About three weeks after it issued the Policy Document on Credit Risk¹, Bank Negara Malaysia (“BNM”) has, on 23 August 2023, issued another document on prudential management for the financial services sector, namely the Exposure Draft of the Policy Document on Liquidity Risk (“Exposure Draft”).
 
In this Article, we provide an outline on the provisions of the Exposure Draft.
 
General
 
The policy document (“the policy document”) to be issued from the Exposure Draft will apply to:
 
a)    a licensed bank under the Financial Services Act 2013 (“FSA”);
b)    a licensed investment bank under the FSA;
c)    a licensed Islamic bank under the Islamic Financial Services Act 2013 (“IFSA”);
d)    a licensed international Islamic bank under the IFSA;
e)    a prescribed institution under the Development Financial Institutions Act 2002; and
f)     a financial holding company engaged predominantly in banking business.
 
BNM has proposed that the policy document is to take effect six months after its date of issuance in 2024.² When the policy document takes effect, it will supersede the “Dear CEO letter on Funds Transfer Pricing (FTP) Practices of Banking Institutions dated 6 November 2014.”
 
The Exposure Draft sets out BNM’s requirements and guidance on the management of liquidity risk³ to ensure that financial institutions are effective in assessing their exposures to liquidity risk and take appropriate measures to address their liquidity needs. The requirements have been developed based on the Principles for Sound Liquidity Risk Management and Supervision⁴ and the Guiding Principles on Liquidity Risk Management for Institutions Offering Islamic Financial Services⁵.  
 
The policy document is to be read together with the policy documents and legal instruments set out in paragraph 6.1 of the Exposure Draft, including the policy documents on Liquidity Coverage Ratio⁶ (LCR) and Net Stable Funding Ratio⁷ (NSFR) which set out minimum regulatory liquidity requirements.
 
Summary of Main Requirements
 
The policy requirements and guidance are set out under the following 11 principles in Part B of the Exposure Draft:
 
Principle 1: The board and senior management must exercise effective oversight of the financial institution’s liquidity risk, including establishing a liquidity risk management framework that includes strategies, policies and controls to ensure that the financial institution maintains sufficient liquidity to address its liquidity obligations and withstand a range of stress events.
 
Principle 2: A financial institution must have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process must include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.
 
Principle 3: A financial institution must actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions. This will contribute towards the smooth functioning of payment and settlement systems.
 
Principle 4: A financial institution must actively monitor and control liquidity risk exposures and funding needs within and across entities within the group and business lines. In doing so, a financial institution is to take into account the legal, regulatory, operational, Shariah and other limitations to the transferability of liquidity.
 
Principle 5: A financial institution must establish a sound funding strategy. The funding strategy must provide for effective diversification in the sources and tenor of funding and include a plan for growing its on- and off-balance sheet activities in a sustainable manner. The financial institution must maintain both an ongoing presence in its chosen funding markets and strong relationships with fund providers and regularly gauge its ability to raise funds quickly from each funding source, and identify and monitor factors that may affect that ability.
 
Principle 6: A financial institution must incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all its business activities (both on- and off-balance sheet), including contingent exposures, thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the financial institution as a whole.
 
Principle 7: A financial institution must conduct liquidity stress tests on a regular basis for a variety of short-term and protracted institution specific and market wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that its current exposures remain within its established liquidity risk tolerance. The financial institution must use liquidity stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans.
 
Principle 8: A financial institution must maintain a cushion of unencumbered, liquid assets that can be converted easily or immediately into cash in a range of liquidity stress scenarios which may entail an institution specific or market wide shock or a combination of both.
 
Principle 9: A financial institution must actively manage its collateral positions, differentiating between its encumbered and unencumbered assets. A financial institution must also monitor the legal entity and physical location where the collateral is held and how it may be mobilised in a timely manner.
 
Principle 10: A financial institution must have a formal contingency funding plan that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. The contingency funding plan must outline policies to manage a range of stress events, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.
 
Principle 11: A financial institution must publicly disclose high-quality liquidity related information on a regular and timely basis to enable market participants and relevant stakeholders to make informed judgements about a financial institution’s ability to meet its liquidity needs.
 
Detailed requirements and guidance relating to each of the aforementioned 11 principles are set out in the respective subsections of Part B of the Exposure Draft.
 
Feedback to BNM
 
Feedback on the Exposure Draft is to be submitted to BNM by 30 November 2023.
 
 
Article by Sharifah Shafika Alsagoff (Partner) and Hafidah Aman Hashim (Partner) of the Islamic Finance Practice and Lee Ai Hsian (Partner) of the Banking and Finance Practice of Skrine. 
 

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