compliance with the bank s established policies, proce-
dures and limits.”81
B. Liquidity Risks
In February 2008, the Basel Committee on Banking
Supervision published a paper titled “Liquidity Risk
Management and Supervisory Challenges”, a paper
which highlighted the fact that many banks had
ignored the application of a number of basic, prin-
ciples of liquidity risk management during periods of
abundant liquidity.82 An extensive review of its 2000
“Sound Practices for Managing Liquidity in Banking
Organisations” was also carried out by the Basel
Ccmmittee as a means of addressing matters and issues
arising from the financial markets and lessons from
the Financial Crises.83 In order to consolidate on the
Basel Committee for Banking Supervisions Principles
for Sound Liquidity Risk Management and Supervision of
September 2008, which should lead to improved man-
agement and supervision of liquidity risks of individual
banks, supervisory bodies will be required “ to develop
tools and policies to address the pro cyclical behaviour
ofliquidity at the aggregate level.84
The Principles for Sound Liquidity Risk Management and
Supervision of September 2008 are aimed at providing
“consistent supervisory expectations” on principal ele-
ments such as “board and senior management oversight;
the establishment of policies and risk tolerance; the use
Ofliquidity risk management tools such as comprehen-
sive cash flow forecasting, limits and liquidity scenario
stress testing; and the maintenance of a Sufllcient cush-
ion of high quality liquid assets to address contingent
liquidity needs.”85
The three aspects to pro cyclicality86—as Iiighliglited
in the Impact Assessment Document amending the
Capital Requirements Directive, have the potential to
trigger a chain reaction. Starting with remuneration
schemes, the impact of these on management incen-
tives, could have a positive or negative effect on bank
regulations (such as Basel II or the CRD). Such regu-
lations could then mitigate or exacerbate pro cyclical
eflects—depending on the effectiveness cf capital ade-
quacy rules. A positive effect of such rules would reduce
the tendency of banks to cut back on lending during
economic “busts” whilst incentives to retain liquidity’
would be increased—hence reducing the likelihood of
the occurrence of maturity’ mismatches.
The link between liquidity and systemic risks as
illustrated in the ECBs Financial Stability Review, is
attributed to the “destruction of specific knowledge87
which banks have about their borrowers and the
reduction of the common pool of liquidity.”88 The
importance of the link between liquidity risks and
systemic risks within the banking sector is highlighted
by the consequences attributed to the reluctance of
banks to retain liquidity—given the cost of holding
liquidity.89 The consequential shortfalls of liquid-
ity as reflected by on and off balance sheet maturity’
mismatches accentuates the importance of the role
assumed by central banks in the funding of bank bal-
ance sheets.90
The link between liquidity and systemic risks is also
accentuated under paragraph 77 of the BCBS Principles
for Sound Liquidity Risk Management and Supervision of
September 2008. Principle 8 states that:
“A bank should actively manage its intraday liquid-
ity positions and risks to meet payment and settlement
obligations on a timely basis under both normal and
stressed conditions and thus contribute to the smooth
functioning of payment and settlement systems.”
Paragraph 7791 elaborates on this by highlighting
the reasons why “intraday liquidity management” con-
stitutes an important component of a bank’s “broader
liquidity management strategy.” It goes on to state that
a bank’s failure to manage intraday liquidity' effectively
could result in its inability’ to meet payment obligations
as they fall due,—hence generating consequences, not
only for its own liquidity position, but also that of other
parties. It illustrates how this could occur in two way’s,
namely:
“The fact that that counter parties may view the
failure to settle payments when expected, as a sign of
financial weakness—which in turn could result not only
in payments to the bank being delayed or withheld, but
also in further aggravation of Hquidity pressures.
It also could leave counterparties unexpectedly short
of funds, impair those counterparties’ ability to meet
payment obligations, and disrupt the smooth func-
tioning of payment and settlement systems. Given the
interdependencies that exist among systems, a bank’s
failure to meet certain critical payments could lead
Vobme 30 ∙ Number 9 ∙ September 2011
Bunking & Financial Services Policy Report ∙ 35