Agencies Issue Liquidity Risk Guidance

Copyright 2010 ProQuest Information and LearningAll Rights ReservedCopyright 2010 Mortgage Bankers Association of America Mortgage Banking

May 2010

COMMERCIAL; Pg. 90 Vol. 70 No. 8 ISSN: 0730-0212

21937

1063 words

Agencies issue liquidity risk guidance

Murray, Michael; Kemp, Carolyn

ABSTRACT

Federal banking agencies and the National Credit Union Administration (NCUA), Alexandria, VA, issued new guidance for financial institutions to strengthen liquidity risk-management practices. The Federal Deposit Insurance Corp (FDIC) issued liquidity risk-management guidance in 2008, and that guidance remains in effect. However, the current policy statement supplements FDIC’s 2008 guidelines. The guidance clarifies the process that financial institutions should follow to appropriately identify, measure, monitor and control funding and liquidity risk, including effective corporate governance: an overview of appropriate strategies, policies and procedures, which include risk limits for managing and mitigating risks and discusses the management of intra-day liquidity and collateral. FULL TEXT

Federal banking agencies and the National Credit Union Administration (NCUA), Alexandria, Virginia, issued new guidance for financial institutions to strengthen liquidity risk-management practices.

The Federal Deposit Insurance Corporation (FDIC) issued liquidity risk-management guidance in 2008, and that guidance remains in effect. However, the current policy statement supplements FDICs 2008 guidelines.

“The agencies expect each financial institution to manage funding and liquidity risk using processes and systems that are commensurate with the institution’s complexity, risk profile and scope of operations,” the guidance statement said.

Risk-based capital ratios measure capital relative to a bank’s risk profile as banks adjust individual asset values relative to their risk. In 1989, the United States adopted capital requirements known as Basel I, established by the Bank for International Settlements (BIS), Basel, Switzerland. The minimum capital requirement reflected a percentage of riskweighted assets of the bank.

Banks determine Tier 1 risk-based capital ratios by a mathematical formula – dividing Tier 1 capital by its riskweighted assets, which represent different percentages of risk. Banks can weigh 100 percent of its commercial real estate assets and 50 percent of residential assets, based on different scenarios.

Agency guidance, driven by recent turmoil in financial markets, emphasized liquidity risk management and measurements through cash-flow projections; diversified funding sources; stress testing; a cushion of liquid assets and a formal, well-developed documented contingency funding plan.

Monitors and controls for liquidity risk exposures and funding needs should take place within and across legal entities, and depository institutions should take into account operational limitations to transfer liquidity, the guidance said.

“[The guidance] clarifies the process that financial institutions should follow to appropriately identify, measure, monitor and control funding and liquidity risk, including effective corporate governance; an overview of appropriate strategies, policies and procedures, which include risk limits for managing and mitigating risks and discusses the management of intra-day liquidity and collateral.”

Axel Weber, president of the Deutsche Bundesbank, Frankfurt, Germany, said in March that the Basel Committee on Banking Supervision is adjusting the Basel Il framework for capital requirements.

Basel II aligns regulatory capital requirements more closely to a bank’s underlying risks. The Basel II framework encourages banks to identify current and future risks and to develop or improve their ability to manage those risks.

“Currently, the proposed measures are being analyzed in a comprehensive quantitative impact study, and in the course of 2010 they will be calibrated and finalized,” Weber said. “Together with new standards for liquidity provisions, the new rules should be implemented by 2012.”

After the U.S. adoption of BIS minimum capital requirements, Tier 1 capital needed to be at least 4 percent of total risk-weighted assets and total capital at least 8 percent of total risk-weighted assets. In 2005, an FDIC teaching exercise said, “Capital adequacy is rated relative to a given bank’s risk profile,” and a 4 rating indicated a deficient level of capital.

“In light of the institution’s risk profile, viability of the institution maybe threatened. Assistance from shareholders or other external sources of financial support may be required,” the training exercise said. “Keep in mind that a bank with a capital component rated ‘4’ is clearly inadequately capitalized and viability may be threatened.”

The Tier 1 common ratio prior to the credit crisis was at nearly 4 percent, The New York Times reported.

Simon Johnson and James Kwak, authors of 23 Bankers: The Wail Street Takeover and the Next Financial Meltdown, said capital requirements “can be gamed,” and alluded to Lehman Brothers at 11.6 percent Tier 1 capita! “shortly before it went bankrupt in September 2008.”

Under the advanced approaches rule, which took effect April 1, 2008, for large, internationally active banking organizations, the banks were “required to develop rigorous riskmeasurement and risk-management techniques as part of a new risk-sensitive capital framework,” the Federal Reserve said.

In June 2008, the Fed said a “standardized framework would be available for banks, bank holding companies and savings associations not subject to the advanced approaches of Basel II.”

Nearly one year later, supervisors of the Supervisory Capital Assessment Program set minimum targeted ratios for 19 banks to determine a desired capital buffer in “more adverse” scenario stress tests. The targets were 6 percent for Tier 1 capital and 4 percent for Tier 1 common ratios. A mathematical formula for Tier 1 common ratios consists of non-common elements – including qualifying perpetual preferred stock, qualifying minority interest in subsidiaries and qualifying trust preferred securities – subtracted from Tier 1 capital with the difference divided by risk-weighted assets.

The financial regulatory reform bill introduced by Sen. Christopher Dodd (D-Connecticul), the Restoring American Financial Stability Act of 2010, does not point to specific capital requirement levels, but leaves it up to regulators, including the Federal Reserve, to impose those levels.

Federal banking agencies and the NCUA also said bank systems should include provisions for stress-testing an institution’s liquidity position under various adverse scenarios.

June 1, 2010