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Banking and Capital Markets
The JournalLiquidity Risk Management: Staying afloatin choppy seas
September 2010
Liquidity could begin to tightenglobally as fears of weaker sovereigncredit continue to spread. Thefinances of many developed debtorcountries are also increasinglystrained. The calibration of theproposed Basel net stable fundingratio is causing uncertainty and, ascentral banks reduce their support,there are concerns over whethermarket-based funding sources willprove sufficient.
It would be a mistake for firms toassume that, simply because theyhave survived until now, they arewell-positioned to weather anotherliquidity crisis. In any case, anothermajor credit event would almostcertainly create new liquiditychallenges that could test even themost successful of firms.
Leading financial institutions do notview liquidity risk management as ashort-term operational issue, but asan integral part of their long-termenterprise strategies. They arereflecting on the lessons to belearned from the recent crisis andpreparing for the new world to come.
Challenging complexity
One of the primary characteristics ofthat new world will be its complexity.Global financial institutions will beobliged to comply with multiplerequirements from regulators acrossthe different regions in which theyoperate. A number of supervisoryand industry groups – including theBasel Committee on BankingSupervision, the Committee ofEuropean Banking Supervisors, theFederal Reserve Bank and theFinancial Services Authority – have
issued, or are planning to issue,updated and upgraded guidelines inan effort to establish sound, system-wide liquidity management practices.
Many institutions have expressedconcern over the impact of thepending and proposed liquidityregulation reforms, which theysuspect will cost them significanttime and money, not least througha lack of harmonisation betweenhome and host regimes. In addition,some host country regulators willalmost certainly require that entityoperating within their jurisdictionbe able to handle a liquidity crisiswithout relying on support from theentity’s parent company. Institutionsthat do not have an effective,enterprise-wide strategy for liquidityrisk management may be left withpools of trapped liquidity in differentregions and an impaired ability tomove those funds to where theyare needed.
Firms need to address these newregulations by implementing updatedpractices and capabilities thatpromote compliance. By doing so,they can not only meet regulatoryexpectations, but also substantiallyenhance their ability to supportdaily liquidity needs and maintainoperations during periods ofheightened stress. This could bolsterfinancial institutions’ confidence and,as a result, reduce systemic risk andimprove capital markets’ chancesof continuing to function after majorliquidity events.
Conducted with the assistanceof 19 leading financial institutions,PricewaterhouseCoopers’ recentglobal benchmarking study of
Shyam VenkatPricewaterhouseCoopers (US) +1 646 471 [email protected]
Adam MikulkaPricewaterhouseCoopers (US) +1 646 471 [email protected]
Bryan MagstadtPricewaterhouseCoopers (US) +1 646 471 [email protected]
2 PricewaterhouseCoopers The JournalLiquidity Risk Management: Staying afloat in choppy seas
Though the storm is subsiding, liquidity remains a critical issue forfinancial institutions. After all, another crisis could come at any time.
liquidity management practicesreveals that there is no ‘one-size-fits-all’ approach to managing liquidityrisk. Firms should seek to developqualitative and quantitative elementsin a coordinated fashion, havingrecognised that these elements areinterrelated. The qualitative elementsof liquidity risk management shouldbe based on sound managementjudgement, embedded within thecorporate culture of the institution,and aligned with the firm’s overallappetite for risk. The quantitativeelements should be based onspecific measures, thresholds orlimits that are set around liquidity riskfactors and diversification of fundingsources, and should be coordinatedwith other risk management activities,such as credit risk, market risk andasset-liability management.
Governance
Implementation of a sound liquidityrisk management framework beginswith appropriate governance.Leading institutions are currentlyfocusing their efforts in five areas:centralisation of oversight; liquidityrisk appetite; board oversight;delineation between tactical andstructural liquidity risk; andintegration of liquidity risk intostrategic management of business.
Achieving the correct balancebetween a centralised anddecentralised approach is a keyfactor in establishing an institution’sgovernance framework. Firms mustestablish the division of responsibilitybetween central group managementand subsidiaries. The mostcommonly observed structure atlarge financial institutions is one ofcentralised oversight at the grouplevel, supplemented by decentralisedunits at either a regional or legalentity level.
Over the past few years, manyinstitutions have made substantialprogress towards establishing andformalising their liquidity riskappetite. As this process continues,institutions should considerarticulating their liquidity appetitethrough both qualitative andquantitative means.
The financial crisis revealed thatboard members often lacked criticalinformation about the liquidity profilesof their institutions. Firms shouldconsider expanding board oversightof liquidity management and ensurethat the board has both a broadunderstanding of liquidity riskmanagement concepts as wellas sufficient knowledge of theunderlying technical details. Inaddition, management shouldincrease the frequency and depthof liquidity management informationprovided to the board and consultwith the board on such areas asapproval of liquidity risk appetite andcontingency funding planning.
As practices around liquidity riskmanagement have become moresophisticated, institutions haveincreased their focus on managingliquidity risk, both on a short-termtactical level and from a long-termstructural perspective. Such anapproach should consider tailoringthe monitoring, measuring andreporting practices to meet thedemands of these two distinctliquidity risk horizons.
Integration of liquidity riskmanagement into the strategicplanning process should beimplemented at the corporate andthe business-line level. In addition,financial institutions should striveto improve their ability to assessthe interaction of liquidity risk withother risk types, such as market andcredit risk.
Policies and procedures
Every financial institution should havea comprehensive set of policies andprocedures in place which describesthe fundamental aspects of itsapproach to liquidity management.Since policies and procedures formthe foundation of an institution’sliquidity governance framework, thedocuments should be of a sufficientbreadth and depth to guide theactions of the business units andfunctional groups acrossgeographies. They should alsopromote a consistent approach tomanaging the institution’s liquidityprofile. Elements that should becovered in the policy frameworkinclude: clear definitions of the risksunder consideration; mandates andprinciples to be applied in managingliquidity; roles and responsibilitiesof different business units andfunctional support groups;authorities, controls and limits;reports produced and metrics used;and key measurement assumptionsembedded in the approach.
An institution should regularly reviewand update its policies to ensurethat these accurately reflect itscurrent and prevailing approachesto managing liquidity. It should alsoensure that its policy frameworksincorporate and reflect guidancefrom relevant industry groups andsupervisory agencies. Theframeworks’ guidance for theoversight of liquidity managementshould extend to both enterpriseand subsidiary levels.
While it is difficult to predict the exactsteps to be taken when a liquiditycrisis occurs, detailed contingencyfunding plans allow institutions toconsider the possible repercussionsof a range of liquidity events. Bydefining formalised action plans,implementing formal simulations of
PricewaterhouseCoopers The Journal 3Liquidity Risk Management: Staying afloat in choppy seas
4 PricewaterhouseCoopers The JournalLiquidity Risk Management: Staying afloat in choppy seas
the contingency funding plan andestablishing liquidity crisis teams,institutions should be able to satisfyregulatory requirements regardingcontingency funding processes and,more importantly, ensure advancedand adequate preparation forpotential liquidity events.
Improved analytics andreporting practices
While measures of liquidity focusingon balance-sheet ratios are stillnecessary, the adoption of leadingpractices requires the implementationof increasingly advanced measures tocapture and assess exposures thatmay arise and affect the liquidityposition of the firm. Examples ofsuch advanced measures includesophisticated multi-scenario stresstesting and varying survival horizons,as well as monitoring intra-dayexposures, intragroup exposures andvarious types of contingent liabilities.
Stress testing is one of the mostpopular tools for assessing liquidityrisk. Leading institutions areincorporating a variety of scenarioswith varying degrees of severity atboth group and subsidiary level.Sophisticated stress-testingtechniques involve implementationof institution-specific and systemicassumptions, instrument-specifichaircuts, and consideration of theimpact of contingent liabilities.
While daily reporting of the liquidityprofile to the treasury function andthe funding desks is prevalent atmany institutions, there are a numberof firms that could benefit fromincreasing the frequency of theirliquidity management reporting,especially to other areas of the firm(such as senior management, ALCO,and risk committees). This broaderreporting of liquidity managementshould provide the contextual
information and qualitative guidancethat senior management needs tounderstand the firm’s liquidity profile.The enhanced liquidity reportingcontent should allow other areasof the business to leverage theinformation produced by the treasuryfunction and the funding desks, andbe customised to address the needsof each of the constituents.
Information systems
Many institutions lack theinfrastructure required to manageliquidity at the level of sophisticationand granularity that they require.There is often a reliance on multiplespreadsheets and time-consumingmanual processes. Enhancingapplication systems and enterprise-wide platforms enables users togenerate increasingly sophisticatedanalytics and ensures that liquiditypositions can be monitored in realtime. This is critical to the effectivemanagement of liquidity in times offast-moving and stressed marketconditions.
Institutions that have immediateaccess to all pertinent liquidity riskinformation are able to manage theirliquidity profile more effectively.Firms should consider maintaininga centralised repository that providesimmediate access to the necessarydata at the desired level of qualityand granularity.
Institutions should considerincreasing their budgets formanagement information systemsto fund infrastructure enhancementsthat improve liquidity and collateralmanagement. Typical areas of focusfor system enhancements includeincreasing capabilities for reporting,analytics and stress testing.
PricewaterhouseCoopers The Journal 5Liquidity Risk Management: Staying afloat in choppy seas
Constant evolution
Once optimised, liquidity riskmanagement practices need toadapt to meet new and emergingchallenges. Institutions should put inplace, procedures to ensure that theirpractices are constantly evolving.
Upcoming regulatory reforms willno doubt impose additional demands– and an increased cost burden –on financial institutions. Seniormanagement should closely monitormarket trends and otherdevelopments that may introducesignificant, unprecedented andcomplex challenges for liquidityrisk management. They should alsoproactively respond to thesedevelopments, adapting theinstitution’s liquidity strategy whennecessary.
Significant benefits
Better liquidity risk managementinevitably comes at a price. However,firms should find that the cost ismore than set off by significantbenefits.
An improved understanding of itsliquidity profile and risk appetite canhelp an institution strike a betterbalance between the desire tomaximise the use of capital togenerate revenues and the need toset aside reserves of unencumberedliquid assets for use during periodsof liquidity stress. Developingalternative sources of funding thatcan be used to fund profitablebusiness opportunities helps ensurethe availability of funds and reducesreliance on any single fundingchannel, even in times of extremestress. Improved visibility andunderstanding of off-balance-sheetexposures, and the implicationsresulting from events that could bringthese exposures onto the balance
sheet, enables a firm to remainproactive.
Identification of contingent liabilitiesand understanding how these couldnegatively influence an institution’sliquidity profile allows a business tomake preparations for mitigating theimpact these contingencies couldhave on the liquidity position.Improved assessment of how a firm’soverall liquidity risk exposure isaffected by interaction among otherrisk types – such as credit risk,market risk and interest rate risk –helps ensure that there is anintegrated risk managementframework in use across theinstitution’s entire risk profile.Recognition of all cash inflows andoutflows, and understanding thebehaviour of these cash flows underplausible adverse scenarios, providesvaluable information for themanagement’s decision-makingprocess.
Enhanced compliance with differentregulatory requirements and reportingneeds across all business units andgeographical areas will satisfyregulators and can send positivesignals to market participants.Enhanced liquidity managementtechniques enable management tomanage liquidity across subsidiariesand geographies more effectivelyand understand the impact of suchstresses at both a local and anenterprise-wide level.
Thus the new world will bring hugechallenges and great change. Asever, the firms that will thrive will bethose that adapt and evolve quicklyand effectively.
If you would like to discuss any aspectof the issues raised in this article,please speak to your usual contactwithin PricewaterhouseCoopers or oneof the article authors.
6 PricewaterhouseCoopers The JournalLiquidity Risk Management: Staying afloat in choppy seas
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For hard copies please contact Russell Bishop at PricewaterhouseCoopers LLP (UK) at [email protected]
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