At the onset of the financial market crisis in 2007, many banks had adequate capital levels but they still ended up experiencing serious difficulties when it came to liquidity risk management. They had failed to sufficiently accounted for their exposure to liquidity risk.
Before the crisis, funding was readily available and cheap. This created the impression that markets were safe and that liquidity for funding purposes would always be plentiful and available.
However, the uncertainty that the financial market crisis had created rapidly caused cheap funding that had been used by banks to manage their liquidity risk to evaporate as lending rates repriced. Eventually nobody would lend and the loans that were made in the good times of abundant liquidity were no longer rolled-over, they had to be repaid.
Consequently, banks came under severe stress. This resulted in regulators providing support by introducing additional liquidity to money markets and eventually also to individual institutions as they also came under stress.
It’s not surprising that under these conditions the question of what is liquidity risk management? and how should it be managed? was increasingly asked as regulators honed in on this particular risk.
What is liquidity risk management?
Liquidity risk management is a key banking function and an integral part of the asset and liability management process.
The fundamental role of banks is the maturity transformation of short-term deposits (liabilities) into long-term loans (assets) and this makes banks inherently vulnerable to liquidity risk. The transformation process creates asset and liability maturity mismatches on a banks balance sheet that must be actively managed with available liquidity. This is the process known as liquidity risk management.
The availability of liquidity either internally or externally is thus paramount in the management of these maturity mismatches. The effective management of liquidity allows a bank to fund increases in its assets (loans and investments) and to meet obligations as they come due (withdrawal of deposits).
A failure in liquidity risk management may result in a bank becoming unable to meet its obligations. This scenario if played out, could easily cause a bank to fail.
A bank can continue to meet its uncertain cash flow obligations and stay healthy by managing liquidity risk prudently.
How should liquidity risk be managed?
A banks liquidity risk management policies should be set down clearly and communicated to key decision makers in the bank.
The risk management process should make up the following broad minimum requirements.
- The risk must be managed within a defined risk management framework (decision-making)
- A clear liquidity risk management and funding strategy must be agreed at an executive and non-executive board level
- Operating limits to liquidity risk exposures must be set and adhered to
- Procedures for liquidity planning under alternative scenarios must be agreed, including crisis situations
Some common failures have been identified in banks liquidity risk management processes, which have contributed to serious sustainability issues.
- A weak liquidity risk management framework that did not account for the risks posed by products and business lines
- Business incentives that were misaligned with the risk tolerance level of the bank
- Misjudging unexpected contingent obligations and the liquidity that would be required by the bank to meet these obligations
- The belief that prolonged liquidity disruptions as experienced during the financial market crisis, were improbable
- Stress tests that failed to account for possible market wide global strain or the severity and duration of disruptions
Some regulatory wisdom
In September 2008, the Basel Committee on Banking Supervision revised their document “Principles for Sound Liquidity Risk Management and Supervision”, by providing more guidance on the following.
- Liquidity risk tolerance
- Maintaining adequate levels of liquidity
- Allocating liquidity costs, benefits and risks to business
- Identification and measurement of contingent liquidity risks
- Design and use of severe stress test scenarios
- A contingency funding plan
- Intraday liquidity risk and collateral
- Public disclosure in promoting market discipline
The published document is arranged around seventeen principles that set out guidance to bank regulators on best practice liquidity risk management in banks. Because of the importance of managing liquidity risks in banks, the principles proposed are valuable and may be found useful regardless of what financial market sector your business is in.
This document can be viewed or downloaded here: Liquidity risk