Liquidity Risk: Management and Supervisory Challenges

The Basel Committee on Banking Supervision has released a paper on 21st February 2008, entitled Liquidity Risk: Management and Supervisory Challenges.

In December 2006, the Basel Committee on Banking Supervision established the Working Group on Liquidity to review liquidity supervision practices in member countries. The Working Group's mandate was to take stock of liquidity supervision across member countries. This included an evaluation of the type of approaches and tools used by supervisors to evaluate liquidity risk and banks' management of liquidity risks arising from financial market developments.

The market turmoil that began in mid-2007 has highlighted the crucial importance of market liquidity to the banking sector. The contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks' balance sheets, led to severe funding liquidity strains for some banks and central bank intervention in some cases. In response to the market events, the original mandate was expanded and the Working Group made initial observations on the strengths and weaknesses of liquidity risk management in times of difficulty. These observations, together with those provided by the review of national liquidity regimes, formed the basis of the report, which was submitted to the Basel Committee in December 2007.

"The extreme liquidity conditions of last summer and resulting difficulties that persist today are vivid illustrations of the critical importance of market liquidity to the banking sector," stated Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank. "These events emphasised the links between market and funding liquidity, the interrelationship between funding liquidity risk and credit risk, and the fact that liquidity is a key determinant of banking sector soundness."

The Working Group is currently conducting a fundamental review of the Basel Committee's Sound practices for managing liquidity risk in banking organisations published in 2000. Drawing from recent and ongoing work on liquidity risk by the public and private sectors, the Basel Committee aims to enhance these sound practices to strengthen banks' liquidity risk management and improve global supervisory practices. The Basel Committee plans to issue the revised sound practices for public comment this summer.

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