MORNBFI Vol. 1 - Planters Development Bank

APP. Q-4408.12.31IV. Definition of Liquidity RiskLiquidity risk is generally defined asthe current and prospective risk to earningsor capital arising from an FI’s inability tomeet its obligations when they come duewithout incurring unacceptable losses orcosts. Liquidity risk includes the inabilityto manage unplanned decreases orchanges in funding sources. Liquidity riskalso arises from the failure to recognize oraddress changes in market conditions thataffect the ability to liquidate assets quicklyand with minimal loss in value.In terms of capital markets and tradingactivities, FIs face two (2) types of liquidityrisk: funding liquidity risk and marketliquidity risk. Funding liquidity risk refersto the inability to meet investment andfunding requirements arising from cashflow mismatches without incurringunacceptable losses or costs. This issynonymous with the general definition ofliquidity risk.Market liquidity risk, on the other hand,refers to the risk that an institution cannoteasily eliminate or offset a particularposition because of inadequate liquidity inthe market. The size of the bid/ask spreadof instruments in a market provides ageneral indication of its depth, hence itsliquidity, under normal circumstances.Market liquidity risk is also associated withthe probability that large transactions mayhave a significant effect on market pricesin markets that lack sufficient depth. Inaddition, market liquidity risk is associatedwith structured or complex investments asthe market of potential buyers is typicallysmall. Finally, FIs are exposed to the riskof an unexpected and sudden erosion ofmarket liquidity. This could be the resultof sharp price movement or jump involatility, or internal to the FI such as thatposed by a general loss of marketconfidence. Understanding marketliquidity risk is particularly important forinstitutions with significant holdings ofinstruments traded in financial markets.Market and liquidity risks are highlyinterrelated, particularly during times ofuncertainty when there is a highcorrelation between the need for liquidityand market volatility. Likewise, an FI’sexposure to other risks such as reputation,strategic, and credit risks, can likewisesignificantly affect an institution’s liquidityrisk. It is therefore important that an FI’sliquidity risk management system isconsistent with its general riskmanagement framework.V. Sound Liquidity Risk ManagementPracticesWhen assessing an FI’s liquidity riskmanagement system, the BSP shall considerhow an FI address the four basic elementsof a sound risk management system:1. Active and appropriate board andsenior management oversight;2. Adequate risk managementpolicies and procedures;3. Appropriate risk measurementmethodologies, limits structure,monitoring and management informationsystem; and4. Comprehensive internal controlsand independent auditsEvaluation of the adequacy of the FI’sapplication of the above elements will berelative to the FI’s risk profile. FIs with lesscomplex operations may generally usemore basic practices while larger, and/ormore complex institutions will beexpected to adopt more formal andsophisticated practices. Large organizationsshould likewise take a comprehensiveperspective to measuring and controllingliquidity risk by understanding howsubsidiaries and affiliates can raise orlower the consolidated risk profile.Manual of Regulations for Non-Bank Financial InstitutionsQ RegulationsAppendix Q-44 - Page 3