Practice Guide: Auditing Liquidity Risk: An Overview

Liquidity risk was not well regulated before the financial crisis that began in 2007. During the crisis, despite having capital levels that complied with relevant regulatory ratios, many banks experienced difficulties funding their lending activities or maintaining daily cash flows because they did not manage liquidity prudently. As the commercial paper market froze, the banking system came under severe stress, and banks were unable to trade or sell assets that had been liquid previously. The crisis brought into focus liquidity’s important role in the healthy functioning of the banking sector, financial markets, and the greater economy. The Basel Committee on Banking Supervision (“Basel Committee”) was established to enhance financial stability by improving the quality of banking supervision worldwide and to serve as a forum for regular cooperation among its 45 member countries on banking supervisory matters. The Basel Committee originally issued a capital adequacy framework in 1988, and continues to revise and supplement the internationally recognized framework in order to strengthen the regulation, supervision, and risk management of the banking sector. In the wake of the financial crisis, the committee reformed its standards and principles related to capital adequacy and LRM. Known as Basel III, the comprehensive set of reform measures aimed to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, strengthen banks’ transparency and disclosures, and improve risk management and governance. Specific to the global liquidity standard, Basel III included a common set of supervisory monitoring metrics, a liquidity coverage ratio (LCR)5, a net stable funding ratio (NSFR)6, and a guidance document for LRM, titled Principles for Sound Liquidity Risk Management and Supervision.7 The 17 internationally recognized principles for managing and monitoring liquidity risk, fully listed in Appendix C, are grouped into five main categories, which form the subsections of this guidance: 1. Fundamental principle for the management and supervision of liquidity risk. 2. Governance of liquidity risk management. 3. Measurement and management of liquidity risk. 4. Public disclosure. 5. The Role of supervisors.