Agreement No. 4 (2018) Modifying Article 35 of Agreement No. 002-2018 on Liquidity Risk Management and Short-Term Liquidity Coverage Ratio

Republic of Panama
Superintendency of Banks
AGREEMENT No. 002-2018
(From January 23, 2018)
"By which provisions on liquidity risk management and the short-term liquidity coverage ratio are established"

THE BOARD OF DIRECTORS
In exercise of its legal powers, and
CONSIDERING:

That following the issuance of Law Decree No. 2 of February 22, 2008, the Executive Branch elaborated a systematic ordering in the form of a single text of Law Decree No. 9 of February 26, 1998, and all its modifications, which was approved by Executive Decree No. 52 of April 30, 2008, hereinafter the Banking Law;

That in accordance with paragraphs 1 and 2 of Article 5 of the Banking Law, the objectives of the Superintendency of Banks are to ensure the solidity and efficiency of the banking system are maintained; as well as to strengthen and foster the conditions conducive to the development of the Republic of Panama as an international financial center;

That in accordance with paragraph 5 of Article 11 of the Banking Law, it is a technical attribute of the Board of Directors to establish, within the administrative scope, the interpretation and scope of legal or regulatory provisions in banking matters;

That in accordance with paragraph 1 of Article 6 of the Banking Law, the Superintendency must ensure that banks maintain appropriate solvency and liquidity coefficients to meet their obligations;

That in accordance with what is established in Article 72 of the Banking Law, the Superintendency may take into consideration and value other risks for the determination of the capital adequacy index;

That Article 73 of the Banking Law provides that every bank with a general license and every bank with an international license whose home supervisor is the Superintendency of Banks, must maintain at all times a minimum balance of liquid assets equivalent to the percentage of the total gross of its deposits in Panama or abroad, which the Superintendency of Banks will periodically set;

That in accordance with paragraph 10 of Article 75 of the Banking Law, the Superintendency may determine other liquid assets as part of the assets that make up the liquidity basket of banks;

That during the financial crisis that erupted in 2007, numerous banks despite maintaining adequate capital levels, found themselves in difficulties due to not managing their liquidity prudently, for which reason, the financial crisis reaffirmed the importance of liquidity for the proper functioning of financial markets and the banking sector;

That in recent years, the Basel Committee on Banking Supervision has carried out essential reforms to achieve a more resilient banking sector, for which it has developed the Liquidity Coverage Ratio (LCR), whose objective is to promote short-term resilience of the bank's liquidity risk profile;

That for the Basel Committee, the Short-Term Liquidity Coverage Ratio (LCR) guarantees that banks have an adequate fund of high-quality liquid assets and free of encumbrances that can be easily and immediately converted into cash in the markets, in order to cover their liquidity needs in a scenario of liquidity problems for 30 days;

That the Basel Committee has reinforced its liquidity framework by introducing minimum liquidity standards by developing the Liquidity Coverage Ratio (LCR), with the objective of ensuring that banks have sufficient funds of high-quality liquid assets to overcome a significant stress episode throughout a month and designed as a fundamental component of the supervisory approach to liquidity risk;

That the Liquidity Coverage Ratio (LCR) will improve the banking sector's ability to absorb disturbances arising from financial or economic tensions of any kind, thereby reducing the risk of contagion from the financial sector to the real economy;

That in working sessions of this Board of Directors, the need and convenience of having a prudential regulatory framework that, based on risk management, establishes the short-term liquidity coverage ratio, in accordance with international regulatory standards, has been manifested.

AGREES:

CHAPTER I
SCOPE OF APPLICATION AND DEFINITIONS

ARTICLE 1. SCOPE AND EXTENT OF APPLICATION. This Agreement applies to:

1. Official banks.
2. General license banks.
3. International license banks of which this Superintendency is the home supervisor.

ARTICLE 2. DEFINITIONS AND TERMS. For the purpose of applying the provisions contained in this Agreement, the following are understood:

1. Intraday liquidity: Having the necessary funds on any business day in the time period in which transactions can be carried out.
2. Repo (Repurchase Agreement): The sale of a financial asset with the commitment by the seller to repurchase it on a future date, at a certain price higher than the sale price.
3. Secured financing: Within the scope of this Agreement, secured financing refers to financing in the form of repo. Any financing that is not in the form of a repo operation is called unsecured financing.

CHAPTER II
LIQUIDITY RISK MANAGEMENT

ARTICLE 3. GENERAL PRINCIPLES OF LIQUIDITY RISK MANAGEMENT. The principles of liquidity risk management are intended to ensure, with a high level of confidence, that the bank is in a position to meet its intraday liquidity obligations and in a longer period of liquidity tensions that affect financing, tensions that may have originated in the entity itself or in the market as a whole. For such purposes, in addition to maintaining good corporate governance and solid liquidity risk management practices, banks must ensure compliance with the following components:

1. Maintain a sufficient liquidity position, integrated by easily marketable assets that place it in a position to survive periods of liquidity tensions.
2. Ensure that its liquidity position is related to the complexity of its operations on and off the balance sheet, the liquidity of its assets and liabilities, the scale of its funding mismatches, the diversity of its business model and its financing strategies.
3. Use sufficiently conservative assumptions regarding the possibility of negotiating in the market the assets that make up its liquidity position, and regarding its access to financing during periods of tension.
4. Do not allow tensions derived from competition to compromise the integrity of its management, the control functions and liquidity risk limitation systems, nor its liquidity position.

ARTICLE 4. DEVELOPMENT OF THE LIQUIDITY RISK MANAGEMENT STRATEGY. Senior management will be responsible for developing and applying the liquidity risk management strategy, in accordance with the bank's risk tolerance. This strategy must include specific liquidity management policies, such as:

1. The composition and maturity of assets and liabilities.
2. The diversity and stability of funding sources.
3. The liquidity management approach in different currencies, countries, business lines, and legal entities.
4. The intraday liquidity management approach.
5. Assumptions regarding the liquidity of assets and their ability to be negotiated in the market.
6. Liquidity needs under normal conditions, the repercussions on liquidity of periods characterized by liquidity tensions, whose origin may reside in the entity itself, in the market as a whole, or in both.

It will be the responsibility of the bank's board of directors to approve the strategy, fundamental policies, and practices, which it must examine at least once a year. Likewise, it must ensure that senior management embodies the strategy in the form of policies, rules, and procedures, which also include control and information systems.

ARTICLE 5. STRATEGY CONSISTENT WITH THE NATURE AND COMPLEXITY OF THE BANK. The liquidity strategy must be adapted to the nature, scale, and complexity of the bank's operations. In formulating this strategy, the bank must take into consideration its legal structures, its main business lines, the breadth and diversity of the markets, products, and jurisdictions in which it operates, as well as regulatory requirements in the home country and destination countries.

ARTICLE 6. STRUCTURE, RESPONSIBILITIES, AND CONTROLS. Senior management must determine the structure, responsibilities, and controls for liquidity risk management, and for the monitoring of liquidity positions of all legal entities, branches, and subsidiaries in the jurisdictions where the bank operates, as well as clearly integrate these elements into the institution's liquidity policies. The degree of centralization or decentralization of the bank's liquidity risk management must take into account any legal, regulatory, or operational restrictions on the transfer of funds.

In the case of banking shareholding companies of banking groups whose structure includes banking and non-banking entities, the group's senior management must be aware of the different characteristics of liquidity risk inherent to each entity, both in relation to the nature of the business and the regulatory environment.

The group's senior management must be able to permanently monitor the liquidity risks of the entire group and each of its entities, implement processes that guarantee that the group's senior management actively monitors and responds quickly to all significant events occurring in the group, with timely notification to the board of directors when appropriate.

ARTICLE 7. COMMUNICATION OF THE STRATEGY. Senior management must communicate the liquidity strategy, the basic policies for the application of that strategy, and the organizational structure for liquidity risk management to the entire organization. Senior management must ensure that all business units carrying out activities that affect liquidity are aware of the liquidity strategy and operate within the framework of approved policies, rules, procedures, limits, and controls.

Persons responsible for liquidity risk management must maintain close contact with those monitoring market conditions, as well as with other individuals with access to critical information such as credit risk managers.

ARTICLE 8. INTERNAL CONTROLS. Senior management must ensure that the bank has adequate internal controls to guarantee the integrity of the liquidity risk management process, as well as that the persons responsible for applying the internal controls are competent and have adequate training and operational independence.

Senior management must ensure the timely application of necessary changes when these are significant and alter the effectiveness of controls, when reviews or improvements of internal controls are required.

Internal audit must periodically examine the application and effectiveness of the framework adopted for liquidity risk control.

ARTICLE 9. MONITORING MARKET TRENDS. Senior management must closely monitor market trends and possible events that could pose substantial, unprecedented, and complex problems in liquidity risk management, so that timely changes can be introduced in the liquidity strategy. Additionally, it must carry out the following tasks:

1. Define specific procedures and approvals to allow exceptions in policies and limits, including reinforcement procedures and follow-up measures to be adopted after accepting certain exceedances.
2. Ensure the effectiveness and appropriateness for the bank of stress tests, contingency funding plans, and the liquid asset portfolio that define the liquidity position.

The board of directors must examine periodic reports on the bank's liquidity position and be informed immediately of novel or growing liquidity problems, including among others:

1. The increase in funding costs or greater concentration thereof.
2. The increase in the liquidity deficit.
3. The exhaustion of alternative liquidity sources.
4. Significant and/or persistent exceedances.
5. A notable reduction in the position of high-quality liquid assets free of encumbrances.
6. Changes in external market conditions susceptible to indicate future difficulties.

The board of directors must ensure that senior management adopts the appropriate corrective measures for these problems.

ARTICLE 10. LIQUIDITY AND BUSINESS MODEL. The bank must define and identify the liquidity risk to which it is exposed in all legal entities, branches, and subsidiaries in the jurisdictions in which it operates. The bank's liquidity needs and the funding sources available to meet them depend significantly on its business model and product portfolio, the balance sheet structure, and the profile of cash flows resulting from its on and off-balance sheet obligations.

ARTICLE 11. FUNDING LIQUIDITY RISK AND MARKET LIQUIDITY RISK. The bank must consider the interactions between exposures to funding liquidity risk and market liquidity risk. The bank that raises liquidity in capital markets must recognize that these sources could be more volatile than traditional retail deposits. The bank must not assume perfect functioning and liquidity of financial markets, in that asset and financing markets may disappear during periods of tension. The lack of market liquidity could complicate the bank in obtaining funds through the sale of assets and thus increase the need to maintain funding liquidity.

ARTICLE 12. PRUDENT VALUATION. The bank must ensure that assets are valued prudently, in accordance with pertinent financial and supervisory reporting standards.

The bank's risk management framework must contemplate the possibility of a deterioration in valuations in tense market environments when assessing the viability of asset sales during tense situations and their impact on the entity's liquidity position.

ARTICLE 13. MEASUREMENT OF LIQUIDITY RISK. The measurement of the bank's liquidity involves comparing cash inflows and outflows and evaluating the liquidity of its assets, in order to detect the possibility of future net liquidity deficits. The bank must be able to measure and project future cash flows resulting from its assets, liabilities, off-balance sheet commitments, and derivative instruments for a series of time horizons, both under normal conditions and in a set of stress scenarios, including severe stress scenarios.

For time horizons in which it is necessary to identify, measure, monitor, and control liquidity risk, the bank must ensure that its liquidity risk management practices integrate and contemplate a series of factors including:

1. Vulnerabilities to intraday changes in liquidity needs and financing capacity.
2. Daily liquidity needs and daily short- and medium-term financing capacity up to one year.
3. Liquidity needs at longer terms exceeding one year.
4. Vulnerabilities to events, activities, and strategies that could significantly alter the internal capacity to generate cash flows.

The bank must identify, measure, monitor, and control its liquidity risk positions resulting from:

1. Future cash flows of assets and liabilities.
2. Sources of contingent liquidity demand and their corresponding inducers associated with off-balance sheet positions.
3. The currencies in which the bank operates.
4. Correspondency, custody, and settlement activities.

ARTICLE 14. RELATIONSHIP OF LIQUIDITY RISK WITH OTHER RISKS. The bank must recognize and consider the strong interactions existing between liquidity risk and other types of risk to which it is exposed, which may affect the bank's liquidity profile. Liquidity risk is usually the result of the actual or presumed existence of deficiencies, failures, or problems in the management of other types of risk.

The bank must identify circumstances that could affect the perception that the market and the general public maintain regarding its solidity, especially in wholesale markets. There is a close link between credit risk and liquidity risk, and high increases in the bank's delinquency or reduction in the rating of rating agencies can translate into strong tensions in the bank's funding.

ARTICLE 15. CASH FLOW FORECASTING. For the purpose of estimating the cash flows to which it is exposed, the bank must comply with the following elements:

1. Have a robust liquidity risk management framework, which provides dynamic future forecasts of cash flows and includes a scenario analysis that can occur with sufficient levels of disaggregation on the probable reactions of major counterparties to changes in conditions.
2. Formulate realistic assumptions about its future short- and long-term liquidity needs that reflect the complexities of the businesses, products, and markets in which it operates.
3. Analyze the quality of assets that could be used as collateral, in order to evaluate their possible backing to obtain secured financing in situations of tension.
4. Try to manage the temporal profile of fund inflows in relation to known outflows, in order to achieve adequate maturity matching in its current state and application of funds.

In estimating cash flows from its liabilities, the bank must evaluate:

1. The "persistence" of its funding sources, that is, their tendency not to be exhausted quickly in situations of tension.
2. In the case of major wholesale providers of secured and unsecured funds, it must evaluate the probability of renewal of funding lines and the possible maintenance of the behavior of fund providers in situations of tension, contemplating therefore, the possibility of the disappearance of secured (repos) and unsecured financing in periods of tension.
3. In the case of secured financing with a maturity of one day, it must not presume automatic renewal.
4. Evaluate the availability of financial assistance through term financing facilities and the circumstances in which it may be sought.
5. Consider the factors that influence the "persistence" of retail deposits, such as volume, interest rate sensitivity, geographic location of depositors, and the collection channel.

ARTICLE 16. CASH FLOWS WITH OFF-BALANCE SHEET ORIGIN. The bank must identify, measure, monitor, and control potential cash flows arising from irrevocable off-balance sheet commitments and other contingent liabilities. For this, it must have a robust framework for projecting the possible consequences of the activation of previously inactive commitments, considering the nature of the commitment, the solvency of the counterparty, and exposures to economic sectors and geographic areas, because counterparties from the same sectors and areas could be simultaneously affected by tensions.

ARTICLE 17. FOREIGN CURRENCY POSITIONS. For the evaluation of liquidity risk in foreign currency, the bank must comply with the following aspects:

1. Evaluate its aggregate foreign currency liquidity needs and determine acceptable currency mismatches.
2. Carry out a separate analysis of its strategy in each currency in which it maintains significant operations, contemplating possible restrictions in periods of tension. The scale of currency mismatches must take into account:
   a. The bank's capacity to raise funds in currency markets. b. The eventual granting in its own national market of backup financial facilities denominated in foreign currency.
   c. The capacity to transfer a liquidity surplus from one currency to another, as well as between jurisdictions and legal entities.
   d. The eventual convertibility of the currencies in which it operates, including the possibility of deterioration or total closure of foreign currency swap markets for certain currency pairs.
3. Understand and be able to manage exposures derived from the use of short-term deposits and credit lines denominated in foreign currency to finance national currency assets, as well as those resulting from national currency financing of foreign currency assets.
4. Take into account the risks of sudden fluctuations in exchange rates or market liquidity, or both, given their potential to abruptly widen liquidity mismatches and alter the effectiveness of foreign currency hedges and hedging strategies.
5. Evaluate the probability of losing access to currency markets, as well as the eventual convertibility of the currencies in which it operates.

In case of maintaining significant exposures to liquidity risk in a given currency, the bank must negotiate a backup liquidity facility in that currency or develop a contingency strategy.

ARTICLE 18. LIQUIDITY RISK MEASUREMENT INSTRUMENTS. The bank must use a whole range of measurement instruments or indicators, considering that no indicator can by itself fully quantify liquidity risk. To have a prospective view of its liquidity risk exposures, it must use indicators that evaluate the balance sheet structure and others that project cash flows and future liquidity positions, taking into account off-balance sheet risks, which must incorporate existing vulnerabilities, both under normal business conditions and in situations of tension, for various time horizons.

Under normal business conditions, prospective measurements must identify the needs that could arise from the relationship between projected cash outflows

and cash inflows, as well as the liquidity needs that could arise from the activation of off-balance sheet commitments.

In situations of tension, the bank must evaluate the impact on its liquidity position of the possible deterioration of the value of its assets, the increase in funding costs, the reduction in the availability of funding sources, and the possible increase in the demand for liquidity from counterparties.

The bank must use a set of indicators that allow it to monitor its liquidity position in a timely manner, including among others:

1. The liquidity coverage ratio.
2. The net stable funding ratio.
3. The cumulative cash flow mismatch.
4. The concentration of funding sources.
5. The dependency on wholesale funding.
6. The liquidity of assets.
7. The intraday liquidity position.

The bank must establish limits for each of these indicators, taking into account its business model, risk profile, and the regulatory requirements applicable to it.

The bank must report the results of the application of these indicators to the board of directors and senior management on a periodic basis, and immediately in case of exceedances or significant changes in the liquidity position.

CHAPTER III
LIQUIDITY COVERAGE RATIO (LCR)

ARTICLE 19. LIQUIDITY COVERAGE RATIO (LCR). The Liquidity Coverage Ratio (LCR) is defined as the ratio between the stock of High-Quality Liquid Assets (HQLA) and the total net cash outflows over the next 30 calendar days under an acute liquidity stress scenario.

The bank must maintain an LCR of at least 100% at all times.

ARTICLE 20. HIGH-QUALITY LIQUID ASSETS (HQLA). High-Quality Liquid Assets are assets that can be converted into cash immediately or within a very short period without significant loss of value, in order to meet liquidity needs in a stress scenario.

HQLA are classified into three levels:

1. Level 1: Includes cash, central bank reserves, and sovereign debt securities issued or guaranteed by the central government or central bank, which are rated AAA or AA-. These assets are discounted at 0%.
2. Level 2A: Includes sovereign debt securities rated A+ or A-, corporate debt securities rated investment grade, and certain covered bonds. These assets are discounted at 15%.
3. Level 2B: Includes equities listed on recognized stock exchanges, certain corporate debt securities rated investment grade, and certain residential mortgage-backed securities. These assets are discounted at 25% to 50%.

The total stock of HQLA must be sufficient to cover the total net cash outflows over the next 30 calendar days.

Level 1 assets must constitute at least 30% of the total stock of HQLA.

Level 2 assets must not exceed 40% of the total stock of HQLA.

ARTICLE 21. CASH OUTFLOWS. Cash outflows are estimated based on the expected reduction in cash balances over the next 30 calendar days under an acute liquidity stress scenario.

Cash outflows are categorized as follows:

1. Operational liabilities: Includes deposits from retail and wholesale customers, unsecured funding, and secured funding.
2. Off-balance sheet commitments: Includes credit lines, liquidity facilities, and other commitments that are likely to be drawn upon in a stress scenario.
3. Other outflows: Includes margin requirements, collateral calls, and other contractual obligations.

The bank must apply appropriate runoff rates to each category of cash outflows, taking into account the stability of the funding source and the likelihood of the outflow occurring in a stress scenario.

ARTICLE 22. CASH INFLOWS. Cash inflows are estimated based on the expected increase in cash balances over the next 30 calendar days under an acute liquidity stress scenario.

Cash inflows are categorized as follows:

1. Operational assets: Includes repayments of loans and advances, maturities of securities, and other assets that are expected to generate cash inflows.
2. Other inflows: Includes proceeds from the sale of assets, receipt of dividends, and other income.

The bank must apply appropriate caps to cash inflows, ensuring that total cash inflows do not exceed 75% of total cash outflows.

ARTICLE 23. CALCULATION OF THE LCR. The LCR is calculated as follows:

LCR = (Stock of HQLA) / (Total Net Cash Outflows over the next 30 calendar days)

Where:
Total Net Cash Outflows = Total Cash Outflows - Min(Total Cash Inflows, 75% of Total Cash Outflows)

The bank must calculate the LCR on a daily basis and report it to the Superintendency of Banks on a monthly basis.

ARTICLE 24. REPORTING AND DISCLOSURE. The bank must disclose information regarding its LCR, HQLA, cash outflows, and cash inflows in its periodic reports to the Superintendency of Banks.

The bank must also disclose this information in its public financial reports, in accordance with the requirements established by the Superintendency of Banks.

ARTICLE 25. SANCTIONS. Failure to comply with the provisions of this Agreement may result in the imposition of sanctions by the Superintendency of Banks, in accordance with the provisions of the Banking Law and other applicable regulations.

CHAPTER IV
FINAL PROVISIONS

ARTICLE 26. ENTRY INTO FORCE. This Agreement enters into force on the date of its publication in the Official Gazette.

ARTICLE 27. REPEALING CLAUSE. All provisions contrary to this Agreement are hereby repealed.

Given in the City of Panama, on January 23, 2018.

BOARD OF DIRECTORS
Superintendency of Banks

[Signatures]

Agreement No. 4 (2018)
Modification of Article 35 of Agreement No. 002-2018

The Board of Directors of the Superintendency of Banks,

IN EXERCISE of its legal powers;

CONSIDERING:

That it is necessary to modify Article 35 of Agreement No. 002-2018, "By which provisions on liquidity risk management and the short-term liquidity coverage ratio are established," to align the national regulatory framework with the international standards established by the Basel Committee on Banking Supervision;

That the modification aims to strengthen the resilience of the banking sector to liquidity shocks and ensure that banks maintain sufficient high-quality liquid assets to meet their obligations in a stress scenario;

That the modification includes changes to the definition of High-Quality Liquid Assets, the calculation of cash outflows and inflows, and the reporting requirements;

ACCORDS:

ARTICLE 1. MODIFICATION OF ARTICLE 35. Article 35 of Agreement No. 002-2018 is hereby modified as follows:

"ARTICLE 35. LIQUIDITY COVERAGE RATIO (LCR). The bank must maintain a Liquidity Coverage Ratio (LCR) of at least 100% at all times. The LCR is calculated as the ratio between the stock of High-Quality Liquid Assets (HQLA) and the total net cash outflows over the next 30 calendar days under an acute liquidity stress scenario.

The bank must calculate the LCR on a daily basis and report it to the Superintendency of Banks on a monthly basis.

The Superintendency of Banks may require banks to hold a higher LCR if it determines that the bank's liquidity risk profile warrants such a requirement.

The Superintendency of Banks may also require banks to hold a buffer of HQLA in addition to the minimum requirement, if it determines that the bank's liquidity risk profile warrants such a requirement."

ARTICLE 2. ENTRY INTO FORCE. This Agreement enters into force on the date of its publication in the Official Gazette.

Given in the City of Panama, on April 12, 2018.

BOARD OF DIRECTORS
Superintendency of Banks

[Signatures]