Liquidity risk management to boost performance

5 December 2011

By Nancy Masschelein, head of Product Strategy, FinArch and
Nele Matthys, business analyst, Product Strategy, FinArch

The financial crisis revealed weaknesses in liquidity risk programs at financial institutions

The causes and the unfolding of the financial crisis have highlighted a number of concerns and issues for practitioners, policy makers as well as academics in the financial sector. One of the key issues was the inadequacy of bank risk management practices to predict and manage liquidity risk, which was further exacerbated with the drying up of funding sources.

A liquidity crisis can impact individual financial institutions with rapid and sudden force. Some well-known examples are Northern Rock, Bear Stearns, Lehman Brothers and more recently MF Global, who entered into financing transactions and matched book positions principally through the use of repurchase agreements and securities lending agreements. Liquidity problems arose when counterparties requested additional margin following the decrease in the market value of the Italian, Spanish, Belgian, Portuguese and Irish sovereign bonds which were used as underlying collateral. Cases show that (counterparty) credit risk can quickly transform into liquidity risk and show how mistrust of asset values due to counterparty credit default risk can generate liquidity risk.

The crisis clearly illustrates that liquidity risk is a key metric for managing any financial institution and that market liquidity can disappear in a heartbeat if not adequately monitored and well managed.

In addition it illustrates the need to place greater emphasis on developing an integrated view of risk across all the risk types.

In order to prevent or to at least blunt the impact of another crisis, policy makers developed a wave of new regulation. Back in September 2008, the Basel Committee published high level guidance arranged around seventeen principles for managing and supervising liquidity risk. A few months later they issued recommendations which were aimed at deepening and strengthening stress testing practices and supervisory assessment of these practices at the banks. The UK’s Financial Services Authority (FSA) has taken the lead in the domestic effort, as it has conducted a comprehensive review and restructuring of its UK liquidity risk regulations. In October 2009, the UK’s FSA finalised a far-reaching overhaul of the UK framework of liquidity regulation. In December 2010 Basel Committee translated these principles and recommendations into a new regulatory capital and liquidity regime, which form the Basel III framework. Basel III requires banks to calculate two ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR identifies the amount of unencumbered liquid assets a bank should hold to offset net cash outflows under a 30 days stress scenario. The purpose of the LCR is to ensure financial institutions can manage a short-term liquidity shortfall. The NSFR measures the amount of available longer-term stable sources of funding over the required amount under a one year stress scenario. The purpose of this ratio is to significantly reduce the refinancing gap. In addition, banks need to monitor and report various liquidity metrics. Example of these metrics includes contractual maturity mismatch, available unencumbered assets, market-related monitoring tools, funding concentration by time bands etc…

Overall international and national regulators have focused on the importance of establishing a robust liquidity risk management framework. Financial firms are now required to measure and monitor various liquidity risk metrics, to run (reverse) stress testing scenarios, to set liquidity risk tolerance levels, to adequately manage their collateral pool and to embed liquidity premium into pricing decisions. Moreover the regulators are putting more emphasis on enterprise risk management and enterprise wide scenario analysis. Indeed, many regulators have not yet finished the conversion of best-practice liquidity risk management in their guidelines and more regulations and revisions on existing guidelines will arise over the coming years.

Banks need to make performance the driver for good liquidity risk management

Best practice liquidity management should go well beyond regulatory requirements. It needs to provide a well-designed risk framework which in turn offers a foundation for sound internal enterprise wide risk management. This can significantly reduce the vulnerabilities associated with global liquidity cycles and as a result reduce the risk of negative liquidity impact on financial institutions’ balance sheets. The key challenges for such a robust liquidity management system in today’s banking industry are numerous:

A best practice liquidity risk management framework should…

- … be able to integrate with multiple risk engines and measurement techniques in order to support enterprise wide risk management. Analysis should be done on an integrated and granular data set. Scenario analysis can measure the impact of economic events on various risk types and on capital and profitability while taking account of all the interactions.

- … support various liquidity risk metrics such as contractual maturity mismatch, behavioural maturity mismatch, including behavioural assumptions, limits, concentration risk metrics by material currency, funding concentration, ratios such as the regulatory liquidity coverage ratio and the net stable funding ratio, (dynamic) liquid asset buffer, cash flow at risk, counterbalancing capacity,…

- … support intra-day data capabilities to allow for intra-day liquidity management. This includes intra-day stress analysis such as shocks affecting the firm bank directly, reducing counterparties’ willingness to make payments to it in a timely fashion or affecting the ability of a major counterparty in the payments system to make payments to the settlement bank as expected as well as preventing firms from receiving payments as expected

- …. support multiple (reverse) stress and forecasting scenarios to assist in decision making within the bank and to contribute to firms’ contingency funding plans.

- … incorporate a collateral management tool in order to analyse the impact of a heightened demand for collateral and the additional uncertainty on prospective liquidity pressures from margin calls. It needs to overcome the lack of transparency that may contribute to asset markets contracting in times of stress.

- … be flexible with a transparent and dynamic process workflow allowing for easy incorporation of adjustments in case of internal or regulatory guideline revisions.

- ….support adhoc query and reporting capabilities to ensure timely reporting of liquidity conditions in financial institutions serving as a base for fast and well-grounded liquidity and funding decisions in line with the liquidity risk appetite of the bank.

- … be augmented with Fund Transfer Pricing (FTP) capabilities based on the costs, benefits and risks of liquidity which is further elaborated below.

Liquidity performance can be quantified with risk adjusted performance measurements

It is important to attribute all elements of the costs, benefits and risks of liquidity to the business line P&L in a consistent manner. Liquidity risk premiums serve as an important risk driver of P&L results and should be taken into account in an adequate P&L framework above and beyond other risk drivers such as credit value adjustment, interest rate drivers, Greeks etc. This is to ensure that incentives are aligned with strategic objectives.

The integration of consistent FTP processes within the liquidity risk management system is the most challenging given the lack of data and of experience that banks have in this domain. However, a liquidity management system is only complete if it provides analysis tools for the identification of the greatest sources of liquidity risk on various levels and dimensions of the balance sheet. The correct allocation of (contingent) funding and liquidity costs and benefits to their respective business lines, products, entities or regions using a sound liquidity risk compliant FTP tool can in turn serve as an input for price setting within financial institutions. The liquidity premium will no longer be ignored and instead it will be used for correct investment decisions and correct asset pricing. Less liquid assets will require higher liquidity premiums especially in volatile economic circumstances due to higher incentives to hold liquid assets. However, higher liquid asset buffers mean lower yield and as such a higher cost to the bank resulting in an impact on the P&L. Finally, a good FTP framework will support the estimation of liquidity risk impact in case of new business and products and therefore maximise a bank’s business potential and inform key strategic product decisions.

Ultimately, banks need to make performance and not regulatory compliance as the key driver for good liquidity risk management. Banks need to comply with the new liquidity risk regime while ensuring that the process provides business benefits. Implementing a liquidity risk management system should not be a purely compliance exercise. Implementing a best practice liquidity risk management system can give a competitive advantage now and in the event of a future crisis.

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