For a corporate entity, liquidity risk is the risk that it cannot meet its financial obligations as they fall due. This can lead to a sudden loss of confidence in the entity, and, potentially, immediate default.
Banks are particularly vulnerable to liquidity risk as a result of the ‘maturity transformation' role that they play in the financial system. Retail banks take in short-term or on-call deposits, while a major part of their lending out is in long-term residential mortgages. The Reserve Bank has imposed minimum prudential standards on registered banks, addressing the degree of liquidity risk that they take on, and their approach to managing that risk.
There are three main components of the Reserve Bank's liquidity policy:
- minimum ratio requirements calculated from banks' financial data;
- rules and guidance on the risk management processes that banks should have in place to manage liquidity risk; and
- requirements for regular reporting to the Reserve Bank of data on their liquidity positions.
All registered banks are normally subject to minimum one-week and one-month mismatch ratios.
The aim of the mismatch ratios is to reduce the risk that an individual bank is brought down by a short-term loss of confidence.
The one-week mismatch ratio models what a bank's expected cash inflows and outflows might be over the first week following a serious loss of confidence in the bank. To be able to meet the minimum ratio requirement, a bank needs to hold a sufficient stock of liquid assets to be able to fill the projected mismatch between cash inflows and outflows. Liquid assets include securities that can be sold quickly and at a reliable price, such as New Zealand government debt.
The one-month mismatch ratio is defined similarly, but over a one-month stress period.
Core funding ratio
New Zealand-incorporated registered banks are also subject to a minimum core funding ratio (CFR). The basic notion underlying the CFR is a comparison between an estimate of the funding of the bank that is stable and can be assumed to stay in place for at least one year (‘core funding'), and the core lending business of the bank that needs to be funded on a continuing basis.
The Reserve Bank initially set the minimum CFR at 65 percent from April 2010, and increased the minimum to 70 percent from 1 July 2011. A final increase raised the minimum to 75 percent from 1 January 2013.
Requiring banks to maintain a minimum CFR reduces the vulnerability of the banking sector in a period of general market disruption.
In late March 2020, as New Zealand was moving into its first lockdown, the Reserve Bank was concerned that banks’ CFRs could begin to decline, which in turn could cause them to reduce lending to the economy in order to maintain their CFR above the 75 percent minimum requirement. On 2 April 2020, the Reserve Bank reduced the minimum CFR requirement from 75 percent to 50 percent to support banks’ lending to the economy during the period of economic uncertainty resulting from the COVID-19 pandemic. The Reserve Bank intends to increase the minimum requirement back to 75 percent on 1 January 2022.
Guidelines on liquidity risk management
There is a standard condition of registration on all New Zealand-incorporated registered banks requiring them to have an internal framework for liquidity risk management that includes certain key elements. A bank's approach to managing liquidity risk must, for instance, consider the material sources of stress that the bank might face, and must prepare the bank to manage stress through a contingency funding plan.
The Reserve Bank's liquidity policy supplements this standard condition with guidelines on the details of a bank's liquidity risk management framework.
Reporting to Reserve Bank
Banks must submit monthly reports on liquidity risk to the Reserve Bank, using a standard template. The template covers compliance with the minimum ratios, a breakdown of liquid assets held, comprehensive data on cash inflows and outflows broken down by maturity, details of new funding raised over the latest month, and the cost of that funding.
The Reserve Bank's liquidity policy can be found on the Banking Supervision Handbook page, listed as Liquidity Policy (document reference BS13) and Liquidity Policy Annex: Liquid Assets (document reference BS13A).
Further discussion of the policy and the rationale for the liquidity policy is set out in The Reserve Bank's new liquidity policy for banks, published in the Reserve Bank Bulletin of December 2009.
Qualifying Crown Agents
Qualifying Crown Agents refer to a class of Primary Liquid Assets, as defined in BS13A.
Refer to the List of Qualifying Crown Agents page.