Cash-flow approach to managing liquidity risk 1 General

4.1.1 AIs are expected to adopt a cash-flow approach to managing liquidity risk, under which they should have in place a robust framework for projecting comprehensively future cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons. The framework should be used for –

• monitoring on a daily basis their net funding gaps under normal business conditions; and

• conducting regular cash-flow analyses based on a range of stress scenarios.

4.1.2 Unless otherwise specified, the cash-flow management standards in this section apply generally to AIs under both normal and stressed situations. See section 5 for further specific guidance on c ash-flow projections for stress-testing purposes.

4.2 Scope and coverage

4.2.1 Cash-flow projections involve the estimation of an A I’s cash inflows against its outflows and the liquidity value of its assets to identify the potential for future net funding shortfalls. The pr ojections should be f orward-looking

20 Please refer to §97I of the BO and rules 5, 8 and 14 of the BLR.

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and based on reasonable assumptions and techniques, covering liquidity risks stemming from –

• on-balance sheet assets and liabilities;

• off-balance sheet positions and der ivative transactions (including sources of contingent liquidity demand and r elated triggering events associated with such positions); and

• core business lines and ac tivities (including correspondent, custodian and settlement activities).

4.2.2 Cash-flow projections should address a variety of factors over different time horizons, including –

• vulnerabilities to changes in liquidity needs and funding capacity on an intraday basis;

• day-to-day liquidity needs and funding capacity over short and medium-term horizons of up to one year;

• longer-term liquidity needs over one year; and

• vulnerabilities to events, activities and strategies that can put a s ignificant strain on an A I’s capacity for generating liquidity.

4.2.3 Cash-flow projections should cover positions in HKD and in all currencies in aggregate. S eparate cash-flow projections should also be pe rformed for individual foreign currencies in which an AI has significant positions. See section 6 for more details.

4.3 Net funding gaps

4.3.1 In order to meet their obligations as they fall due and thereby stay in business, AIs need to ensure that either a positive cash-flow position is maintained or otherwise sufficient cash can be generated from their assets or funding sources to cover their funding gaps promptly.

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4.3.2 Net funding gaps can be as sessed through the construction of a maturity profile (supplemented where relevant with additional analysis of the funding capacity of specific on- or off-balance sheet items). All AIs are required to report their maturity profiles to the HKMA periodically under Part 4 of Return MA(BS)23. In addition to this, AIs should develop as appropriate internal methodologies to project their maturity profiles taking into account any special characteristics of their operations (if not already captured by the Return). Some general guidance in this regard is provided below.

4.3.3 An AI’s maturity profile together with any related supplemental analysis should cover all cash flows arising from assets, liabilities and of f-balance sheet claims and obligations. Where appropriate, the maturity profile should also cover securities flows that may affect an AI’s liquidity position. For example, such securities flows would include collateral posted by an AI that may require funding and collateral received by the AI that can be used for raising secured funding.

4.3.4 An AI’s maturity profile should encompass adequate time bands so that the AI can monitor its short-term as well as medium-term and longer-term liquidity needs. It is generally expected to have daily time bands in the very short term (say for a period of five to seven days), which may be followed by wider and less granular time bands for other periods²¹. The time frame can also vary depending on an A I’s business. AIs that are less dependent on s hort-term money markets may, for example, need to actively manage their net funding gaps over a s lightly longer period (such as one to three months ahead).

4.3.5 AIs should set internal limits to control the size of their cumulative net mismatch positions (i.e. where cumulative cash inflows are exceeded by cumulative

21 As a general guidance, the medium to longer time horizon covered by an AI’s maturity profile may be calibrated into 1 week, 2 weeks, 1, 2, 3, 6 and 9 m onths, and 1, 2, 3, 5 years and beyond 5 years.

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cash outflows), at least for the shorter-term time bands (e.g. next day, seven days, and one month). Such limits should be in line with the established liquidity risk tolerance, and should take into account the potential impact of adverse market conditions on an A I’s funding capacity. M aturity mismatch limits should also be imposed for individual foreign currencies in which an AI has significant positions (see section 6).

4.3.6 The maturity mismatch limits should be properly documented in the liquidity risk management policy statement. AIs should regularly review the suitability of such limits.

4.4 Cash-flow assumptions and techniques

4.4.1 While certain cash flows can be projected based on contractual maturities, some may need to be estimated based on certain assumptions. In these circumstances, AIs should make realistic assumptions (with a reasonable degree of prudence) to reflect the characteristics of their businesses and products, as well as economic and market conditions. For example, AIs may take into account the following factors in setting the assumptions for cash-flow projection:

• expected future growth or contraction in the balance sheet;

• the proportion of maturing assets and liabilities that AIs reasonably expect to roll over or renew;

• the quality and pr oportion of liquid assets or other marketable securities that can be used as collateral to obtain secured funding;

• the behaviour of assets and liabilities with no clearly specified maturity dates, such as repayment of overdrafts and demand deposits;

• the potential cash flows arising from off-balance sheet activities, e.g., drawdown under loan

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commitments and c ontingent liabilities (including all potential draws from contractual or non-contractual commitments);

• the behaviour of cash flows under different service delivery channels (e.g. branches vs e-banking channels);

• the convertibility of foreign currencies;

• the lead time required for the monetization of marketable debt securities, taking into account the settlement time and the impact of time differences if the clearing or custodian agents are located outside Hong Kong; and

• access to wholesale markets, standby facilities and intragroup funding (see section 9 for more details).

4.4.2 AIs engaged in correspondent banking, custodian and settlement services should understand, and have the capacity to manage, how the provision of these services can affect their cash flows. For instance, the gross value of customers’ payment traffic (inflows and outflows) could be s ufficiently large to affect an AI’s liquidity position, both intraday and ov ernight. If an AI is a participant in a pa yment and settlement system, it should have a clear understanding of the procedure for handling incidents of settlement failure within the system, so that it is able to assess and m anage the potential liquidity needs arising from such incidents.

4.4.3 Techniques employed by AIs for designing cash-flow assumptions should be commensurate with the nature and complexity of their business activities. These may range from historical experience and s tatic simulations based on current holdings to sophisticated modelling (for more complex AIs), taking into account ongoing market developments.

4.4.4 In deriving behavioural cash-flow assumptions, AIs may analyse historical observations on c ash-flow patterns.

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While there is no standard methodology for making such assumptions, it is important that the assumptions used are consistent and r easonable and they should be supported by sufficient historical or empirical evidence.

The minimum criteria for using behavioural assumptions for cash-flow analyses are set out in Annex A.

4.4.5 AIs should document in their liquidity risk management policy statement the underlying assumptions used for estimating cash-flow projections and t he rationale behind them. The a ssumptions and t heir justifications should be appr oved, and s ubject to regular review, by senior management to take account of available statistical evidence and changing business environment.

5. Stress-testing and scenario analysis