Liquidity Risk Management

Relevance of liquidity risk 

The recent financial crisis involved a sharp decrease in market liquidity and growing distrust among market participants, resulting in serious (liquidity and solvency) problems for many banks. This led in turn to reliance upon financial support from governments, often under restrictive conditions or even nationalisation. This lack of liquidity, the vast sums the central banks injected into markets and sovereigns provided for the support of tarnished institutes to alleviate the problems - as well as the subsequent substantial impact on the real economy - has brought liquidity risk to the forefront of regulatory authorities' priorities, and to the attention of the public in general. 

Dimensions of liquidity (risk)

The term liquidity is used in the financial world in different contexts:

• liquidity as a measure of the saleability of securities such as bonds or shares 
• liquidity as a description of the financial solvency of individual institutions 
• liquidity as a level of market activity 
• liquidity as unhindered cash flows within an economy

The primary objective of liquidity risk management remains the same: to ensure an institution's ability to meet financial obligations as they fall due at all times - for example, achievable by an adequate liquidity buffer consisting of unencumbered, high quality liquid assets.

By its digital character (either a firm is able to meet financial obligations or it is out of business) liquidity risk takes on a unique position within the risk management; unlike other types of risk (market risk, credit risk, operational risk etc.) it cannot be covered entirely by regulatory capital requirements, but it has a significant emphasis on short term activities, requiring immediate but adequate reaction in stressed situations.  

To successfully manage liquidity risk, one should consider all relevant factors: from the business structure which determines liquidity needs, the analysis of markets (market price, market liquidity and market depth), and finally the necessary level of funding diversification. This makes liquidity risk management a very complex and comprehensive topic. 

New regulatory requirements

One consequence of the recent crisis is closer supervision and a tighter regulatory regime to be imposed upon the banks and financial markets by Government-sponsored regulatory authorities.

Recent updates of the MaRisk (regulatory requirements in Germany, 08/2009) reveal the lessons learned through the financial crisis. The following innovations can be found: 

• specification of three types of stress scenarios (idiosyncratic, market-wide and combination of both) that have to be considered in the treatment of liquidity risk
• updated requirements for the provision of liquidity reserves 
• separate analysis of liquidity per currency 

In general, the updated MaRisk requirements (regarding the coverage and the degree of specification) are significantly less stringent than those released by the UK's FSA, as described in the following section.

In October 2009 the FSA (the UK regulatory authority) specified new regulatory requirements concerning liquidity risk management in the policy statement PS09/16 (Strengthening liquidity standards), thereby finalising a series of consultation papers (CP08/22, CP09/13 and CP09/14). The policy details new requirements such as the Individual Liquidity Adequacy Standards (ILAS) or the Liquidity Reporting. Crucial points are:

• enhanced system and control requirements for adequate liquidity risk management  
• definition of principles of adequate liquidity and self-sufficiency 
• multidimensional breakdown of contracts (e.g. currency, asset type or time buckets)
• stress-test scenarios have to cover short-term and protracted stress scenarios (2 weeks / 3 months), institution-specific (idiosyncratic) and market-wide stress, as well as combinations of both - all evaluated across 10 prescribed key risk drivers
• coherent interpretation of results and individual liquidity guidance (ILG) by the FSA
• new definition of liquid assets and risk-based buffer as well as the demand for a regular realisation of a significant portion of the liquidity buffer
• new reporting regime: granular, frequent (daily, weekly, monthly, quarterly) and partially automated – the "Enhanced Mismatch Report" has to be submitted weekly (with the ability to report daily) in an automated process.

With regard to systemic risks these standards do not only apply to UK firms only, but also to non-UK firms with branches in the UK. In order to keep the regulatory requirements to a reasonable level, modifications and simplification on an individual basis are provided. In particular, non-UK firms with branches in UK may apply for a "whole-firm modification" in the course of which the supervision is mainly left to the parent firm and only a significantly reduced amount of reports at low frequency (but for the whole firm) has to be submitted. 

Based on their "Principles for Sound Liquidity Risk Management and Supervision" published in 09/2008 the Basel Committee on Banking Supervision (BCBS) issued a new consultation document "International framework for liquidity risk measurement, standards and monitoring" for comment in December 2009. Within this paper they propose - amongst other things - two new standards:

• Liquidity Coverage Ratio (LCR): ratio of the stock of unencumbered, high quality liquid assets to the net cash outflows over a 30–day time period under an acute liquidity stress scenario (prescribed combination of idiosyncratic and market-wide shock). 
• Net Stable Funding (NSF) ratio: ratio of the available amount of stable funding to the required amount of stable funding.  

The LCR is intended as a measure for the short-term (30 days) view in a stressed situation (prescribed by the supervisors), whereas the NSF ratio has a longer perspective (1 year) on the funding needs with respect to illiquid assets and securities held (regardless of accounting treatment). Furthermore, the paper recommends consistent monitoring tools; including contractual maturity mismatch, concentration of funding, available unencumbered assets, and market-related tools to monitor the liquidity risk profiles of supervised entities. 

Following the invitation of the BCBS to comment upon this document, the international discussion on sound liquidity risk management and corresponding supervision will continue, and further standards and requirements on national level will be developed.


Liquidity risk management framework

Before the crisis, the management of liquidity risks was not an issue because banks were accustomed to a functioning interbank money market which usually was a reliable source for short-term funding. Nowadays sound liquidity risk management has gained significant importance and is emphatically required by public and regulators. All firms active in the financial markets should be equipped with an adequate framework to identify, measure, manage and monitor their liquidity risks. The aims of a comprehensive liquidity risk management, based on a well-founded knowledge and understanding of the institution's liquidity profile, are included in (but not limited to) the following aspects:

• Securing the institution's ability to meet its financial obligations at all times, and possessing a graduated and detailed plan for different stress situations at hand
• Creation of revenue possibilities by controlled maturity transformation and resulting in applicable steering recommendations 
• Optimisation of liquidity costs (e.g. the composition of the liquidity buffer)

On an organisational level, the liquidity risk management framework should be separated into a management and a controlling side. At the top level, the Board of Directors defines the risk appetite and sets the liquidity risk strategy - which has to be approved, and will be continuously monitored, by the Supervisory Board. On an operational level the Treasury department is responsible for meeting the short-term financial obligations of the firm. The risk controlling department assures that all Treasury operations stay within the liquidity risk strategy. Moreover, the risk controlling department defines modelling for liquidity risk analyses (e.g. for non-deterministic cash flows) and performs stress tests. Results emanating from the risk controlling department's actions on the liquidity situation of the bank may also serve as basis for regulatory reporting.

Results from the performed stress test should enter into the contingency funding plan, prescribing gradually differentiated actions to be taken in various situations of liquidity stress. 


Measures and Tools

An important measure in liquidity risk management is the liquidity gap analysis. This analysis unveils maturity mismatches by displaying the expected future net cash flows aggregated in "time buckets". The liquidity required in any one particular time bucket can thus be determined, implicating the need to fill the "gap" when the net cash flow is negative. Depending on the particular case, the balance sheet presentation shows different alignment and granularity, and further key figures (e.g. maximum cash outflow) can be derived.

Another important measure is the counter-balancing capacity. This analysis shows the cash in flows that could potentially be generated by the institution. These cash-flows can originate from selling own assets, entering into repo engagements, pledging assets at central banks, issuing secured bonds, and others. The counter-balancing capacity may serve as limit for the liquidity gap, i.e. the sum of net cash-flow in the gap report and the counter-balancing capacity must always be positive otherwise the institute is illiquid at that particular time.

Results and conclusions from liquidity gap and counter-balancing capacity analyses are further supported and complemented by stress-tests. The most basic stress scenarios cover idiosyncratic stress (i.e. the institution alone is affected, e.g. by a rating downgrade), market-wide stress (e.g. the whole market is affected), and a combination of these two scenarios. Defining these stress scenarios, identifying their key risk drivers and the corresponding early warning indicators, together with the modelling of non-deterministic cash flows (current accounts, loan commitments, contracts with rights of cancellations, options, shares etc.) is a significant challenge.

The following approaches are taken in practice when modeling non-deterministic products:

• Simple and pragmatic: This relies on observed historical values, e.g. average value over past years. Risks are then assessed using semi-heuristic forecasts.
• Econometric: Models cash-flows with established time-series models. Forecasts are created through statistical analysis of results. 
• Simulation-based: Econometric and financial motivations are harnessed to create Monte-Carlo simulations, through which risks are assessed.

All approaches hold advantages and disadvantages (accuracy versus speed, complexity versus stability) and the most suitable method will depend on available resources. 

In order to cope with potential concentration risk, the analysis of funding sources plays a major role in liquidity risk management and is already incorporated into several regulatory requirements. 

Liquidity gap reports as well as counter-balancing capacities are solely based on the expected cash-flows of transactions. Other liquidity analyses are desirable and advisable; for instance the potential costs arising from any reduction in liquidity gaps or the impact that new business would have on the bank's P&L. Incorporation of these considerations allows the migration of liquidity risk into a wider, more general risk framework within a bank; such a migration is not possible through simple cash-flow analysis.

The basic methods outlined above are typically based on simple assumptions and do not venture far into the stochastic modelling world of mathematical finance. More complex stochastic approaches such as Liquidity at Risk (maximum liquidity gap within a certain time horizon and for a given confidence level) or Liquidity Value at Risk (maximum cost of liquidity under certain assumptions) do exist. Although these stochastic approaches are academically well-developed,
practical implementations are relatively few at present. 


Liquidity Risk Management - What we can do for you

Our experts can help you quantify and manage your liquidity risk. Is your liquidity risk management state-of-the-art? Which stress scenarios have to be considered? How to model non-deterministic products? How to calculate Liquidity at Risk figures? What is needed for a whole-firm application?

Based on our extensive experience with liquidity risk management, we offer:    

• quick and comprehensive checks of your concepts, models and processes, and benchmarking against the best practice
• design and development of a framework for internal management and controlling processes, as well as for regulatory reporting
• quick and efficient support in the implementation of new national regulatory requirements and reports, e.g. those required by the FSA
• well-founded technical and economic competence in liquidity risk methods and analyses
• substantial experience with the available software solutions, data extraction and customisation
• support in all project phases: starting from the business analysis, followed by the design of the projected tailor-made solution, through the proof of concept, to the actual implementation and final testing completed by a professional project management

Benefit from our sound competence in liquidity risk management.

We would be delighted to provide you with further information on our approach, together with our references.  

Please contact:

Dr. Oliver Hein

Tel.: +49 69 90737-324