The regulatory treatment of liquidity risk in South Africa
Jacobs, Johann Renier Gabriel
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South Africa will be implementing Basel II on 1 January 2008. Basel II provides regulatory capital requirements for credit risk, market risk and operational risk. The purpose of capital requirements is to level the playing field for all internationally active banks and to protect consumers against these risks. Although there is an obvious threat of liquidity risk and it is important to correctly measure and manage liquidity risk, it is almost glaringly omitted from Basel II. The result of not managing liquidity risk properly may have dire consequences for banks because a liquidity crisis may happen without warning. Therefore, the aim of this study was to explore current practices and to propose guidelines for effective liquidity risk regulation in South Africa. A literature study and quantitative analysis on liquidity risk in South Africa were conducted to assess whether it is valid for regulators to require banks to hold capital for liquidity risk. This study provides conclusions and recommendations on the regulatory treatment of liquidity risk in South Africa under Basel II. Although Pillar 2 reviews a variety of other risks and not only liquidity risk, it is proposed that the liquidity risk part of such reviews is conducted on the basis of a questionnaire used to determine possible gaps between banks' practices and prescribed criteria regarding the management and measurement of liquidity risk. It is important to note that such an approach has a constraint in terms of the substantial amount of work that would have to be done on the regulation of liquidity risk by both regulators and banks. Therefore resource constraints and the cost versus the benefit of such an approach would have to be considered carefully. The all-encompassing conclusion to this study is that capital would not be an effective mitigant for liquidity risk for a number of reasons. Liquidity risk differs from bank to bank and a general capital charge for all banks may not be sensible, therefore liquidity risk should be analysed on a bank-by-bank basis. In other words, capital could be charged for liquidity risk under Pillar 2(b) of Basel II. Such a capital charge would not serve the purpose of covering losses resulting from liquidity risk, but would instead impose a penalty on banks that are deemed to manage and measure liquidity risk imprudently. Such a penalty would typically be quite small but would serve as an incentive for banks to improve their management and measurement techniques to the desired level as set out by prescribed criteria. The criteria that should be used for determining whether banks measure and manage liquidity risk prudently should be of such a nature that the Bank Supervision Department (BSD) of the South African Reserve Bank (SARB) complies with Basel Core Principle 14: Liquidity Risk in regulating liquidity risk. In addition, it should align the criteria used to the 14 Principles for the sound management of liquidity as prescribed by the Bank for International Settlements and the Institute of International Finance. Furthermore, it is proposed that the BSD should not prescribe to banks which methods to use to report their liquidity risk, because all banks are not the same in terms of size and sophistication. For this reason, banks should be allowed to follow an internal models approach for liquidity risk whereby banks are, subject to regulatory approval, allowed to use their own internal liquidity risk measures to report liquidity risk to the BSD. This approach is similar to the approach followed by the Bundesbank in Germany. A liquidity risk questionnaire could be drafted according to which banks' liquidity risk management and measurement is assessed in terms of the sound Principles for managing liquidity risk and the Basel Core Principles. One questionnaire could be used for the purposes of assessing the quality of banks' liquidity risk management and measurement in terms of a Supervisory Review and Evaluation Process (SREP) as well as for banks applying for approval of an internal models approach for liquidity risk. The same questionnaire could be used for both purposes, or the questionnaire could be divided into two clear sections whereby all banks are required to answer the SREP (or Pillar 2(b)) section, and only banks applying for the use of an internal models approach for liquidity risk are required to complete this section. A further conclusion to this study is that the BSD should publish a framework in which its approach to regulating liquidity risk is described in detail. Some aspects that should be included in such a document include a widely-accepted definition for liquidity risk and guidelines/minimum standards for measurement and management techniques for liquidity risk and the process that will be followed under Pillar 2 of Basel II. If the BSD is concerned about the level of potential liquidity risk in the South African banking system, it should consider having the additional instruments that are eligible as collateral included as instruments eligible for liquid asset reserve requirements. An additional mitigant for liquidity risk may be that the BSD requires banks to report their liquidity risk more frequently than the current monthly basis.
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