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Australian Prudential Regulation Authority

APRA Sound Liquidity Management Principles Conference

H.C. Coombs Centre, Kirribilli

3 May 2007


Liquidity − the ability of a financial institution to meet its obligations as they fall
due − is critical to the continued operation of an individual deposit-taking
institution and to the stability of the financial system as a whole. I am very pleased
to welcome all of you to APRA’s Sound Liquidity Management Principles Conference
to discuss this very important topic and to contribute to APRA’s thinking on how
liquidity management can be effectively supervised.

The risk of a liquidity problem is intertwined with all of the other risks faced by a
bank, building society or credit union – a group we know collectively as authorised
deposit-taking institutions (ADIs). For this reason, liquidity risk is often referred to
as a consequential risk.

In many cases, it is not poor liquidity management per se that causes an ADI to
experience difficulties in meeting its cash flow obligations. Instead, it may be
problems in some other area, such as in its credit or trading portfolio, or simply its
reputation as a counterparty, which generates liquidity stress. The potential for
such stress is, of course, inherent in the maturity transformation function that ADIs
perform − the process of transforming short-dated or at call borrowings into longer
dated assets or loans.

In the normal course, ADIs are able to run large cash flow mismatches without
incident. It is only when the lenders of those short-term funds have reason to
doubt the soundness of the ADI - such as in the event of a perceived credit
deterioration - that the mismatch is, in a sense, realised and liquidity management
becomes problematic.

Scenario-based or ‘what if’ assessments are therefore core to sound liquidity

management in an ADI. It is reasonably straightforward for an ADI to identify its
liquidity needs on a day-to-day basis in business-as-usual circumstances. The more
challenging aspect of liquidity management is to consider those factors or events
that might cause an ADI’s depositors or other counterparties to withdraw their
funds at short notice and, in doing so, put pressure on the mismatch on which an
ADI’s business is based.

Of course, liquidity pressures need not arise from within the ADI itself. There are
also a range of external factors, such as general market disruptions or country-
specific credit issues, which may undermine counterparty confidence in an ADI and
lead to liquidity stress. Payments system problems are another factor. Indeed,
the potential for liquidity problems in one ADI to spread to other ADIs by way of
the payments system has been the driving factor behind the introduction of real-
time gross settlement systems in major markets.

APRA’s current prudential approach

APRA’s current prudential framework for dealing with liquidity risk in ADIs, set out
in APS210, was introduced in 1998. This framework replaced the fairly crude and
inflexible Prime Assets Ratio (PAR) requirement for banks - under which each bank
was required to maintain a given percentage of liabilities in the form of

government securities, cash and deposits with the RBA - with an approach that
places greater emphasis on ADIs’ own liquidity management practices.

The current approach requires each ADI to agree with APRA a liquidity management
strategy and, for many ADIs, a corresponding set of reports to be submitted to
APRA. The strategy must be appropriate for the operations of the ADI to ensure it
has sufficient liquidity to meet its obligations as they fall due and should set out
how the ADI will measure, manage and assess its liquidity position and respond to a
liquidity crisis. Within this, ADIs may pursue a range of procedures to manage
liquidity, including setting limits on maturity mismatches, holding liquid assets,
diversifying liability sources and developing asset sale strategies.

Central to the measurement and management approach for many ADIs is scenario
analysis. This sets out how the ADI plans to manage its cash flow position under
different operating circumstances. The two sets of scenarios specified in APRA’s
prudential standard are a business-as-usual or “going-concern” scenario and a
“name crisis” scenario.

The purpose of the first scenario is to assess the ADI’s ability to meet its
obligations under normal operating conditions. Under this scenario, any cash flow
shortfalls that an ADI expects to incur over a one-month horizon should be less than
the ADI’s capacity to obtain market funding.

The second scenario is one in which the ADI confronts adverse circumstances
specific to it and, as a consequence, has significant difficulty in rolling-over or
replacing its liabilities. For this scenario, the ADI must demonstrate that it is
capable of operating for at least five business days in a crisis. In other words, the
ADI’s net cash flow position over the 5-day crisis period must be positive, taking
into account any cash inflows received from realising liquid asset holdings or by
accessing other funding sources that would be available to the ADI in that

APRA’s current framework offers ADIs considerable scope for flexibility. Each ADI
must agree cash flow assumptions with APRA under each of the two scenarios. The
outcomes of the scenarios should be examined by the ADI and regularly reported to
APRA in an appropriate form.

For the “name crisis” scenario, the assumptions that ADIs have made about the
cash flow behaviour of their products cannot, in most cases, be empirically verified
– and, indeed, this is one of the areas that will be explored further over the course
of this Conference. APRA did, some time ago, develop guidance on name crisis
assumptions for ADIs’ main product areas and we want to revisit this guidance to
ensure that it accords with APRA’s current thinking and with ADIs’ own practices.

I mentioned just above the word flexibility. This goes hand in hand with non-
prescription. The non-prescriptive nature of many parts of the prudential
framework for liquidity inevitably gives rise to differing interpretations of what was
intended. As is the case for all our prudential standards, APRA endeavours to
provide consistent responses to ADIs and, where we identify inconsistencies, to iron
out these as quickly as is practicable.

In the case of the “going concern” scenario, ADIs are continually revising their
approaches to liquidity management. It is timely for us to review our prudential
framework to ensure that it accommodates developments on this front.

APRA’s prudential framework also needs to keep pace with developments in
financial markets and with ADIs’ participation in those markets. On both counts,
the past decade has witnessed a good deal of change. In financial markets, ADIs
now have much more ready access to a broader range of wholesale funding
sources, such as securitisation and offshore funding. In its recent Financial Stability
Assessment Program (FSAP) report on the Australian financial system, the IMF drew
particular attention to the high reliance of Australian banks on wholesale funding;
in 2006, offshore liabilities accounted for more than a quarter of total liabilities in
the domestic books of Australian banks, a figure that is much higher than in most
other banking systems.

Wholesale funding is now well embedded in ADI funding strategies and reflects the
need to fund strong balance sheet growth from sources other than household
savings, which have been increasingly redirected from traditional deposit products
into superannuation and wealth management products. Wholesale funding exposes
banks to a range of operational, counterparty and liquidity risks, even if foreign
exchange and interest rate risks are hedged. An important challenge is
management of the liquidity risk considerations that follow from dealing with a
much more sophisticated investor set, particularly an offshore investor set that
may be especially sensitive to country-wide credit concerns. On the positive side is
the diversification that this changing funding structure brings – in terms of
investors, regions, currencies, markets and instrument types and tenors. And, of
course, market scrutiny provides its own strong discipline on banks to carefully
manage their funding risks.

APRA’s liquidity review project

Against the background of these financial market developments and changing ADI
practises, APRA decided to review the current prudential framework for liquidity
risk management in ADIs. This review is part of a much larger project to enhance
our capacity to respond swiftly and effectively to an emerging crisis, be it one that
affects an individual entity, a group of entities, or APRA itself.

The liquidity review has been given to a small, high-powered team under the
leadership of one of our most battle-hardened General Managers. The objective is
to ensure that our prudential framework provides ADIs and our supervisors with a
sound, robust and relevant basis for assessing and monitoring liquidity risk.

Part of this project involves a check that ADIs and our own supervisors are
interpreting and implementing the framework consistently and as intended, and
that ADIs are continuing to focus on improving liquidity risk management,
particularly given competing priorities such as the introduction of Basel II. The
project also involves a stocktake of our prudential framework against those of our
international counterparts – and we are very pleased to have Craig Marchbanks of
the US Federal Revenue Board of Governors and Willy Chetwins of the Reserve Bank
of New Zealand at this Conference - to ensure that our approach is consistent with
good practice globally.

A very important component of the project is this two-day gathering. The

Conference allows us to raise with you the issues that we are dealing with in
setting an effective prudential framework. Equally, it represents an opportunity
for you to raise issues with our current approach and how it might be enhanced.
We welcome frank input and your willingness to work with us on constructive

Just as importantly, we hope that the Conference will provide opportunities for
you to share information amongst yourselves, either through the structured
sessions or during the various breaks. Such opportunities may not arise often in
your day-to-day activities. During the course of the conference, I expect that you
will be able to identify areas where a particular practice in your own institution
may be improved, however small that improvement may be. And if everyone
returns to their institutions with one or two ideas on how some aspect of liquidity
risk management can be approached differently, we will have achieved one
immediate objective of raising the benchmark of good practice across the industry.

On that note, let me formally open the Conference and repeat my words of
welcome. We are indeed fortunate to have such an array of experts gathered
together in this one room, and we are delighted with the level of support we have
had from you. We hope you find the next two days informative, always interesting
and occasionally very provocative.