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BASEL COMMITTEE ON INTEREST RATE|International Banking Laws|Study Notes


The Basel Committee on Banking Supervision has issued standards for Interest Rate Risk in the Banking Book (IRRBB).

The standards revise the Committee's 2004 Principles for the management and supervision of interest rate risk, which set out supervisory expectations for banks' identification, measurement, monitoring and control of IRRBB as well as its supervision. The key enhancements to the 2004 Principles include:

  • More extensive guidance on the expectations for a bank's IRRBB management process in areas such as the development of interest rate shock scenarios, as well as key behavioural and modelling assumptions to be considered by banks in their measurement of IRRBB;

  • Enhanced disclosure requirements to promote greater consistency, transparency and comparability in the measurement and management of IRRBB. This includes quantitative disclosure requirements based on common interest rate shock scenarios;

  • An updated standardised framework, which supervisors could mandate their banks to follow or banks could choose to adopt; and

  • A stricter threshold for identifying outlier banks, which is has been reduced from 20% of a bank's total capital to 15% of a bank's Tier 1 capital.

Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. 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.



LEGAL & REGULATORY FRAMEWORK


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.

In February 2008 the Basel Committee on Banking Supervision published Liquidity Risk Management and Supervisory Challenges. The difficulties outlined in that paper highlighted that 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 sources.

The Basel Committee on Banking Supervision has today issued standards for Interest Rate Risk in the Banking Book (IRRBB). The standards revise the Committee's 2004 Principles for the management and supervision of interest rate risk, which set out supervisory expectations for banks' identification, measurement, monitoring and control of IRRBB as well as its supervision.

The key enhancements to the 2004 Principles include:

  • More extensive guidance on the expectations for a bank's IRRBB management process in areas such as the development of shock and stress scenarios as well as key behavioural and modelling assumptions to be considered by banks in their measurement of IRRBB;

  • Enhanced disclosure requirements to promote greater consistency, transparency and comparability in the measurement and management of IRRBB. This includes quantitative disclosure requirements based on common interest rate shock scenarios;

  • An updated standardized framework, which supervisors could mandate their banks to follow or banks could choose to adopt; and

  • A stricter threshold for identifying outlier banks that has been reduced from 20% of a bank's total capital to 15% of a bank's Tier 1 capital. In addition, interest rate risk exposure is measured by the maximum change in the economic value of equity under the prescribed interest rate shock scenarios.

The IRRBB standards reflect changes in the market and supervisory practices since the Principles were first published in 2004, which is particularly pertinent in light of the current exceptionally low-interest rates in many jurisdictions. The revised standards, which were published for consultation in June 2015, are expected to be implemented by 2018.



JUDICIAL FUNCTIONS


In February 2008 the Basel Committee on Banking Supervision published Liquidity Risk Management and Supervisory Challenges. The difficulties outlined in that paper highlighted that 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 sources.

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:

  • the importance of establishing a liquidity risk tolerance;

  • the maintenance of an adequate level of liquidity, including through a cushion of liquid assets;

  • the necessity of allocating liquidity costs, benefits and risks to all significant business activities;

  • the identification and measurement of the full range of liquidity risks, including contingent liquidity risks;

  • the design and use of severe stress test scenarios;

  • the need for a robust and operational contingency funding plan;

  • the management of intraday liquidity risk and collateral; and

  • public disclosure in promoting market discipline

Guidance for supervisors also has been augmented substantially. The guidance emphasizes 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.

This guidance focuses on liquidity risk management at medium and large complex banks, but the sound principles have broad applicability to all types of banks. The implementation of the sound principles by both banks and supervisors should be tailored to the size, nature of business, and complexity of a bank's activities. A bank and its supervisors also should consider the bank's role in the financial sectors of the jurisdictions in which it operates and the bank's systemic importance in those financial sectors. The Basel Committee fully expects banks and national supervisors to implement the revised principles promptly and thoroughly and the Committee will actively review progress in implementation.

This guidance is arranged around seventeen principles for managing and supervising liquidity risk.



CRITICAL ANALYSIS


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.

In view of the relevance and timeliness of the report, the Basel Committee is publishing this summary of the key findings. This document highlights financial market developments that affect liquidity risk management, discusses national supervisory regimes and their components, and then outlines initial observations from the current period of stress and potential future work related to liquidity risk management and supervision.

The Working Group is currently conducting a fundamental review of the Basel Committee's publication Sound practices for managing liquidity risk in banking organizations published in 2000. While the guidance remains relevant, the Working Group identified areas that warrant updating and strengthening. The Basel Committee plans to issue the enhanced sound practices for public comment in the summer of 2008.



CONCLUSION


As recent financial crises showed, the BCBS needs to recognize the inherent limitations and weaknesses of liquidity provisioning. The proposals at an international level to supplement Basel III liquidity risk measures with other internationally harmonized and appropriately calibrated liquidity standards have been welcomed and could lead to its adoption by a wide range of countries in the future. The LCR and NSFR cannot do the job alone; it needs to be complemented by other prudential tools or measures to ensure a comprehensive picture of the dissipation of liquidity in banks as well as the financial system. Additional measures to provide a comprehensive view of aggregate liquidity, including embedded liquidity, and to trigger enhanced surveillance by supervisors need to be developed.

There appears to be a consensus that no single tool or measure would have prevented the financial crisis and that an adequate policy response requires a mix of macro- and micro-prudential policy tools. The LCR and NSFR can be useful prudential tools and can be relatively easy to implement, for jurisdictions that do not want to rely solely on risk-sensitive capital requirements. Combining the LCR and NSFR with Basel-type capital rules can reduce the risk of depleted liquidity in banks. As the findings in this paper showed, however, policymakers need to be cognizant of the inherent limitations and weaknesses of the LCR and NSFR.



REFERENCES

1. https://www.bis.org/bcbs/publ/d368.htm

2. https://www.bis.org/publ/bcbs144.htm

3. https://www.hindawi.com/journals/ddns/2013/172648/

4. https://www.bis.org/speeches/sp101109a.htm

5. https://www.bis.org/press/p190117.htm

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