Managing
Liquidity Risk in a New Regulatory Environment
This article
examines the controls corporates and financial institutions can put in place
to lower liquidity risk.
The
acute liquidity crunch in the days and weeks following the failure of Lehman
Brothers in the autumn of 2008 has shown the importance of liquidity to
financial institutions in general, and banks in particular. Traditionally,
banks have taken on significant duration risk by continuously rolling
short-term borrowings to fund long-term businesses. Mainstream media has used
every opportunity to fault banks for this ‘short-termism’. It
wasn’t as if banks weren’t aware of the risks of funding
long-term business with short-term money. Ever since the dawn of banking, but
more so since the late 1980s, banks have incorporated processes to assess
that the risks they take are covered by the capital they hold. This was
certainly true for the duration risk arising from the funding model adopted
by them. However, the recent crisis has shown a new avenue for failure. A
bank could be extremely well capitalised, but inadequately liquid - as with
Northern Rock in 2007.
When
inter-bank lending froze in the wake of the failure of Lehman Brothers, it
quickly became apparent that capital was an inadequate response to a
liquidity crisis. Regulators have been quick to note this, and a slew of
regulations are now expected around liquidity risk management. The Financial
Services Authority (FSA) in the UK was the first regulator to act, with the
release of a consultation paper (CP-08/22 - Strengthening Liquidity
Standards) setting out new liquidity standards for banks operating in the UK
in December 2008. The FSA has subsequently released two more papers in 2009 -
one in April 2009 and the other in June 2009. A paper outlining the
FSA’s policy statement on the new liquidity standards was issued on 5
October 2009, which reaffirmed the FSA’s intent on going through with
the new liquidity standards it had consulted on before.
Other
regulators appear to be close to releasing similar regulations around
liquidity risk management. The Committee of European Banking Supervisors
(CEBS) published their draft guidelines on liquidity buffers in a
consultation paper (CP28) issued in July 2009. Besides the absence of a
self-sufficiency clause (the most contentious aspect of the FSA guidelines),
the CEBS paper’s approach and guidelines are very much along the lines
of the guidelines issued by the FSA. The Basel Committee has issued what
could be an addendum to Basel II covering liquidity risk in December 2009 - a
prescriptive paper rather than the principles-based papers issued in the
past. Thus far, the FSA’s paper is the most significant as it clearly
outlines an approach to managing liquidity risk and also clearly lays out a
timeline to implement by.
Adequate Buffers
While
regulatory requirements will vary across regions and regulatory
jurisdictions, there are two aspects that appear to be common to all
regulations emerging around liquidity risk. First, companies are required to
hold a buffer of liquid assets to cover unexpected liquidity demands.
Regulators are keen on ensuring that the assets held in these buffers are
adequate given the business and that the assets are not only liquid now, but
will also be as liquid in a crisis. It appears that the only assets that
would qualify are high-quality government bonds, with even cash held in a
bank being considered to be subject to liquidity risk. The second aspect is
to do with determining the size of the liquid asset buffer a company has to
hold.
While
neither the FSA nor CEBS has outlined a methodology that companies could
employ to determine the amount of liquid assets they need to hold, both
bodies agree clearly that stress-testing is an important component of this.
Companies will be required to stress their liquidity profiles to determine
the extent of risk that is sustainable by the company, which the regulator
could compare to the companies’ peer group to determine the extent of
risk the company poses from the perspective of the financial system. The FSA
in the UK has termed this process the Supervisory Liquidity Review Process
(SLRP), the outcome of which will be an Individual Liquidity Guidance (ILG)
to the company. Besides giving companies insight into the FSA’s opinion
of the companies’ liquidity profile relative to their peers, the ILG is
also expected to outline to each company the FSA’s expectation of the
size of the liquidity buffer they expect the company to hold. The supervisory
process in other regions will probably not vary significantly from this.
State-of-the-art Liquidity Risk Management
Besides
the regulatory aspect, there is the fact that a company that is better at
managing its liquidity will improve its competitiveness in a market that is
already seeing unprecedented stresses. The liquidity buffers companies are
now expected to hold mandatorily add to the cost of doing business, while
margins are already stretched in difficult circumstances. Therefore,
companies need to not only optimise the size of the liquidity buffer they
need to hold, but also to leverage this buffer in the best way possible.
Companies will also need to understand to what extent each of their product
groups or organisation units contribute to this cost. Besides the cost of
holding liquid assets, the new requirements also pose new challenges and
costs to companies in terms of implementing these new requirements. A key
challenge lies in establishing the appropriate mechanism of determining the
company’s liquidity profile and in stressing this for adverse
conditions.
On
a day-to-day basis, the primary source of liquidity risk in a company would
be any payment mismatches on its assets and liabilities. A company hits a
crisis when that mismatch grows significantly and unexpectedly against the
company, i.e. the company faces massive payment demands or outgoing cash
flows, to a point where the company cannot match demand and therefore fails
to meet obligations in the short-term. Such a crisis is serious even if the
company may be otherwise solvent; the company will then need to take drastic
measures to survive that would most certainly result in an erosion of value.
The asset liability committee (ALCO) of a company has traditionally looked to
mitigate and manage this risk with gap and duration analyses available in
most asset liability management (ALM) software.
While
this may have worked in the past, gap analysis and duration analysis have
proven inadequate in terms of being prepared for a crisis, as the credit
crunch in late 2008 showed. Companies have taken on enormous duration risk by
increasing their reliance on wholesale funding markets, based on the
assumption that those markets would always function. ALM looks at duration
risk from the point of view of earnings and, as a consequence, capital.
Companies generate a spread by borrowing short-term and lending long-term,
but this spread is exposed to interest rate change. Spreads could tighten if
short-term interest rates go up, leading to lower earnings or even a loss,
and consequently to an erosion of capital. Gap analysis, on the other hand,
looks at the impact of mismatched cash flows, which brings it close to
assessing the risk of illiquidity. However, the assumption has traditionally
been that liquidity would always be available and the impact of cash flow
gaps is to increase costs (and as a consequence reduce earnings). The
possibility of liquidity simply being unavailable is no longer remote, and
traditional gap analysis needs to be taken further.
Liquidity
products on the market can address these particular gaps in a traditional ALM
solution by quantifying this ability of a company to bear adverse cash flow
demands. It does this with the use of scenario analysis, so that companies
could not only determine their liquidity profile on an ongoing basis, but
also helps the company understand the impact to its liquidity profile in
stressed conditions.
The
fundamental principle this type of product is based on is the fact that
capital is an inadequate response to a liquidity crisis. The most relevant
means of countering a liquidity squeeze are to draw down on any credit lines
available to the company and to repo/sell assets on its balance sheet. Of
these, the regulators’ preference is for companies to hold portfolios
of highly liquid assets explicitly for the purpose of countering liquidity
squeezes, as credit lines are typically revocable and therefore not reliable.
We refer to this buffer of credit lines and liquid assets as the
company’s ‘counterbalancing capacity’.
Given
this, companies need to determine their liquidity exposure and then compare
this to their counterbalancing capacity. A situation where the liquidity
exposure exceeds the company’s counterbalancing capacity would be
disastrous for the company. Companies must focus on the their liquidity
exposure and counterbalancing capacity to determine the circumstances that
could cause failure due to illiquidity. The first step in this is to
determine the company’s liquidity exposure.
The
risk to liquidity a company faces arises from the businesses it undertakes.
This is more so with financial institutions, as every part of the business is
dealing with money, which makes the flow of money all that more vital.
Determining the liquidity exposure of a company, therefore, begins with a
projection of the cash flows within its various organisations or business
groups. Financial institutions typically tend to run their treasury functions
centrally, as it gives them leverage of their size or on costs. Even if the
treasury function is federated, it is bound be working with multiple
organisation units as it is impractical for every organisation unit to have
its own treasury function. Liquidity risks would therefore manifest
themselves at the treasury department even though the source of such risks is
elsewhere. Also, it is the treasury department of a company that holds the
liquid assets and has access to the credit lines that form the
company’s counterbalancing capacity. As a consequence, it is important
that companies are able to aggregate cash flow or transactional data from
across its various businesses to determine the company’s liquidity
exposure and to compare this to its counterbalancing capacity.
Projecting Cash Flows
A
key aspect of determining a company’s liquidity exposure is in
projecting cash flows resulting from transactions and behaviour (of
counterparties and depositors) across the organisation.
The
cash flow projections are typically of a daily granularity and the
projections are combined into buckets as they go out in time. For example,
the cash flows for the first month may be of daily granularity, while cash
flows further out than that could be grouped into monthly, quarterly or
annual buckets as required, so that users can easily view cash flow and liquidity
profiles to maturity. The cash flows for each bucket are typically broken
down into three groups:
1. Deterministic or fixed cash flows, i.e. without optional portions.
2. Non-deterministic or floating cash flows, i.e. of all positions with
optionality.
3. Hypothetical or simulated cash flows, i.e. synthetic cash flows or
simulated effects of stress scenarios.
These
cash flow projections are then translated into a liquidity exposure. This
liquidity exposure is compared to the company’s counterbalancing
capacity to determine if there is a shortfall of liquidity even after taking
the company’s liquid asset buffer and funding sources into account. As
a further step, all of these (the cash flows leading to the liquidity
exposure and the counterbalancing capacity) can be stressed for different
scenarios so that the company can determine what conditions could be
disastrous to its operation.
Article
by Drüen joined Fernbach as a product manager in November 2007. Prior to
that, he was freelance for three years, following a five-year stint as a
consultant at ifb in Cologne. His focus was on counterparty risk management,
rating and on DB calculation. At the same time, he began his doctoral thesis
on Basel II, which he completed in 2006. He received his undergraduate
economics degree from Marburg University.
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