Basel II and the 13 Principles For Liquidity Risk Management

Principle 1:

A  bank  is responsible for the sound  management  of liquidity  risk . A  bank  should establish a robust liquidity  risk   management  framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources.

Supervisors should assess the adequacy of both a  bank’s  liquidity  risk   management  framework and its liquidity position and should take prompt action if a  bank  is deficient in either area in order to protect depositors and to limit potential damage to the financial system.

Principle 2:

A  bank  should clearly articulate a liquidity  risk  tolerance that is appropriate for its business strategy and its role in the financial system.

Principle 3:

Senior  management  should develop a strategy, policies and practices to manage liquidity  risk  in accordance with the  risk  tolerance and to ensure that the  bank  maintains sufficient liquidity. Senior  management  should continuously review information on the  bank’s  liquidity developments and report to the board of directors on a regular basis.

A  bank’s  board of directors should review and approve the strategy, policies and practices related to the  management  of liquidity at least annually and ensure that senior  management  manages liquidity  risk  effectively.

Principle 4:

A  bank  should incorporate liquidity costs, benefits and  risks  in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the  risk-taking  incentives of individual business lines with the liquidity  risk  exposures their activities create for the  bank  as a whole.

Principle 5:

A  bank  should have a sound process for identifying, measuring, monitoring and controlling liquidity  risk . This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.

Principle 6:

A  bank  should actively monitor and control liquidity  risk  exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.

Principle 7:

A  bank  should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providersto promote effective diversification of funding sources.

A  bank  should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.

Principle 8:

A  bank  should actively manage its intraday liquidity positions and  risks  to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.

Principle 9:

A  bank  should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A  bank  should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner.

Principle 10:

A  bank  should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a  bank’s  established liquidity  risk  tolerance.

A  bank  should use stress test outcomes to adjust its liquidity  risk   management  strategies, policies, and positions and to develop effective contingency plans.

Principle 11:

A  bank  should have a formal contingency funding plan (CFP)that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.

Principle 12:

A  bank  should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources.

There should be no legal, regulatory or operational impediment to using these assets to obtain funding.

Principle 13:

A  bank  should publicly disclose information on a regular basis that enables market participants to make an informed judgement about the soundness of its liquidity  risk   management  framework and liquidity position.

According to the  Bank  of International Settlements, 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.

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