies that can put a significant strain on internal cash generation capability.
Sources of contingent liquidity demand
39)A bank should identify measure, monitor and control potential cash flows relating to off-balance sheet commitments and other contingent liabilities. This should include a robust framework for projecting the potential consequences of undrawn commitments being drawn, considering the nature of the commitment and credit worthiness of the counterparty, as well as exposures to business and geographical sectors, as counterparties in the same sectors may be affected by stress at the same time.
40)For banks engaged in securitization activities, they should monitor the existence of recourse provisions in asset sales, the extension of liquidity facilities to securitization vehicles and the early amortization triggers of certain asset securitization transactions. Banks should also consider the nature and size of the bank’s potential non-contractual “obligations”, where the support provided to securitization and conduit programmes is critical to maintaining ongoing access to funding and the bank reputation in the market.
41)A bank should incorporate cash flows related to the re-pricing, exercise or maturity of financial derivatives contracts in its liquidity risk analysis, including the potential for counterparties to demand additional collateral in an event such as a decline in the bank’s credit rating or creditworthiness or a decline in the price of the underlying asset.
Guarantees and commitments
42)Undrawn loan commitments, letters of credit and financial guarantees represent a potentially significant drain of funds for a bank. A bank 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. For example, an episode of financial market stress may trigger a substantial increase in the amount of draw-downs of letters of credit provided by the bank to its customers. Similarly, liquidity issues can arise when a bank relies on committed lines of credit provided by others.
Currencies in which a bank is active
43)A bank should assess its aggregate foreign currency liquidity needs and determine acceptable currency mismatches. A bank should 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 should take into account: (a) the bank’s ability to raise funds in foreign currency markets; (b) the likely extent of foreign currency back-up 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, including the potential for impairment or complete closure of foreign exchange swap markets for particular currency pairs.
44)A bank should be aware of, and have the capacity to manage, liquidity risk exposures arising from the use of foreign currency deposits and short-term credit lines to fund domestic currency assets as well as the funding of foreign currency assets with domestic currency. A bank should 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.
Correspondent, custody and settlement activities
45)Where relevant, a bank should understand and have the capacity to manage correspondent, custodian and settlement bank services and how they can affect its cash flows. Given that the gross value of customers’ payment traffic (inflows and outflows) can be very large, unexpected changes in these flows can result in large net deposits, withdrawals or line-of credit draw-downs that impact the overall liquidity position of the correspondent or custodian bank, both on an intraday and overnight basis. A bank also should understand and have the capacity to manage the potential liquidity needs it would face as a result of the failure-to-settle procedures of payment and settlement systems in which it is a direct participant.