Liquidity risk – Algorithmics highlights dangers of proposed standard liquidity ratios in its response to Basel Committee

Toronto, London - 19 July 2010

In its recent submission to the Basel Committee on Banking Supervision’s consultative document, ‘International framework for liquidity risk measurement, standards and monitoring’, Algorithmics has cautioned against the danger that is inherent in the proposals to use standard liquidity ratios that do not account for bank size, resulting in a simplistic indication of a bank’s liquidity position.

The Basel document proposes two standard ratios that all banks should be obliged to maintain above a defined minimum: Liquidity Coverage Ratio and Net Stable Funding Ratio. Algorithmics warns that applying these ratios without considering bank size might not provide enough protection against the systemic risks of larger banks, while penalizing smaller banks, which do not pose a systemic risk, through unnecessarily high liquidity requirements.

By having standard rather than size-dependant ratios, the regulations fail to recognize that size in itself is a risk, which has been an issue in the recent crisis. The standard ratios only provide a simplistic indication of a bank’s ability to withstand liquidity stresses and, despite being created with severe stress assumptions in mind, they should not be exclusively relied upon by senior management.

Algorithmics has made two recommendations to the Basel Committee with respect to liquidity risk measurement. The first is the use of liquidity buffer and survival horizon measures in conjunction with economic capital as part of a comprehensive framework that reflects the institution’s risk appetite. The second recommends that banks should not only stress and reverse stress risk factors, but also the underlying assumptions of the corporate strategies and business plan, as well as their interdependencies.

Dr Mario Onorato, Senior Director of Balance Sheet & Capital Management Solutions at Algorithmics and Honorary Senior Lecturer, Cass Business School in London, said: “Even if two banks show equal ratios, the potential systemic impact of a liquidity issue can be totally different depending on the absolute amounts of their exposures. Our response to Basel recommends that banks’ size should be taken into account when defining the standard requirement, and that the ratios should be complemented with liquidity VaR for market liquidity risk, liquidity buffer and survival horizon for funding liquidity risk, and the interaction between the two.”

Ratios aren’t the only issue that banks are dealing with. Dividing scarce and expensive resources, such as capital and liquid assets, between competing needs is a pervasive problem facing firms, as Dr Onorato explains, “Correctly understanding the cost of liquidity associated with the right level of liquidity buffer will be a key factor in optimizing capital management and business growth. Our advice is to ensure that liquidity risk management becomes an integral part in the setting and monitoring of explicit enterprise risk appetite and reward targets at the balance sheet policy level.”

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