This document provides recommendations on principles of liquidity risk management from the Institute of International Finance's Special Committee on Liquidity Risk. It discusses emerging issues in liquidity risk management, recommends best practices around governance, analytical frameworks, and stress testing, and offers considerations for the official sector around regulation and oversight. The goal is to promote strong liquidity risk management and raise expectations for financial institutions.

1. Principles of Liquidity Risk Management
Institute of International Finance
March 2007

2. Principles of Liquidity Risk Management
Table of Contents
2 IIF Special Committee on Liquidity Risk
6 Drafting Committee
7 Complex Financial Instruments Task Force
8 Executive Summary
10 Preface
12 General Notes
13 Emerging Liquidity Issues in a Changing International Environment
19 Recommendations on Industry Practice for Liquidity Risk
19 A. Governance and Organizational Structure for Managing Liquidity
27 B. Analytical Framework for Measuring, Monitoring, and Controlling Liquidity Risk
34 C. Stress Testing and Contingency Planning
40 Considerations for the Official Sector
44 Analytical Discussion 1: Reliance on Secured-Financing Sources
48 Analytical Discussion 2: The Impact of Complex Financial Instruments upon Liquidity-Management
Policies and Practices
55 Appendix 1: Possible Sources of Liquidity Vulnerabilities and Potential Metrics
59 Appendix 2: Recommendations on Industry Practice for Liquidity Risk

3. IIF Special Committee on Liquidity Risk
Chairman Vice-Chairman
Mr. Ahmass Fakahany Mr. Chris Grigg
Vice Chairman & Chief Executive
Chief Administrative Officer UK Business Banking
Merrill Lynch & Co., Inc. Barclays PLC
Committee Members
Mr. Armin Widjojoatmodjo Mr. Joseph C. Noto
Senior Vice President Managing Director
Directorate Group ALM London Corporate Treasury
ABN AMRO Bank N.V. Bear, Stearns & Co., Inc.
Mr. Charalambos Kourtidis Mr. Robert Upton
Assistant Manager Senior Managing Director & Treasurer
Risk Management Division Bear, Stearns & Co., Inc.
Alpha Bank
Mr. Christian Lajoie
Mr. Jackson Ricardo Gomes Senior Vice President
Senior Managing Director Basel II Group Coordinator
Banco Itaú S.A. BNP Paribas
Mr. Carlos Eduardo Lara Ms. Catherine Royere
General Manager Liquidity Management
Treasury ALM Treasury
Banco Itaú S.A. BNP Paribas
Mr. Alejandro González Sosa Mr. Michael G. Horrocks
Executive President Executive Vice President
Banco Mercantil, Venezuela Treasury & Risk Management
CIBC
Mr. Millar Wilson
Chief Risk Officer Mr. Marc Weinberg
Banco Mercantil, Venezuela Head of Global Liquidity Oversight
Citigroup Inc.
Mr. Richard Pattinson
Head of Regulatory & Mr. Wolfgang Hartmann
Industry Issues Member of the Board of Managing Directors
Global Payments Chief Risk Officer
Barclays PLC Commerzbank AG
Mr. Miguel Angel Iglesias Mr. Willi Schwarz
Head of Market Risk Department Senior Vice President
BBVA Head of Market Risk Control
Commerzbank AG
2

4. IIF Special Committee on Liquidity Risk
Committee Members
(continued)
Mr. Markus Sunitsch Ms. Veronica Foo
Managing Director Vice President
Head of Liquidity & ALM Corporate Treasury
Credit Suisse Goldman Sachs & Co.
Mr. Cato Baldvinsson Mr. Michael Kurlander
Senior Vice President Vice President
Head of ALM Corporate Treasury
Danske Bank Goldman Sachs & Co.
Dr. Knut Pohlen Mr. John Flint
Deputy Group Treasurer Group Treasurer
Deutsche Bank AG HSBC Bank plc
Mr. Geert M. Tuinema Mr. Edmund Stokes
Head of Liquidity Management Head of Business Development
Deutsche Bank AG Global Balance Sheet Management
HSBC Bank plc
Mr. Matthias Behrens
Head of Liquidity Risk Control Ms. Vishakha Mulye
Risk Governance and Controlling Group Chief Financial Officer
Dresdner Bank AG ICICI Bank Limited
Dr. Martin Knippschild Mr. Constant Thoolen
Head of Strategic Risk & Head of Corporate Risk Management Retail
Treasury Control ING Group N.V.
Dresdner Bank AG
Mr. Alessandro Frascarolo
Mr. Michael Santer Treasury & Liquidity Management
Group Liquidity Manager Intesa Sanpaolo S.p.A.
Head of Foreign Exchange & Money Markets
Erste Bank Mr. Renato Maino
Head of Risk Capital and Policies
Mr. Werner D’Haese Risk Management Department
Market Risk Advisor Intesa Sanpaolo S.p.A.
Central Risk Management
Fortis Mr. Tod J. Gordon
Managing Director
Ms. Elizabeth E. Beshel Treasury
Managing Director & Treasurer J.P. Morgan Chase & Co.
Goldman Sachs & Co.
3

5. IIF Special Committee on Liquidity Risk
Committee Members
(continued)
Mr. Rik Janssen Mr. Ulf Grunnesjö
General Manager Senior Vice President &
ALM Risk Management & Economic Capital Head of Investor Relations
KBC Group N.V. SEB
Mr. Paolo R. Tonucci Ms. Agathe Zinzindohoue
Managing Director & Head of Funding
Global Co-Treasurer Asset & Liability Management
Lehman Brothers Société Générale Group
Mr. Christopher B. Hayward Mrs. Helene Faracci-Steffan
Senior Vice President Head of Asset & Liability Management
Global Treasurer Société Générale Group
Merrill Lynch & Co., Inc.
Mr. Phil Leverick
Mr. Marc Saidenberg Head of Balance Sheet Management
Managing Director Group Treasury
Regulatory Policy & Relations The Royal Bank of Scotland Group
Global Treasury
Merrill Lynch & Co., Inc. Mr. Bill Rickard
Senior Manager
Mr. Takeshi Ogasawara Group Treasury
Executive Officer & General Manager The Royal Bank of Scotland Group
Corporate Risk Management
Mitsubishi UFJ Financial Group, Inc. Mr. A. Aykut Demiray
Deputy Chief Executive
Mr. Koji Nishiwaki Treasury & Foreign Relations Department
Deputy General Manager Turkiye Is Bankasi A.S.
Risk Management Division
Mizuho Financial Group, Inc. Ms. Wendy Lucas
Executive Director
Mr. Michael Cervasio Group Treasury
Internal Auditor UBS AG
National Bank of Kuwait, S.A.K.
Mr. Sergio Sorrentino
Mr. Francois Tremblay Head of Market Risks &
Head of Liquidity Management Basel II Project
Corporate Treasury UniCredit Group
RBC Financial Group
4

6. IIF Special Committee on Liquidity Risk
Committee Members
(continued)
Mr. Alessandro Brusadelli Mr. Thierry Nardon
Head of Group ALM & Managing Director
Financial Planning Group Treasury
Group Finance Area WestLB AG
UniCredit Group
Mr. Thorsten Kanzler
Group Treasurer-Member of Division Board
UB ALM/GB Group Treasury
WestLB AG
5

7. IIF Special Committee on Liquidity Risk
Drafting Committee
Committee Members
Mr. Richard Pattinson Mr. Edmund Stokes
Head of Regulatory & Industry Issues Head of Business Development
Global Payments Global Balance Sheet Management
Barclays PLC HSBC Bank plc
Ms. Catherine Royere Mr. Marc Saidenberg
Liquidity Management Managing Director
ALM Treasury Regulatory Policy & Relations
BNP Paribas Global Treasury
Merrill Lynch & Co., Inc.
Mr. Marc Weinberg
Head of Global Liquidity Oversight Mr. Francois Tremblay
Citigroup Inc. Head of Liquidity Management
Corporate Treasury
Mr. Willi Schwarz RBC Financial Group
Senior Vice President
Head of Market Risk Control Ms. Wendy Lucas
Commerzbank AG Executive Director
Group Treasury
Mr. John Flint UBS AG
Group Treasurer
HSBC Bank plc
6

8. IIF Special Committee on Liquidity Risk
Complex Financial Instruments Task Force
Chairman
Mr. John Flint
Group Treasurer
HSBC Bank plc
Task Force Members
Mr. Richard Pattinson Mr. Geert M. Tuinema
Head of Regulatory & Industry Issues Head of Liquidity Management
Global Payments Deutsche Bank AG
Barclays PLC
Mr. Edmund Stokes
Mr. Willi Schwarz Head of Business Development
Senior Vice President Global Balance Sheet Management
Head of Market Risk Control HSBC Bank plc
Commerzbank AG
Mr. Marc Saidenberg
Mr. Markus Sunitsch Managing Director
Managing Director Regulatory Policy & Relations
Head of Liquidity & ALM Global Treasury
Credit Suisse Merrill Lynch & Co., Inc.
7

9. Principles of Liquidity Risk Management1 ment of policy positions and in evaluation of firms’
positions and practices.
Executive Summary It is important to underscore that the deliberations of
the Special Committee demonstrated repeatedly that
In late 2005, the Institute of International Finance (IIF) firms’ needs and strategies can, for legitimate business
established a Special Committee on Liquidity Risk. The reasons, vary considerably, so that the Recommenda-
Special Committee, chaired by Ahmass Fakahany, Vice tions proposed must be understood as describing a
Chairman and Chief Administrative Officer of Merrill range of good practices, not a prescriptive list of nec-
Lynch, with Chris Grigg, Chief Executive, UK Business essarily “best” detailed practices. Moreover, all Rec-
Banking of Barclays as vice chairman, includes repre- ommendations and commentary apply on a “comply
sentatives of about 40 of the largest global financial in- or explain” basis, and controlled firms may have good
stitutions. The objective of the Special Committee was reasons to take quite different approaches.
to develop a perspective and Recommendations on li-
quidity risk measurement, monitoring, management, A brief overview of Emerging Liquidity Issues in a
and governance at financial institutions. The focus is Changing International Environment offers a review
timely, as the liquidity characteristics of international of market developments behind the analysis. While it
markets have been undergoing significant changes at a can be argued that the markets have become more re-
time when the industry and the regulatory community silient with recent innovation and increasing intercon-
have been giving relatively greater attention to other nectedness, it cannot be known with certainty whether
issues. The Special Committee is broadly encouraged new vulnerabilities have been created or old ones dis-
by the growing sophistication of firms’ approaches to placed in ways that will need to be dealt with in the
liquidity risk management and does not see any immi- event of a liquidity crunch. This appreciation of what
nent cause for special concern. Nevertheless, increased we may not know or fully understand is why attention
globalization of firms and the financial system, the in- to good practices is timely and why the industry on
creasingly concentrated number of firms that provide the whole has made substantial investments in liquid-
market volume and liquidity, the increased reliance ity risk management.
on secured funding, and the lack of harmonization of
global liquidity standards suggested that a closer look Both effective governance and organizational structure
was needed. for managing liquidity are critical given that liquidity
issues come up in various ways for firms with different
This report focuses on funding liquidity risk, explor- mixes of business, funding structures, market char-
ing appropriate practices and making a number of acteristics, and risk appetites. Because no formulaic
Recommendations for the private sector on three approach will yield appropriate or prudential results
broad topics: governance and organizational structure across the board, internal governance and controls are
for managing liquidity; an analytical framework for the keys to reducing liquidity risk for a firm. Similarly
measuring, monitoring, and controlling liquidity; and critical is public disclosure of information about each
stress testing and contingency planning. The intent firm’s liquidity risk management practices.
of the report is to raise expectations for liquidity risk
management. The fundamental premise is that firms The analytical framework for measuring, monitoring,
should deliver, and supervisory and regulatory ap- and controlling liquidity risk in each firm receives con-
proaches should recognize, risk-management frame- siderable attention, reflecting the priority that firms
works that are tailored to each firm’s business model need to give to developing appropriate measurement
and market position. To this end, the report also in- and monitoring tools. Current risk-management tech-
cludes some Considerations for the Official Sector that niques provide firms with clearer views, better-under-
the Special Committee hopes will be useful in assess- stood internal strategies, and better control overall.
1
Related regulatory papers consulted include “Sound Practices for Managing Liquidity in Banking Operations,” Basel Committee on Banking Supervision, February 2000;
“Sound Practices for the Management of Liquidity Risk at Securities Firms,” Report of the Technical Committee of the International Organization of Securities Commis-
sions, May 2002; and “The Management of Liquidity Risk in Financial Groups,” The Joint Forum, Basel Committee on Banking Supervision, May 2006. They are referenced
where appropriate.
8

10. Such techniques, however, require careful review of risk management structures. Although complete con-
assumptions and experience to provide strong under- vergence of regulations may not be feasible, regula-
pinnings for the sound judgment that each firm must tors should seek to harmonize regulations in order to
apply to assessing its needs and risks in both business- facilitate sound internal risk-management systems.
as-usual and stressed conditions in order to establish Liquidity regulations should be based on qualitative
appropriate metrics and limits within its strategy. The approaches designed to foster sound enterprise risk
Special Committee believes that no simple, prede- management, not prescriptive, quantitative require-
termined metrics or quantitative measures with pre- ments. As part of any review of the regulatory and su-
scribed assumptions would work to provide either ad- pervisory approach, the problem of trapped pools of
equate liquidity safeguards or truly useful disclosures. liquidity must be addressed in order to enable groups
Imposing such simple measures across institutions to manage firm-wide liquidity more efficiently and to
might have some immediate appeal but is unlikely to avoid unnecessary potential problems. To this end,
give truly comparable results across institutions. In central banks and settlement systems should expand
fact the lack of comparability may render the informa- and harmonize the range of collateral that they ac-
tion yielded by such measures at best not useful and at cept. Finally, central banks should consider providing
worst potentially deceptive. greater and more uniform clarity on their role as lend-
ers of last resort and, where they are not already doing
Each firm’s liquidity management must include sub- so, participate more actively in firm- and system-wide
stantial attention to stress testing and contingency contingency planning. Although this raises moral haz-
planning. While methodological work is constantly ard issues that need to be managed, the trade-off be-
improving sensitivity analyses and scenario testing, tween the ability to plan for a crisis against time-bound
management judgment remains critical and the ques- “constructive ambiguity” needs to be reexamined.
tion becomes, essentially, how to structure the process
to make sure that modern and well-founded tech- Given their significance in recent market develop-
niques are used to support but not to supplant good ments, the report highlights two additional emerging
judgment. Part of that analysis needs to be focused on issues: the increased reliance on secured funding as an
clearly understanding the role of central bank facilities incremental source of liquidity and the need to con-
and the limits on these facilities. sider how complex financial instruments can affect a
firm’s liquidity. Secured financing is now fundamental
The short but significant list of Considerations for the to the liquidity profiles of international financial in-
Official Sector reflects the concerns of the industry stitutions. Recommendations are thus aimed at firms’
about the increasing disconnect in globalized markets developing a deep understanding and robust planning
between firms that conduct a substantial amount of for issues of access to secured funding, and refining
their business across borders, often largely managed their risk-management and risk-mitigation practices.
on a group-wide basis, and historical patterns of local Central banks’ policies have a critical effect on firms’
regulation. While it is essential to recognize the ben- access to secured funding, and this fact is a central
efits of liquidity risk regulations, both for the public at facet of contingency planning. Similarly, the complex
large and firms in the financial industry, and certain financial instruments that have emerged recently have
jurisdictional constraints faced by the official sector, significantly affected the market, and while many of
failing to adapt regulatory and supervisory structures these ways have been beneficial, Recommendations
to more integrated and responsive markets may in- still are needed as to the prudent monitoring and ef-
crease the chance of firm-specific or systemic cross- fective mitigation of the liquidity risks arising from
border problems, and reduce the efficiency of liquidity such instruments.
risk management for firms.
It is the IIF’s hope and intent to generate a constructive
As in other areas of regulation, it is essential that home dialogue on risk-management issues, using this report
and host supervisors of international groups coordi- as a point of departure.
nate their supervision of groups’ integrated liquidity
9

11. Preface there have been significant advances in risk-manage-
ment practices at financial institutions and a strength-
In late 2005, the IIF established a Special Committee ening of market infrastructure in recent years, struc-
on Liquidity Risk. The Special Committee is chaired tural changes in markets, including growing product
by Ahmass Fakahany, Vice Chairman and Chief Ad- complexity and the entry of new participants, as well
ministrative Officer of Merrill Lynch, and Chris Grigg, as the important role of large and complex global insti-
Chief Executive of Barclays UK Business Banking, is tutions, highlight the need for continual reassessment
the vice chairman. It includes representatives from and improvements. Lessons from past market liquidity
about 40 of the largest global financial institutions.2 crises can be studied with an eye toward steps that can
The objective of the Special Committee was to develop be taken to prevent future crises and improve response
a perspective and Recommendations on liquidity risk preparedness. The Special Committee deliberated as to
measurement, monitoring, management, and gover- whether gaps exist in processes for timely internation-
nance at financial institutions. This focus is timely, as it al information sharing among authorities at times of
has been noted for some time that while a vast body of crisis.
regulatory and academic literature exists about credit,
market, insurance, and operational risks, relatively less A detailed but relatively informal questionnaire was
attention has been given to liquidity risk. Moreover, a developed and distributed among IIF members. The
proper distinction between the various types of liquid- responses formed the basis of this report and provided
ity risk and corresponding risk measurement models a point of departure upon which a working group of
and outputs is not always made. Concerns have also experts built its analysis.4
been expressed that the lack of harmonization of li-
quidity requirements and practices at the international Recommendations for the Private Sector; Public-Sector
level has resulted in suboptimal prudential and com- Considerations. The report proposes Recommenda-
petitive conditions. To address these concerns and to tions that include objectives and specific and action-
perform a review of industry practices, the IIF estab- able items. These Recommendations would apply
lished a Special Committee on Liquidity Risk. under an umbrella “comply or explain” ethic, whereby
industry participants who do not adopt, or develop
In the course of preparing its Recommendations, the plans to meet, these Recommendations should be ex-
Special Committee also considered the integration of pected to explain why they consider a particular Rec-
liquidity risk with other existing risk-management ommendation inapplicable or inappropriate or why
processes, namely, market, credit, and operational risk they have failed to comply with a Recommendation if
management. In addition, it addressed the relationship it is applicable.
between liquidity risk and capital adequacy require-
ments, including the obligation to take liquidity into A number of Recommendations in this report origi-
consideration for the purposes of Pillar 2 of Basel II, nate from the principles set out in the February 2000
Supervisory Review Process. Basel Committee on Banking Supervision (BCBS) pa-
per, “Sound Practices for Managing Liquidity in Bank-
There has been growing private sector and regulatory ing Operations.” The principles represent a sound
concern in this area. The Counterparty Risk Manage- foundation to build on and from which to reflect on
ment Policy Group II in its report states, “The evapo- the increase in the complexity of the financial industry
ration of market liquidity is probably the second most and its products since their adoption in 2000.
important variable in determining whether and at what
speed financial disturbances become financial shocks In addition to the Recommendations for the private
with potentially systemic traits.”3 The Special Commit- sector, this report includes a short but significant list
tee considered not only institutional liquidity, but also of Considerations for the Official Sector that reflect
the resilience of the financial system to shocks. While the concerns of the industry about the increased dis-
connect in globalized financial markets between firms
2
See the list of participants attached.
3
“Toward Greater Financial Stability: A Private Sector Perspective,” The Report of the Counterparty Risk Management Policy Group II, July 27, 2005.
4
Responses to the questionnaire were provided on an anonymized basis with distinctions being made only between commercial and investment banks and domicile.
10

12. that conduct a substantial amount of their business platforms, but their perspective has likely not been com-
across borders, often largely managed on a group-wide pletely covered.
basis, and historical patterns of local regulation. While
it is essential to recognize the benefits of liquidity risk The report highlights the differences between cash
regulations, both for the public at large and firms in management and long-term structural balance-sheet
the financial industry,5 and certain jurisdictional con- management. It focuses on both the short-term need to
straints faced by the official sector, failing to adapt reg- survive the initial period of a crisis as well as structural
ulatory and supervisory structures to more integrated long-term liquidity management. In the context of the
and responsive markets may increase the chance of report, liquidity-management issues include business-
firm-specific or systemic cross-border problems. as-usual and anticipating stressed conditions.
Scope of the Inquiry. The report begins with a section The report does not, however, address the intraday li-
on “Emerging Liquidity Issues in a Changing Interna- quidity issues that have recently attracted the attention
tional Environment” that offers a brief review of market of the world’s central banks, for example, those concerns
developments and other environmental factors. This addressed by the Board of Governors of the Federal Re-
section sets the stage for the analysis in the balance of serve System in its consultation paper “Intraday Liquid-
the report. The report also includes Analytical Discus- ity Management and Payment System Risk Policy,” June
sions on “Reliance on Secured-Financing Sources” and 15, 2006.6
“The Impact of Complex Financial Instruments upon
Liquidity-Management Policies and Practices.” The scope of the report is not so wide as to address busi-
ness continuity issues. The link between a pure liquidity
It should be noted that the members of the Special crisis and a business continuity problem is shown within
Committee were drawn from internationally active the report, but the main focus is on managing a liquidity
banks, including large and medium-sized, or regional, crisis regardless of its origin.
banks, but not from small, local, or primarily domestic
banks. We acknowledge the report’s focus and also note Focus on Funding Liquidity Risk. The report distin-
that there are liquidity issues with respect to smaller, guishes between the risk to funding the firm, which is
noninternationally active banks that need to be ad- referred to as “funding liquidity risk,” and the risk that
dressed separately. Furthermore, the report addresses a particular on- or off-balance sheet market or prod-
liquidity issues as confronted by commercial and in- uct is illiquid, which is referred to as “market liquidity
vestment banks, not other sectors of the financial in- risk.” As noted in the May 2006 Joint Forum document
dustry such as the insurance industry or hedge funds. entitled “The Management of Liquidity Risk in Finan-
This narrower scope does not suggest that firms with cial Groups,” funding liquidity risk is “the risk that the
insurance as well as commercial or investment bank firm will not be able to efficiently meet both expected
platforms should manage liquidity in their insurance and unexpected current and future cash flow and col-
platforms completely separately from the other plat- lateral needs without affecting either daily operations
forms or that liquidity-management principles for the or the financial condition of the firm.” The same docu-
insurance platform should necessarily differ materially. ment describes market liquidity risk as “the risk that a
This report recommends a central liquidity-manage- firm cannot easily offset or eliminate a position without
ment oversight function for firms with multiple plat- significantly affecting the market price because of inad-
forms and legal entities, irrespective of whether firms equate market depth or market disruption.” The close
have chosen a decentralized or centralized liquidity- link between these two risks is recognized both by the
management structure, so that such potential issues as industry and the Joint Forum, including the fact that
contagion risk can be identified and addressed early. common events may trigger both. This report primarily
Other Recommendations in this report may also ap- addresses funding liquidity risk.
ply to firms with no commercial and investment bank
5
Firms draw some comfort in knowing that their counterparts have to meet sound minimum regulatory standards, provide disclosure of their practices, and are subject to
regulatory oversight.
6
In order to avoid duplication of work we have also referenced within the report studies by other parties.
11

13. Range of Practices. The responses to the questionnaire differences. This would help supervisors and regulators
reflected a range of practices. To some degree, these to understand that the differences between the entities
differences reflect firms’ assessments of suitable ap- justify the range of practices. Furthermore, it would
proaches to unmitigated liquidity risk tolerance, and help supervisors and regulators understand the differ-
some firms believe that it is important to strike a bal- ences, identify the outliers, and make informed deci-
ance between an appropriate level of funding liquidity sions, as opposed to requiring conformity.
risk and mitigation costs. Fundamentally, firms need
to define and manage their own risk appetites within The Special Committee hopes this report contributes to
basic prudential limits that take into consideration the understanding of liquidity risk and its management
their current and prospective financial conditions.7 and that the proposed Recommendations contribute to
Banks may with perfect reason conclude as a matter better management and supervision of liquidity risk.
of business strategy that total risk elimination would
be too costly and then manage their liquidity risks ac- General Notes:
cordingly.
The term “firm” is used in this report as a generic term
In addition to differences deriving from varying risk and may refer to the group, the parent firm, or an in-
appetites and risk profiles, many legitimate differences dependent subsidiary. Whenever pertinent, specific
result from firms’ histories, cultural traditions, legal references are made to these entities or others, such as
structures, markets in which they operate, complexity, “branches.”
or management philosophies. This report encourages
embracing these differences across firms, which de- References in this report to the “board of directors” of
pend on diverse business models, such as those result- a firm should be read with reference to the context of
ing from centralization or decentralization of manage- each firm. In some countries, this term may refer to the
ment. most senior level of management, in which case “super-
visory board” corresponds to what other countries refer
The intent of this report is to encourage an overall to as “board of directors.”
raising of expectations while not imposing a rigid
template on a rapidly changing industry. We recog- In addition, references to the “board of directors” should
nize that firms must manage their own risks and needs always be understood to include a committee, properly
and develop tailored models and approaches within an constituted under the firm’s charter and applicable law,
acceptable range. It should also be kept in mind that to which relevant authority has been delegated by the
the theoretical best may be the enemy of the practical full board.
good and that firms need to be prudent and thought-
ful given their particular needs. What might have been Where local law permits and it is customary to do so,
bright lines in the past may now be best addressed on a and if appropriate internal authority exists, the Special
“comply or explain” basis. Committee believes it is acceptable for senior manage-
ment to approve policies or take other actions that may,
The report also encourages firms to increase transpar- in other firms, be reserved to the board or a committee
ency and to provide additional information in their fi- of the board.
nancial statements to increase understanding of such
Risk-appetite considerations are covered at several points in this report, notably in Recommendation 8.
7
12

14. Emerging Liquidity Issues in a investors. In reaction to these events, there were with-
drawals of liquidity from the global financial system by
Changing International Environment
investors as the appeal of carry strategies declined and
economic fundamentals came into question in high-
This study addresses liquidity questions at a time of ex-
yield markets. Thus, at the global investor level, some
traordinary change. Recent economic conditions have
tightening of liquidity occurred in emerging markets,
been benign, yet the implications of rapidly chang-
and the period of May–June 2006 exhibited increasing
ing markets and technologies, cross-border financial
volatility compared to previous low levels.
system consolidation, growing interdependencies of
markets, new market infrastructures and participants,
The one thing that is certain is that the recent benign
regulatory and accounting change, and even improve-
markets are unlikely consistently to characterize fu-
ments in the sophistication of liquidity risk manage-
ture periods. Indeed, the USD has exhibited signs of
ment, merit thoughtful attention by both the private
weakness since the latter part of November 2006 as
and the public sectors.8 As is often noted, develop-
investors’ concerns have risen over the willingness of
ments that generally strengthen liquidity in the system
countries with large current account surpluses to con-
may shift risks or create new risks in ways that are not
tinue to accumulate substantial USD assets. Hence the
yet fully understood.
need to take a fresh look at liquidity issues, taking into
account market changes over the past decade, particu-
To some degree, the greatest liquidity risk to global
larly during the low-volatility period.
financial stability may be the pace of change and the
need to understand what is new, modified, or inter-
Globalization Context. The increasing consolidation
acting differently. The private sector perspective pro-
and centralization of financial groups with the grow-
posed here has been developed with an eye toward
ing integration of financial markets means that firms
these developments, but also with an appreciation of
will increasingly have dispersed, multilateral obliga-
what remains to be well understood.
tions, commitments, and assets that they will need to
subject to coherent risk management. Globalization
Background and Context
of the financial system collides with the policies and
procedures of traditional home and host supervisors
This section offers a brief review of environmental fac-
and local supervision of international payment and
tors to set the contextual stage for the analysis in the
settlement systems. This divergence from traditional
balance of the report.
jurisdiction-circumscribed regulatory, monetary, and
political management constitutes a profound policy
Economic Context. The fundamental background fact
challenge for public and private sectors alike.
to this report is that the past few years have been a time
of benign markets, resulting in compressed risk pre-
Technological Context. The acceleration of communi-
mia, when there has been pressure on investors and as-
cations and the vastly increased power of firms to col-
set managers to press the “search for yield” into poten-
lect and analyze data are well known. These changes
tially riskier territory. At the same time, there has been
underpin much of the present discussion, but also are
concern among economists that a sudden unwinding
worth mentioning independently.
of global imbalances could result in a weakening of the
U.S. dollar (USD), and, with higher U.S. interest rates,
Similarly, market developments, such as the continuous
that could lead to reduced global liquidity. In the recent
linked settlement system (CLS) and greater reliance on
past there have been indications that concerns about
real-time gross settlement (RTGS) of payments, have
global growth and inflation and the ability of industri-
very substantially reduced settlement risk in important
al countries to manage monetary policy effectively in
segments of payments and foreign exchange, albeit at a
an uncertain environment will lead to higher volatility
price of perhaps moving liquidity stress points to other
in financial markets and a new risk aversion among
The May 2006 Joint Forum paper has been important in catalyzing discussion, but other public-sector agencies, including the IMF, European Central Bank, European
8
Commission, Federal Reserve Bank of New York, and many others have addressed aspects of the issues raised here.
13

15. parts of the system. Securities settlement systems have the private and public sectors. This report provides a
also reduced their internal risks, at a cost of increasing general discussion of this topic as well as a series of
collateral requirements. Recommendations.
The Bank of England’s introduction of fundamental Derivatives/Structured Transactions. The development
reforms in the sterling money market9 to reduce po- of credit derivatives has given banks greater freedom
tential liquidity bottlenecks, the U.S. Federal Reserve’s to manage their balance-sheet constraints and risks.
continuing long-term process of close study of and Moreover, credit derivatives have enabled banks to take
improvement to the functioning of the USD intraday a more market-driven view of credit in general. Like
markets, and the introduction of the euro and the Eu- securitization transactions, credit derivatives allow the
ropean Central Bank’s development of margin lending shift of longer-term risk to other market players who
in a large Eurozone all change the picture from what seek to hold and manage it because of their desired
it was a few years ago and reflect policy attention to risk profiles. In addition, the new risk markets allow
multinational liquidity issues. a greater degree of market-based pricing of credit, al-
though post-transaction marking to market remains
Finally, Internet banking is developing rapidly, even highly problematic for many areas of lending.
(or especially) for small retail customers. While Inter-
net banking changes delivery channels, it may also af- There is also a significant argument to be made that
fect the nature and behavior of products, as discussed more liquid bond markets, securitization, and credit
below. These changes allow corporate and retail cus- derivatives are reducing the traditional pro-cyclical-
tomers to more easily compare product offerings and ity of bank lending by creating more market transpar-
economics and make rational decisions. ency, which allows both earlier identification of credit
issues for specific debtors and the market as a whole
Issues Arising from Changes in Banking Funda- and more diversification of the investors in the market.
mentals This yields better market pricing and more flexible re-
sponses to cycle dynamics.11
The following observations are broad generalizations
that apply unevenly across firms and countries but re- Credit derivatives markets have faced certain infra-
flect fundamental developments. structure issues, which are now being resolved, albeit
at a substantial cost in Information Technology (IT)
Securitization.10 While market developments over investment and personnel.12 More basically, these mar-
many years have led banks to be more dependent on kets have developed rapidly against the background of
secured finance, regulatory developments, including what could have been a systemically serious issue born
Basel II, have been significant in spurring further de- of the Long-Term Capital Market incident of 1998,
velopment of asset-backed (including covered-bond) which required concerted private-public sector efforts
channels. Securitization has a long and deep history in to resolve a serious liquidity problem. Since then, the
certain products and markets, but the pace of devel- markets have weathered such substantial storms as
opment appears to be accelerating. These are positive the downgrading of General Motors’ and Ford’s debt
trends for market liquidity and for the reduction in in 2005 and the Amaranth failure of 2006 relatively
funding liquidity risk, as are recent advancements in smoothly, in part because the developing depth and
secured-funding markets. However, there are risks in- diversification of investors provided market flexibility.
volved in these trends, which have been noted by both
9
“Reform of the Bank of England’s Operations in the Sterling Money Markets: A paper on the new framework by the Bank of England,” April 2005.
10
See the Analytical Discussion 1: Reliance on Secured-Financing Sources.
11
See “The Influence of Credit Derivative and Structured Credit Markets on Financial Stability,” Global Financial Stability Report, IMF, April 2006. The alleged procyclicality
of Basel II would also be somewhat mitigated by this effect.
12
As is well known, back-office and market-practice questions about confirmation and novation of credit-derivative transactions caused considerable concern over the past
year; however, a concerted effort by the private sector, with helpful catalysis by the Federal Reserve Bank of New York, the Financial Services Authority, and other public-
sector authorities, has substantially reduced the problems. Back-office, technological, and market-discipline approaches have all contributed to reducing the problem.
14

16. Much of that market capacity has been provided by The more equity-like tranches of both securitization
hedge funds. Substantial concerns about the potential and credit derivative transactions, which have often
behavior of these funds in a market crisis have been been retained by originating institutions, also may
expressed by some central banks. What is the true im- create exposures that could weaken an institution in a
pact of hedge funds or similar actors, particularly non- time of stress; new opportunities to off-load such expo-
regulated ones, on the markets? Can they be counted sures have developed but could dry up in such times.
on to continue to participate, or will they “rush for Market developments, improved internal economic
the exits”? Other official observers, although cautious capital analysis, and the more risk-sensitive regula-
about the limitations of current knowledge, have been tory approach of Basel II should reduce such risks, al-
more sanguine about the role of hedge funds noting, though prudence suggests that they will be least liquid
for example, that managers of these funds quickly en- (or most expensive to dispose of) in difficult markets.
tered the market to seize perceived opportunities at
the time of the 2005 downgrades. Many observers have found grounds for optimism in
the fact that some investors, such as hedge funds, have
Insurance companies and pension funds have longer been willing to take on more risk, even in moments of
liability horizons and avoid the classic bank mismatch market uncertainty. Still, it is notable that a substantial
problem. They are better placed in some respects to part of the liquidity resilience of these new markets
acquire and hold risk transferred by banks via securiti- (and of their ability to shift risk away from banks to
zation transactions or credit derivatives. Such institu- other sources of capital) depends on the opportunistic
tions sometimes face legal-investment or capital con- behavior of a relatively new, unregulated class of insti-
straints that may limit their ability to participate in the tutions whose strength is its readiness to change form
new markets, and, a few years ago, their understanding and pursue new strategies opportunistically.14 Liquid-
of credit derivatives and other new instruments was ity also depends to some extent on insurance compa-
sometimes questioned. If there was an issue with the nies and pension funds that, for many good reasons,
sophistication of such investors, it is now much re- approach the markets with caution.
duced, at least for the major firms. In addition, the in-
terpretation of ratings of nontraditional instruments, The financial system ultimately cannot reduce actual
such as collateralized debt obligations (CDOs), is now economic risk, but can only transfer it to parties with
better understood than even a short time ago.13 different time horizons and risk appetites and dilute it
by diversification. A good deal of firms’ examination
However, questions still arise about the willingness of liquidity issues against the foregoing market devel-
of such investors to participate in markets in stressful opments has to do with hedging against the behavior
times, especially when one-way markets occur, even of institutions that have generally done a good job of
if some have argued in parallel that high-quality as- providing risk intermediation in the new markets.
set-based securitization (ABS) could represent a better
refuge than high-quality corporate bonds in times of Thus, there is much to be encouraged about in recent
crisis because the specifics of the underlying exposure developments, but experience is limited, and it cannot
are more transparent. In addition, as the market de- be said with certainty how the markets will perform in
velops, there are more bespoke, illiquid products and severely adverse circumstances.
more products with longer time horizons, which are
more difficult to price. The willingness of investors Concentration Questions. A further issue is the relative
to take on these risks has not been tested outside of concentration of the dealer side of the market (and
relatively calm conditions. There is a chance that mar- at a more macro level, the consolidation of the inter-
kets that appear to be developing well from a strategic national top tier of firms into large, complex institu-
viewpoint may suddenly lack depth at critical points tions). A few large firms provide a large part of the vol-
in time. ume and liquidity in certain markets. The prospect of
13
The question has been whether investors fully understood the differing risks and default behavior of instruments, such as CDOs, as opposed to traditional bonds. While
some investors may still be uncritically reliant on ratings on their face, there is less excuse for this now that a great deal has been written on the subject. Moreover, the rating
agencies are considering new approaches, such as “stability scores” that provide more tailored ways of assessing transactions.
14
This report does not focus on counterparty risk, which has been amply treated elsewhere, but of course, counterparty risk must be part of any institution’s prudent analysis
of its participation in the market.
15

17. a significant player disappearing from the market has Greater reliance on secured finance requires a focus
been a source of concern, although efforts at modeling on the hierarchy of liquidity characteristics of differ-
what would happen have suggested that the market is ent types of collateral. Good collateral (with qual-
large enough and mature enough to deal with such an ity obligors, subject to market-appropriate haircuts)
eventuality. Originators and dealers in securitization is the best assurance of liquidity and the best assur-
markets are less concentrated, at least in the most fre- ance of avoiding moral hazard or inappropriate reli-
quently traded instruments. Nonetheless, participants ance on lenders of last resort. Yet regulatory require-
in, for example, home-currency mortgage securitiza- ments, jurisdiction-specific central bank expectations,
tion markets, can be relatively few, although it would and clearance-system limitations combine to create a
be the potential desire of a smaller or less-involved disconnect between collateral sources that remain to
player to offload assets in a crisis that would be the a substantial extent compartmentalized on tradition-
likely issue rather than the capacity of major dealers. ally defined bases and by the globally driven needs of
many firms. In addition, collateral has a cost, and un-
A broader question is the interconnectedness of mar- necessarily burdensome requirements not only impose
ket participants, especially the largest institutions that costs on firms but also act as a brake on the efficiency
participate in many markets across multiple products, of the financial system as a whole.
currencies, settlement systems, and jurisdictions. The
world’s large and complex financial institutions are Much could be said about the technicalities of collat-
deeply and increasingly interconnected, which raises eral questions; however, the basic problems are simple.
liquidity issues because they provide so much of the How can a global market find ways to leverage avail-
market volume that they – and their clients – rely on. able collateral and remove artificial roadblocks so as
to use that collateral to avoid liquidity problems for
Collateral Issues.15 Participants in the financial system participants in any local or sectoral market?
today are much more reliant on secured finance than
in the past.16 This is part of the overall shift away from To some extent, the problem is a technical one of trans-
customary banking toward market-based finance, but ferability; however, technical problems should be rela-
large commercial banks in general are significantly de- tively easy to overcome since much collateral is held in
pendent on their ability to marshal collateral for repur- Central Securities Depository (CSD) or International
chase agreements (repos) and other secured-financing Central Securities Depository (ICSD) systems, from
vehicles. In this they are like investment banks in that which it could be made available to any pledgee (in-
they use wholesale funding sources in largely profes- cluding central banks) on short notice. Direct trans-
sional markets. The degree of this reliance on the mar- fers are not yet seamless, but they are continuing to be
kets (in addition to wholesale markets for certificates of nudged in at ever greater ease and speed. Legal ques-
deposit (CDs) and commercial deposits), rather than tions have been reduced compared to 20 years ago, al-
on retail deposits, varies from firm to firm, but the fact though there remain legal doubts and efforts such as
is well established, especially for the large, cross-bor- the proposed Hague Convention have become bogged
der institutions. down. Thus, the market does need to push to do more
to address the problems of international usage of col-
Outright disposals of assets are less vulnerable to firm- lateral, but the most fundamental problems are else-
specific issues but, of course, raise potentially severe where.
business issues if selling into down markets occasions
substantial losses. In addition, asset sales, particularly “Interoperability” of collateral is more of an issue than
outside of trading and available-for-sale books, can transferability. Progress has been made in this area, but
have deleterious tax consequences. more needs to be done to ensure the clear, undisputed
availability of government obligations and other high-
Traditional secured-lending and repo markets depend quality collateral from national system to national sys-
on the ready availability and acceptability of collateral. tem. The restrictions that result in “trapped pools of
15
Please refer to the collateral-marshalling ideas in the document “Managing Payment Liquidity in Global Markets: Risk Issues and Solutions,” Report by the Cross-border
Collateral Pool Task Force, The Payments Risk Committee, March 2003.
16
See the Analytical Discussion 1: Reliance on Secured-Financing Sources.
16

18. collateral” need to be lifted. Even if the aggregate of of liabilities and, in many countries, experience sug-
collateral anachronistically locked up in national can- gests highly consistent behavior since the beginning of
tonments is, as some contend, greater than the amount industrialization. Yet this should not stop firms from
that would be maintained by firms if they were free to continually challenging their assumptions, especially
use global pools of collateral, the net power of readily in marketplaces in which change is material and oc-
transferable, widely accepted collateral across global curring rapidly, as even modest changes to erosion fac-
markets to protect against liquidity crises and conta- tors could have a notable impact on liquidity.
gion would quite likely be greater.17
How is this experience affected by technological change
Although it is not the purpose of this report to address and the large intergenerational wealth transfer cur-
intraday mechanics, the shift toward real-time gross rently underway? Where firms are becoming increas-
settlement of payments moves the burden away from ingly reliant on on-line deposits, are past assumptions
credit toward liquidity risk. Central banks typically about the stickiness of consumer funds still holding?
make intraday secured credit available for liquidity Are customers with only an on-line relationship, who
purposes. And central banks should have an incentive can more easily move funds electronically, significant-
to accept as wide a collateral range as possible to re- ly more prone to changing firms to obtain better rates
duce collateral costs and prevent settlement delays or or to react to negative news about their current firm?
blockages. But restricted eligible collateral remains a What are the practical obstacles to closing out on-line
problem for firms, especially those that must manage relationships that may restrain transfers? Firms that
obligations in a number of payment and settlement focus on on-line business are cognizant of these issues
systems. and approach them conservatively. But how conserva-
tive to be about such assumptions remains somewhat
A situation could arise in which a house is highly liquid speculative and varies by the market. Even outside
overall but could still face a difficult situation in one of the “e-banking” sphere, well-informed consumers
system because of restrictions and transfer problems. may prefer not to deal with a bank whose reputation is
This risk is compounded by the fact that collateral may questioned, simply to avoid the frictions of recovering
become more difficult to move in a crisis, which could funds if a failure occurs, even if their funds are fully
exacerbate risks or create unnecessary liquidity block- covered by deposit insurance.18
ages. Obstacles to effective access to collateral, based
on outdated market models, may deepen a crisis rather Beyond these simple but basic questions, big-picture
than alleviate it. This potential problem is on top of the questions can also affect these issues. Changes in in-
day-to-day fact that firms must finance and warehouse ternational capital flows and in global liquidity affect
liquidity (i.e., cash and collateral positions) on the bal- each other and may in turn be affected by political
ance sheet on a basis that is suboptimal from a global motivations, especially where global imbalances are
perspective. concerned. Such macro effects may then affect the be-
havior of professional investors and their willingness
Behavior of Liabilities. Behavior of demand and un- to deploy liquidity and accept risk.
restricted savings deposits, and of retail instruments
such as short-term certificates of deposit, remains Concluding Remarks
highly predictable and easily modeled under most cir-
cumstances. The effects of deposit guarantees and the There is an argument that market innovations may
inertia of consumer behavior are well known. This is tend to smooth out cyclicality and provide liquidity.
hardly surprising given that banks have literally hun- On the other hand, the argument is also made that the
dreds of years of experience with the most basic types overall effects of recent innovations in instruments
17
This is a separate point from the equally important point that well-managed firms that are diversified across multiple markets should generally be stronger for the diver-
sification.
18
Quite apart from the question of “stickiness,” when a bank’s name comes into question, the volatility of consumer funds may be increased by on-line competition both
among banks and with highly liquid money market funds, or, where permissible, by third-party brokering of insured deposits.
17

19. and diversification of participants in markets may be The point of this section is not to be alarmist. Quite
a shift to less-frequent but higher-impact crises.19 The the contrary. There are substantial indications that the
concern would be that all of these innovations are ef- resilience of markets that are wider, deeper, and more
fective so long as participants can see opportunities in diverse on the investor side, and vastly larger than ever
difficulties, which has been the case recently; however, before, has increased, thanks to technology, financial
it is not clear how these new market factors would per- innovation, and interconnectedness, and that this re-
form in a crisis that appears extraordinarily difficult to silience outweighs the vulnerabilities created by the
participants. Furthermore, many of these market in- same factors. But we cannot know for sure. That is the
novations have existed only during periods of relative reason for the industry’s reflections in this report, the
calm in the markets. Difficulty with a few key players reason for very substantial investments in risk man-
could have a profound impact on the functioning of agement and stress testing, and the reason for the
these markets. Recommendations for greater transparency and incre-
mental collaborative mechanisms between the public
and private sector in contingency planning.
See, for example, Sir John Gieve, “Financial System Risk in the UK - Issues and Challenges,” Bank of England Web site, speech to the Center for the Study of Financial
19
Innovation, July 25, 2006.
18

20. Recommendations on Industry Practice The following Recommendations refer to liquidity
management under both normal circumstances and
for Liquidity Risk
stressed conditions.
The previous section provides the context from which
A. Governance and Organizational Structure for
the IIF Special Committee on Liquidity Risk concluded
Managing Liquidity:
that it would be time well served to examine interna-
tional liquidity issues. New instruments, newly global
Liquidity Risk Definition
competition, reliance on secured-funding alternatives,
and the rapidly increasing sophistication of risk man-
Recommendation 1: Firms should define the differ-
agement require a new perspective on liquidity ques-
ent forms of liquidity risk to which they are exposed
tions.
(including relevant subsets within each form defined);
identify where they fit in their enterprise risk universe;
This is very much a private sector discussion, and it is
and communicate these definitions across their groups
intended to be useful to private sector executive man-
so that a common understanding is applied when iden-
agement and liquidity-management departments in
tifying and evaluating liquidity risk related to existing
evaluating their risk-management efforts for liquidity.
businesses, business reviews, new businesses, products
The report is intended to suggest food for thought rath-
or initiatives, and acquisitions and alliances.
er than categorical prescriptions. It outlines reasonable
practices on many aspects of liquidity management,
Recommendation 2: Firms should distinguish be-
but one of the conclusions of the Special Committee
tween funding liquidity risk and market liquidity risk
is that firms vary considerably in their needs, their
in their enterprise risk universe. Within funding li-
management styles, and their risk appetites. There is
quidity risk, firms should address their practices re-
little scope for single-answer solutions and consider-
lated to the management of the following (on a time
able need for flexibility within prudentially reasonable
continuum for the first two subsets):
parameters, given that decisions about how to man-
age liquidity often reflect basic business strategy over
• Structural liquidity risk (over one year – long-
which the firm must retain control in an increasingly
term, or strategic gap, ratios and funding mix;
competitive and globalized market.
cash capital; survival horizon),
• Tactical liquidity risk (similar concepts as long-
The report’s Recommendations, therefore, should be
term but for shorter terms; operational, cash
considered just that: directional suggestions of issues
flow), intraday (cash and collateral manage-
that good risk managers should think about, not for-
ment), and
mulae or prescriptions for what they should do. With-
• Contingency liquidity risk (stress testing, i.e.,
in the scope of the principles suggested here, there is a
sensitivity analysis and scenario testing, special
considerable range of reasonable responses. Moreover,
liquidity asset pools, contingency plans, ratios,
it should always be understood that a firm may, on
and earmarked liquidity asset pools).
the basis of its business mix and strategy, decide that a
Recommendation is better disregarded than followed,
Discussion:
even within the usual range of flexibility. Therefore, to
the extent that the market or a supervisor might ques-
Firms generally make a clear distinction between fund-
tion any firm’s response to any Recommendation, the
ing liquidity risk and market liquidity risk.21 In defin-
“comply or explain” principle always applies: the firm
ing these risks, firms can be influenced by regulatory
should be able to provide a good explanation of its
definitions. Market liquidity risk is usually considered
strategic or tactical choices, on the one hand, and, on
a form of market risk.
the other, the market or the supervisor should accept
a firm’s well-grounded rationale for the way it chooses
to proceed.20
The Special Committee recognizes that the level of flexibility available to each firm for choosing not to comply may vary by Recommendation.
20
For definitions, differences, and links between these two forms of liquidity risk, see the Preface to this document.
21
19

21. In defining funding liquidity and/or market liquidity Recommendation 4: A firm’s board of directors (or a
risk, firms make reference to how issues with the man- committee thereof under delegated authority) should
agement of this risk may affect financial performance approve the strategy and significant policies related to
and to wanted and unwanted outcomes of liquidity the management of funding liquidity risk under both
management. Issues typically considered include: normal and stressed conditions and review and ap-
prove these policies annually. Board-approved docu-
• Risk to earnings and capital of a significant im- ments should identify key funding liquidity limits and
pairment in the ability to meet on a timely basis approval levels, as well as those authorities delegated
any financial on- or off-balance sheet obligations to senior management committees or those executives
as they fall due; accountable for approving detailed strategies, goals,
• Material, sudden, and unexpected increases in procedures, limits, and exceptions. The board should
funding costs and liquid asset price discounts/ also ensure that senior management takes necessary
collateral margins; steps to appropriately manage, measure, monitor, and
• The inability to achieve an optimal and cost-ef- control funding liquidity risk in an integrated fashion
ficient liability structure; with other closely associated risks to facilitate enter-
• The inability to monetize assets due to loss in prise-wide risk-management solutions. The board
market access or insufficient market depth; should be informed regularly of the funding liquidity
• The inability to conduct business as a result of position of the firm (metrics, indicators, and outlooks),
reduced secured- or unsecured-funding capac- and immediately notified if there are any material
ity and/or liquid assets or as a result of a lack of changes in the firm’s current or prospective funding
these; and liquidity positions.
• The need to meet requirements in normal and
stressed conditions. Recommendation 5: Firms should have a manage-
ment structure in place to effectively execute their
In general, regulators are more interested in short-term funding liquidity strategies. Roles and responsibilities
and intraday liquidity-management practices under of various board and senior management committees
stressed conditions, whereas rating agencies are more in the funding liquidity-management structure, as
interested in structural liquidity under stressed condi- well as those of different functional and business units,
tions. Because funding liquidity risk can manifest itself should be documented, and these roles and responsi-
in a number of different ways with varying degrees of bilities should demonstrate appropriate segregation of
complexity, different firms use various metrics to de- duties between the execution, design, and oversight
fine and measure this risk. and monitoring roles within the firm. This structure
should include the ongoing involvement of members
Roles and Responsibilities, Integrated Risk Manage- of senior management, who must ensure that funding
ment, and Limit Setting liquidity is effectively managed on a regular and timely
basis and that appropriate policies and procedures are
Recommendation 3: Firms should have an agreed- established to limit and control material sources of
upon strategy for the day-to-day management of funding liquidity risk.
funding liquidity risk that takes into consideration
their business models and legal structures (e.g., mix of Recommendation 6: Firms should have adequate in-
foreign branches versus foreign operating subsidiar- formation systems for measuring, monitoring, control-
ies), complexity (the breadth and diversity of markets/ ling, and internally reporting their funding liquidity
products, geographies, and legal entities), key lines of risk positions. Management should be able to prepare
business, home and host regulatory requirements and these reports in times of firm-specific and systemic
environments, marketplaces, and risk materiality in business contingencies.
the context of the firm-wide risk-management strategy
and appetite. The rationale for this strategy should be
explained, and the strategy should be communicated
throughout the organization.
20

22. Discussion: The day-to-day transactional implementation of
these strategies typically occurs in either the func-
Board and senior management committees are in- tion with overall responsibility for funding liquidity
volved in reviewing funding liquidity-management management, in the Capital Markets/Trading divi-
strategies and performing risk oversight on a regular sion of the firm, or in both, in which case each group
basis. Consistently with common practice, signifi- has distinct responsibilities (e.g., term funding and
cant policies (such as the liquidity framework, fund- capital issuance in Treasury, collateral/liquid asset
ing liquidity strategy, and contingency plan) need to trading in the trading division, and short-term un-
be reviewed and approved annually by the board (or secured funding and securitization in either one).
a committee thereof). The boards of some firms del- These transactional groups manage financing and
egate authority to approve various policies, limits, and rollover risk. Funding relationships with liquidity
related exceptions for specified entities and items to providers are managed by the Treasury function, the
management committees or functions. In such in- sales force of the trading division, and/or by credi-
stances, authority is clearly highlighted in board-ap- tor relations groups (dealers). There are a number
proved policies. While the board of directors of a few of acceptable variations, especially for decentralized
firms may review the funding liquidity position of the firms.
firm as often as once a month, we believe that quar-
terly reviews are acceptable practice. Typically, the main function with firm-wide re-
sponsibility for funding liquidity management is
Key management committees and functions involved independent of the financing, lending, and trading
in funding liquidity management include the Asset Li- functions. Independent oversight, reporting, and
ability Committee (ALCO), Risk Committee, Finance monitoring are provided by Risk and/or the func-
Committee, Treasury, Risk Management, Finance, and tion with primary responsibility for funding li-
Trading. Some ALCOs meet weekly, although month- quidity management (e.g., Treasury and Finance).
ly is the norm. Many firms have separate ALCOs for Some firms separate the function responsible for
subsidiaries, business divisions, and countries, in compliance and limit monitoring from the one that
which group functions participate. Subsidiaries con- performs firm-wide analyses and reports. In other
sider both regulatory and group requirements in man- firms, these responsibilities may be located in differ-
aging their funding liquidity and related governance ent functions for different subsets of funding liquid-
processes. Some subsidiaries have separate internal ity risk. Irrespective, most firms emphasize the need
frameworks and policies that the parent firm reviews for proper segregation of functions in the funding
to provide advice and counsel. The strength of links liquidity-management process, especially between
between subsidiary and group ALCOs (and between execution and the other roles (design, monitoring,
treasury functions) varies, reflecting firms’ preferences and oversight of policy, strategy, and limits). If some
for centralized versus decentralized structures. execution is conducted by the function that plays the
latter roles, the execution and the governance pro-
There are almost an equal number of firms in which cesses are overseen by senior management commit-
the boards approve the most senior limits and those tees.
in which senior management committees or group
executives do so, typically on an annual basis. Either Other noted related practices include:
board or senior management limit approval is consid-
ered acceptable, provided that key limits are included • Funding liquidity reports reviewed as often as
in board-approved documents. Based on materiality, intraday or daily (based on type, materiality,
within board-approved guidelines it is viewed as satis- and volatility of the metric) by businesses, and
factory for more detailed strategies, limits, and proce- functions with direct responsibility for fund-
dures to require approval only by senior management ing liquidity management; and
committees or an executive in the function responsible • Increased reporting frequency and level of de-
for liquidity management. In some firms, limits are set tail from board to senior management to busi-
by Risk Management while the goals, strategies, and nesses and functions with direct responsibility
procedures are set by Treasury. for funding liquidity management.
21