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Liquidity Risk Management in Financial Institutions Following the Global Financial Crisis

July 2, 2010
Bank of Japan

Executive Summary

The turmoil in global financial markets and the financial crisis since the summer of 2007 have left many important lessons on the financial institution's risk management front. One of them is that the foundation of financial institution management could be threatened by a liquidity crunch, even though the financial institution had a solid capital base. Appropriate liquidity risk management is vital both for achieving sound management of financial institutions and for maintaining financial system stability. With such recognition growing, central banks as well as the regulatory and supervisory authorities have been reviewing the framework for financial regulation and supervision, including liquidity regulation.

In highly globalized financial markets, liquidity risk could immediately spread once it manifests itself and might induce a global liquidity crisis. Financial institutions need to strive constantly to improve liquidity risk management. The financial authorities also need to encourage financial institutions to steadily pursue such efforts in order to preempt a future financial crisis.

As the central bank of Japan, the Bank of Japan has been providing funds to counterparty financial institutions through its complementary lending facility and market operations. To prepare for appropriate fund provisioning, the Bank investigates financial institutions' business and financial conditions through on-site examinations and off-site monitoring. In doing so, it is important to check the liquidity risk and how such risk is managed. Moreover, the"appropriateness of liquidity risk management" has been stipulated as one of the requirements for becoming eligible counterparties for the Bank's complementary lending facility and market operations. The Bank has been monitoring the liquidity conditions of financial institutions on a daily basis, and providing advice and guidance when necessary to encourage improvement in their liquidity risk management.

The Bank's liquidity monitoring, advice, and guidance are characterized by their flexible and fine-tuned approaches through daily dialogues with financial institutions while taking account of financial conditions at different times. This practice has proved effective in the recent financial crisis. That, together with the efforts by financial institutions, appears to have contributed significantly to preventing Japan's financial system from experiencing a grave liquidity crisis.

At the same time, through the financial crisis, challenges in financial institutions' liquidity risk management have also become clear. First, financial institutions need to gauge their liquidity risk profiles, taking into account the characteristics of their businesses and funding measures, and establish an institution-specific liquidity risk management system. That should be addressed with a high priority especially in a financial institution that does not have a stable funding source of deposits. Second, financial institutions are required to further strengthen their resilience in a liquidity stress phase. For example, in addition to formulating contingency plans, financial institutions are required to hold a sufficient level of liquid assets in normal times. Third, there are challenges to internationally active financial institutions. To begin with, those financial institutions should thoroughly recognize risks concerning funding at each business base in local markets and risks concerning intra-group funding, respectively. On top of that, they are required to further enhance their liquidity risk management system on a global basis.

Taking into account those challenges and recent international discussions, the Bank believes it necessary to encourage financial institutions to further improve their liquidity risk management. To that end, from now on, the Bank will check, both in terms of on-site examinations and off-site monitoring, financial institutions' liquidity risk management system by focusing on the following points. New points have been added to the points raised in"The Bank of Japan's Approach to Liquidity Risk Management in Financial Institutions" issued in June 2009, reflecting the experience of the recent financial crisis. The Bank also intends to use those points to check the"appropriateness of liquidity risk management," which is one of the requirements for an eligible counterparty for the Bank's complementary lending facility and market operations.

  1. Developing a governance structure in risk management
  2. Gauging the liquidity risk profile and balance sheet management
  3. Ensuring stability in daily cash management
  4. Strengthening resilience in a stress phase
  5. Action plan in case of emergency
  6. Establishing a global liquidity management system

The Bank will check on a regular basis whether the checklist for liquidity risk management is appropriate in light of the then prevailing financial and economic environment as well as financial transaction methods. Together with that, to further improve the effectiveness of its monitoring, advice, and guidance, the Bank will strive to improve information collection from and the exchange of views with financial institutions as well as analytical methods of the collected information, while paying due attention to the burden of financial institutions.