The Bank of Japan's Approach to Liquidity Risk Management in Financial Institutions
June 26, 2009
Bank of Japan
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The turmoil in global financial markets since the summer of 2007 has again highlighted the importance of liquidity risk management in financial institutions. This paper clarifies the relationship between liquidity risk in financial institutions and a central bank's policy and operations, and then describes the Bank of Japan's approach to liquidity risk management. This paper aims at contributing to the further improvement in risk management in Japanese financial institutions and to international discussions on liquidity risk management.
What makes liquidity risk management in financial institutions difficult is the fact that where the risk lies and how significant it is cannot necessarily be assessed from the figures on the balance sheets. Factors that trigger the manifestation of liquidity risk lurk in all the areas of financial institution management, and the way of manifestation and the size of liquidity risk can vary according to the business model and its surrounding environment. Thus, in considering liquidity risk management, it is important to take into account a broad range of factors associated with liquidity.
In terms of yen currency, Japanese financial institutions, on the whole, have robust asset/liability structures, including off-balance items, against liquidity risk: (1) a high share of deposits, which are a stable funding source, (2) a sizable amount of securities holding that can be liquidated through selling or pledging as collateral and (3) the limited size of contingent liabilities. In terms of foreign currencies, though the gap between investment and funding remains large, the financial institutions, on the whole, have maintained a conservative short-term foreign currency position.
The Bank gauges and analyzes the developments in liquidity as a whole in the financial markets and the financial system from a macro-perspective. In addition, the Bank monitors closely financial institutions' liquidity conditions on a daily basis, and offers guidance and advice if necessary.
The Bank's liquidity monitoring consists of off-site monitoring, in which the staff constantly conduct research through interviews with officers of financial institutions and regular information gathering, and on-site examination, in which examiners visit and investigate financial institutions at regular intervals. The Bank utilizes those two channels in an integrated manner. For example, it monitors financial institutions' funding and investment policies, financial data, and liquidity positions largely in the off-site monitoring section and it grasps and verifies the internal control mechanism and the preparation of contingency plans mainly through the on-site examination.
In the off-site monitoring section, persons in charge are placed for all the counterparty financial institutions including banks, securities firms and Japanese branches of foreign financial institutions. They monitor liquidity positions on a daily basis and exchange opinions regularly, which is a major characteristic of the Bank's liquidity monitoring. Moreover, based on the recent diversification and globalization of the businesses of financial institutions, the Bank is in close communication with other central banks and domestic and foreign regulatory authorities.
In assessing liquidity risk in financial institutions, the Bank does not assess it using a single financial indicator but takes into consideration multiple indicators and qualitative information from financial institutions. To be more precise, the Bank verifies the following aspects of liquidity risk in each financial institution in detail and offers guidance and advice.
- Profile of liquidity risk and administration
- Balance sheet management
- Daily cash management
- Action plan in case of emergency
The nature and size of liquidity risk can change significantly as a result of business developments in financial institutions and changes in the circumstances surrounding financial institutions. It is important for financial institutions to properly grasp their own liquidity risk profile at the time, and to adequately manage liquidity risk. The Bank will also make sure whether individual financial institutions are taking appropriate measures, and encourage improvement if necessary. On that basis, the Bank will contribute further to financial system stability by ensuring smooth settlement of funds between financial institutions.