Financial Supervision Commission

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Recommendation P

concerning the management of financial liquidity risk in banks

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Warsaw, March 2015

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Introduction

This document is issued pursuant to Article 137(5) of the Banking Law Act of 29 August 1997 (Journal of Laws of 2015, item 128) and constitutes a collection of principles regarding best practices in liquidity risk management.

The need to issue a new Recommendation P was primarily driven by the necessity to update Recommendation P from 2002, a requirement arising from the experiences of the international financial crisis that began in 2008. Many banks, despite a satisfactory capital position, encountered difficulties in the area of measuring and managing liquidity risk, which, together with associated types of risk – market and funding risk – contributed to the emergence of systemic phenomena. Under normal conditions, access to developed wholesale capital markets, which provide relatively cheap sources of funding, encouraged banks to undertake intensified lending activities financed by short-term liabilities. Excessive balance sheet growth and funding gaps proved to be a serious source of liquidity risk for banks in situations where access to wholesale capital markets was unavailable. As a result of the crisis escalation, there was a sharp increase in interbank market rates, a shortening of the tenor of concluded transactions, and a reduction in limits on exposures to individual entities, which led to increased funding costs and difficulties in managing current liquidity and hedging risks. The disappearance of mutual trust among market participants caused banks – uncertain about the financial situation of counterparties – to prefer depositing free funds in central banks. In order to protect their liquidity position, banks reduced lending activity, thereby harming the real sector of the economy. Intensifying problems related to the decline in asset prices resulting from their mass sale, the assessment of credit risk of counterparties, and the adequacy of bank capital required state assistance and central bank interventions in money markets.

The international situation during the crisis was also reflected in the loss of trust in the interbank market in Poland. Despite the good financial condition of banks, increased credit risk aversion and the preference for flexibility in liquidity management contributed to a decrease in banks' activity in the money market, a restriction of transactions to the shortest tenors, the removal of mutual limits on transactions with the longest maturity dates, and an increase in credit risk margins. Maintaining low credit limits and uncertainty regarding the development of the situation on global financial markets led some domestic banks to deposit free funds at the National Bank of Poland (NBP) in the form of overnight deposits, at the cost of losing additional interest from placing a deposit in another bank.

Events that took place after 2008, due to the permanence and severity of their consequences, brought an increase in knowledge regarding liquidity risk. New experiences necessitated the definition, at an international level, of new practices relating to liquidity risk management in banks.

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Liquidity management should contribute to reducing the frequency and scale of a bank's liquidity problems in order to protect depositors and minimize the potential impact of these problems on the financial system and the real economy.

The amended Recommendation P takes into account recommendations contained in international guidelines and includes indications regarding:

• determining the bank's liquidity risk tolerance,
• capturing the full range of liquidity risk types, including unexpected liquidity demand risk,
• maintaining a constant presence on selected, significant funding markets,
• diversification of liquid assets,
• conducting stress tests and functionally linking them with the contingency funding plan,
• managing collateral,
• maintaining a surplus of unencumbered, high-quality liquid assets,
• applying a cost allocation mechanism and benefits from various types of liquidity risk in the internal transfer pricing system,
• managing intraday liquidity,
• disclosing information regarding the bank's liquidity.

Recommendation P also indicates the desirable direction of actions undertaken by the bank's management board and supervisory board within the liquidity risk management process.

Additionally, it should be noted that banks should limit liquidity risk arising from structural mismatches in liquidity positions, which, in the event of disruptions in the functioning of the financial system, could lead to the spread of systemic risk. To this end, banks should make greater use of long-term bank debt instruments.

It is worth emphasizing that liquidity risk may arise from perceived or actual weaknesses, errors, or problems in managing other types of risk. Regardless of the bank's organizational structure and the degree of centralization of liquidity risk management, it is important for the bank to understand where risk may emerge.

Recommendation P is addressed to all banks, as well as to branches of credit institutions – until the date of entry into force of the delegated act referred to in Article 460 of Regulation (EU) No 575/2013, and its provisions should be applied both at the level of the individual entity and the consolidating entity, regardless of the consolidation level. It should be borne in mind that policies and procedures reflecting the recommendations should be adequate to the nature, size, and scale of the bank's activity, the complexity of its business model, and the bank's risk profile.

Provisions to which the principle of proportionality applies in particular include:

• Recommendation 6.2 regarding the consideration of dependencies between exposure to liquidity risk and market liquidity risk,
• Recommendation 6.10 regarding transactions with special purpose vehicles,
• Recommendation 7.1 in the scope relating to geographic concentration,
• Recommendation 7.6 regarding wholesale market funding,
• Recommendations 10.5, 10.7 – 10.15, 10.18 – 10.20 regarding the conduct of stress tests,
• Recommendation 14 regarding the inclusion of costs and benefits from various types of liquidity risk in the internal transfer pricing system,
• Recommendation 15 in the scope covering intraday liquidity management.

Adaptation of mortgage banks to the individual provisions of Recommendation P should be carried out taking into account the nature of the activity conducted by these banks, considering the provisions of the Act on Mortgage Bonds and Mortgage Banks and implementing acts issued on its basis.

In the case of cooperative banks operating within an association, the supervisor expects that provisions regarding the adopted policy should be developed with the support of the associating banks, taking into account the individual specificity and risk profile of each associated cooperative bank and the principle of proportionality. However, the process of creating internal regulations in these banks, despite the active role of the associating bank, must not contradict the scope of duties and statutory responsibility of the governing bodies of the associated cooperative banks defined in the individual recommendations.

Cooperative banks of significant size, including in particular banks with own funds exceeding the equivalent of 5 million euros (calculated according to the average exchange rate resulting from the exchange rate table published by the National Bank of Poland, applicable at the end of the year preceding the year of achieving the specified level of own funds), should have procedures fully taking into account the requirements contained in the recommendations.

Associating banks should support associated cooperative banks in developing analytical tools for the purpose of measuring the level of liquidity risk, as well as preparing and conducting stress tests.

It should be assumed that banks operating within an institutional protection system (IPS) will fulfill the provisions of Recommendation P insofar as they do not arise from specific IPS agreements.

Recommendation P indicates the minimum standard, in the opinion of the supervisor, regarding best practices for liquidity risk management. Due to differences that may arise, especially from the risk profile of a given institution and the scale and complexity of its activity, it is permissible for banks to use alternative solutions if they can demonstrate that these are equivalent solutions allowing the achievement of the same prudential goal.

The KNF expects that Recommendation P concerning the management of financial liquidity risk in banks, constituting an annex to Resolution No. 59/2015 of the Financial Supervision Commission of 10 March 2015 (Journal of KNF, item XXX), will be implemented by 31 December 2015.

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Glossary of Terms:

1. Liquidity Risk Tolerance – the level of liquidity risk that a bank intends to bear. The greater the bank's liquidity risk tolerance, the greater the risk it will accept in order to achieve financial benefits from its activity. The level of the bank's liquidity risk tolerance should result from the risk appetite embedded in the overall business strategy of the bank and be consistent with it. It should also correspond to the following business conditions, such as:

   • a) business strategy and strategic objectives,
   • b) operational objectives,
   • c) the role the bank plays in the financial system,
   • d) financial condition,
   • e) ability to obtain funding.

2. Liquidity Risk – the threat of losing the ability to finance assets and timely fulfillment of liabilities in the course of normal bank activity or under other foreseeable conditions, causing the need to incur unacceptable losses.

3. Intraday Liquidity – the ability to fulfill all monetary obligations on the current day.

4. Intraday Liquidity Risk – the threat of losing the ability to fulfill monetary obligations on the current day.

5. Short-term Liquidity – the ability to fulfill all monetary obligations by the payment date falling within a period of 30 consecutive days.

6. Medium-term Liquidity – the ability to fulfill all monetary obligations by the payment date falling within a period from 1 to 12 months.

7. Long-term Liquidity – the ability to fulfill all monetary obligations by the payment date falling within a period of more than 12 months.

8. Market (Product) Liquidity – the possibility of easy conversion into cash within a required time for specific products on the market without significant financial losses on these products.

9. Market (Product) Liquidity Risk – the threat of losing the possibility of converting specific products on the market into cash within a required time, causing the need to incur significant financial losses on these products.

10. Liquidity Gap (Contractual) – a compilation of mismatches in the maturity dates of assets and the due dates of liabilities in a given time interval, prepared based on estimates of cash flows to determine the future level of liquidity. Estimating cash flows involves determining the remaining periods to the maturity of assets and the due date of liabilities and off-balance sheet positions by compiling these assets, liabilities, and off-balance sheet positions in cumulative time intervals, counting from the date of preparation of the compilation. The occurrence of a positive/negative difference between the sum of maturing assets and the sum of due liabilities and off-balance sheet positions in a given time interval indicates the maintenance of a positive/negative gap.

11. Liquidity Gap (Realistic) – a compilation of mismatches in the maturity dates of assets and the due dates of liabilities in a given time interval, taking into account assumptions regarding possible behaviors of asset, liability, and off-balance sheet positions to realistically determine the future level of liquidity. Estimating realistic cash flows requires the bank to develop its own, prudent technique for their assessment, taking into account assumptions regarding, among others, early withdrawal of deposits, later repayment of loans, stability of funding sources, rules of impact on the liquidity position of contingent liabilities and receivables and other off-balance sheet transactions, costs of forced sale of assets, or changes in economic situation and customer preferences.

12. Scenario Analysis – involves assuming scenarios of simultaneous change of many co-occurring risk factors and studying their impact on the bank's situation.

13. Sensitivity Analysis – involves assuming changes in individual risk factors, as well as combinations of such changes, and statically analyzing their impact on the bank's situation.

14. Reverse Stress Test – involves assuming the occurrence of negative consequences from the materialization of liquidity risk and determining scenarios within scenario analysis that could lead to such situations.

15. Key Obligations – obligations whose failure to be fulfilled by a specified time during the day may pose a threat to the bank's reputation or its activity. They may include obligations for which there is a specified time during the day, those requiring settlement of positions in payment and settlement systems, and those related to market activity, such as delivery or return of a money market instrument or payments of supplementary deposits.

16. Key Clients – clients whose behavior may significantly and unexpectedly influence the bank's cash flow profile during the day, thereby increasing the bank's exposure to intraday liquidity risk. Key clients include, among others, those for whom the bank provides correspondent banking services and fiduciary services.

17. Second-round Effects – effects resulting from the deterioration of economic conditions in the real sector of the economy, which with a certain delay, indirectly negatively affect bank balance sheets, causing a deterioration in the financial condition of the entire banking sector, among others, by lowering asset quality, increasing non-performing loans, lowering profitability, or increasing the risk of bank insolvency.

18. Market Access Management – development of presence on markets where the bank can sell assets or strengthening arrangements (relationships) allowing the bank to incur secured or unsecured liabilities. Strengthening relationships with current and potential investors may take place by maintaining appropriate frequency of contacts and frequency of using a given funding source.

19. Alternative Funding Sources – potentially available sources of liquidity strengthening the bank's ability to survive crisis events. Depending on the nature, severity, and duration of the crisis event, potential funding sources may include, for example:

• a) increase in deposits,
• b) extension of liability maturity dates,
• c) new issuances of short- and long-term debt instruments,
• d) fund transfers within the group, new equity issuances, sale of subsidiaries or business lines,
• e) securitization of assets,
• f) sale or repo transactions of unencumbered, highly liquid assets,
• g) drawing on granted funding lines,
• h) Lombard credit from the central bank.

20. Liquidation or Loan Value of Assets – the estimated cash value available to the bank if assets are liquidated or used as collateral for secured funding.

21. Trigger Events – events related to off-balance sheet positions, the occurrence of which triggers actions contained in contracts generating liquidity demand. Trigger events concern in particular derivative contracts, securitization transactions, and relationships with special purpose vehicles (hereinafter: SPV), granted guarantees, and granted credit lines. They may include, for example, changes in economic conditions, reduction of the bank's credit rating, country risk, special market disruptions (e.g., securities), modifications of contracts due to changes in legal, accounting, or tax regulations, and other similar changes. The occurrence of trigger events may condition, among others, the activation of clauses requiring liquidation of an over-the-counter derivative contract or submission of collateral, the need to replenish the margin deposit in derivative instruments, the need for early repayment in some asset securitization transactions, fulfillment of granted contingent obligations, or the need to finance draws on granted credit lines.

22. Encumbered Assets – assets that – explicitly or implicitly – are the subject of a pledge or security agreement or credit enhancement of a given transaction. Such use of assets may be used to obtain funding (e.g., asset-backed securities, covered bonds, repo transactions) or for trading and risk management purposes (e.g., derivatives and securities lending).

23. Unencumbered Assets – assets that can be immediately used by the bank as the subject of a pledge securing funding acquisition or for trading or risk management purposes.

24. Ability to Compensate for Shortfalls – a plan to maintain a liquidity surplus or have access to liquidity sources relative to the normal conditions scenario in the short, medium, and long time horizons, and in the event of realization of extreme scenarios, as well as a plan for further ways to obtain liquidity, whether through new funding sources, adapting activity, or other actions specified in the contingency funding plan. The ability to compensate for shortfalls contains a liquidity surplus and is significantly broader than it.

25. Crisis Events/Situations/Conditions – the most severe extreme condition scenarios that may affect the bank's ability to sell assets or restrict access to both secured and unsecured funding sources. They may concern only the bank, the entire market, or a combination of these factors.

26. Ease of Marketability – the possibility of pledging or selling individual asset components in the event of various crisis events without incurring large financial losses related to forced, immediate liquidation. Marketability may vary depending on the crisis scenario and its duration. Nevertheless, certain general factors can be distinguished that may increase the liquidity of a given asset component, including:

• a) factors related to the characteristics of the asset component:
  • low market risk,
  • short maturity date,
  • transparency of structure and risk characteristics,
  • ease and certainty of valuation,
  • large scale of issuance,
  • low correlation with other risk-generating assets,
• b) factors related to the characteristics of the issuer:
  • high creditworthiness of the issuer,
• c) factors related to the characteristics of the market:
  • existence of a regulated market for a given type of asset,
  • broad, diversified base of buyers and sellers,
  • liquid market for a given type of asset,
  • acceptability by the central bank as collateral,
• d) factors related to the bank's activity:
  • presence of the bank on a given market,
  • regular turnover of assets included in the liquidity surplus,
  • low volume of held assets relative to average market turnover,
  • operation of the bank under its own brand.

27. Extra-contractual "Obligations" of the Bank – obligations that, during a crisis situation, may necessitate supporting SPVs not included in the balance sheet or off-balance sheet liabilities. This refers especially to securitization and conduit programs, in which the bank treats this type of assistance as critical for maintaining constant access to funding. Similarly, under extreme conditions, the fear of losing reputation may lead the bank to purchase assets from money market funds or other investment funds managed by or cooperating with it.

28. Trade Confirmation – should be understood in accordance with Article 1(c) of Delegated Regulation (EU) No 149/2013 of the Commission of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, clearing obligation, public register, access to trading venues, non-financial counterparties, risk mitigation techniques for OTC derivative contracts not cleared by a central counterparty.

29. FTP (Fund Transfer Pricing) – a mechanism for setting transfer prices used for all significant types of activity and balance sheet and off-balance sheet positions for internal liquidity valuation, efficiency measurement, or valuation within the process of risk analysis and profitability of potential new products or services.

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List of Recommendations

I. Management Board and Supervisory Board

Recommendation 1
The bank's management board should develop a liquidity risk management policy that ensures the maintenance of sufficient liquidity, including a surplus of unencumbered, high-quality assets enabling survival from diverse crisis events, including the loss or restriction of access to both unsecured and secured funding sources. The policy in this regard should result from the risk management strategy approved by the supervisory board for the conducted activity, in particular reflecting the risk appetite specified in the strategy and accepted by the supervisory board of the bank.

Recommendation 2
The bank should develop in written form and implement liquidity risk management procedures resulting from the liquidity risk management policy.

Recommendation 3
The bank's management board should appoint persons responsible for implementing and realizing the bank's policy on liquidity risk management.

Recommendation 4
The supervisory board, within the fulfillment of its functions and responsibility for the risk management process in the bank, should supervise the implementation of the liquidity risk management policy.

Recommendation 5
The bank's organizational structure, in a manner corresponding to the scale of activity and risk profile, should ensure the separation of functions between units: a) conducting transactions affecting liquidity risk, b) responsible for monitoring and controlling liquidity risk.

II. Identification, Measurement, Assessment, and Tools Supporting the Liquidity Risk Management Process

Recommendation 6
The bank should have a reliable process for identifying, measuring, and assessing liquidity risk. This process should include comprehensive estimation of cash flows from assets, liabilities, and off-balance sheet positions on the scale of adequately defined time intervals.

Recommendation 7
The bank should develop a funding strategy that ensures diversification of sources and funding periods and takes into account the need for diversification of liquid assets. The bank should identify the main factors influencing its ability to obtain funding and continuously monitor these factors to ensure an up-to-date assessment of funding acquisition capacity.

Recommendation 8
The bank should develop a set of indicators to support the liquidity risk management process for identifying increased risk or emerging weaknesses in the position