Liquidity Risk Management: Meeting the Basel III challenge

The finalised Basel III regulation published in December 2010 will have far-reaching implications for the banking industry. Many experts believe the inclusion of the liquidity regulation to be the most significant modification, estimated to pose considerable challenges for credit institutions across the globe. Likely effects like disruptions to the interbank market, trapped pools of liquidity in individual territories and increased monitoring and reporting requirements will require banks to fundamentally review and improve their funding and liquidity management frameworks.

What are banks required to do?

Among others, banks will need to consider the following elements in response to the new global regulation:

• Embed funding and liquidity management into strategy and business planning;
• Enhance profitability by optimising funding structure, reducing funding costs while maintaining funding profile in line with liquidity risk appetite;
• Develop funds transfer pricing frameworks to ensure funding and liquidity costs and benefits are transparently allocated to respective businesses and products;
• Upgrade systems infrastructure to be able to obtain required data with required accuracy and frequency;
• Ensure comprehensiveness of liquidity risk management framework, including implementation of processes and controls focusing on key liquidity risk drivers as intragroup, intra-day and cross-currency risks;
• Review and update stress testing frameworks, including an optimisation of composition and size of liquidity reserves across the banking group;
• Align global regulatory reporting requirements with internal monitoring and reporting framework;
• Prepare Board and Senior Management for supervisory visits.

The impact of the Basel III regulation is not uniform across institutions or even entities of the same banking group. Solutions by Luxembourg institutions need to be tailored to specificitiesof the local financial place, taking into account both business models (e.g. custodian banks and covered bond issuance) as well as the implications of Basel III on subsidiaries of international groups (i.e. the impact of singleentity vs. consolidated application of the new regulation).

Subsequent to the credit crisis, liquidity risk management has shifted in the focus of many bank’ improvement efforts. However, respective efforts have often been focused on individual elements, resulting in fragmented rather than integrated solutions.

The challenges posed by Basel III should thus also be perceived as an opportunity to review and optimise existing liquidity risk management frameworks.

How we can help

PwC is a leading provider of assistance in the domains of funding and liquidity management as well as risk management. We have assisted numerous global, national and local banks in enhancing their liquidity risk management frameworks, both in response to the new rules as well as to improve efficiency.

You can use our global pool of industry and regulatory expertise to proactively and efficiently transform your liquidity risk management framework. Our extensive expertise in related areas will enable us to assist you in developing streamlined solutions taking into account potential interactions with other elements of the Basel III regulation.

Liquidity risk management framework - Potential key issues

Key issues

• Impact of Basel III currently not fully understood Interaction with other elements of Basel III often not considered (e.g. LCR/NSFR and leverage ratio)
• Business planning and strategy need to consider funding and liquidity implications
• Liquidity risk management framework needs to be better integrated with governance of other risks
• Roles and responsibilities need to be clearly defined between treasury, risk and finance functions
• Policies and procedures are not adequately documented to comply with regulatory requirements

• Understanding of key liquidity risk drivers is insufficiently developed
• Correlations between different risk drivers are often not identified or neglected
• Divergences in internal and regulatory assumptions
• Estimates of market liquidity and behaviour of market participants highly dependent on expert judgement

• Lack of integration between business, finance and risk management systems
• Difficulties in extracting integrality of cash flow information of on- and off-balance sheet positions
• Necessary data is not available at required level of granularity
• Reporting frameworks are not streamlined, leading to inefficiencies

• Lack of tools to adequately measure and assess all the liquidity risk drivers
• Liquidity risk management tools are not forward-looking and overly reliant on accounting ratios based on historical data
• Liquidity stress testing does not capture all cash flows and is insufficiently reflected in management decisions
• Funds transfer pricing approaches are not implemented or not embedded in performance management and the assessment of new products and business decisions
• Liquidity buffers are cost inefficient and do not comply with regulatory requirements
• Deficiencies in contingency planning

Selected liquidity risk management assigments

• Regulatory compliance & best practices - Assisted clients in benchmarking their current liquidity risk management frameworks against regulatory standards and market best practices.
• Regulatory impact - Assisted clients in analysis of impact of recent changes in regulation.
• Liquidity stress testing - Assisted clients in designing stress tests appropriate to their respective business models.
• Liquidity risk measurement - Assisted client in setting up maturity mismatch metric including several stress tests.
• Liquidity risk documentation - Assisted clients in drafting required documentation and aligning it with group documentation.
• Reporting - Assisted clients in setting up reports tailored to target stakeholders.

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