Barbican Consulting Limited
Liquidity
Liquidity
"Markets can remain irrational longer than you can remain solvent."
JM Keynes
Definition
Risk drivers
Stress testing
Board responsibility
Days of survival
Buffers
Funds transfer pricing
Outcome
Definition
In financial markets the term liquidity has two meanings.
First, how easy is it to sell an asset and convert it into cash?
Second, how much cash do you have available to meet the payments that must be made?
The two definitions are closely connected.
For banks liquidity is a sensitive topic. Maturity transformation means that at any one time if all depositors sought repayment there would be insufficient cash available. Of course this likelihood is most unusual. It normally happens when confidence hits rock bottom.
Managing liquidity is about understanding how and why money is withdrawn. In the run up to 2007 a relaxed regime permitted banks to run down high quality assets in a drive to lift profits.
Post 2007 regulators have sought to strengthen banks’ liquidity although some of the earlier legislation is being watered down in order to recognise the adverse impact excessive liquidity ratios can have on lending and the real economy.
Managing liquidity
Regulators main concern is that banks are self-sufficient in respect of liquidity. This originally meant that banks should not rely on access to the central bank. The following refers to the UK regime (which is still changing).
Banks are required to regularly assess their liquidity risk. This is done by preparing a regulatory assessment (Internal Liquidity Adequacy Assessment). In 2008 the UK regulator (FSA) identified ten key “drivers” of liquidity risk. They are:
Wholesale secured and unsecured funding risk
Retail funding risk
Intra-day liquidity risk
Intra group liquidity risk
Cross currency liquidity risk
Off-balance sheet risk
Franchise viability risk
Marketable assets risk
Non marketable asset risk
Funding concentration risk
To assess the amount of liquidity that is required a bank must consider each risk driver and how it could be affected under different stressed conditions.
Three stressed conditions were considered; a market stress, a firm stress and a stress that combines both the market and the firm. The analysis is both quantitative and qualitative. Past data is helpful in forming an opinion on how things could behave but ultimately the nature of stress and its outcome are judgemental.
Banks were expected to hold sufficient liquidity to be able to survive over two weeks and three months for the firm stress and market stress respectively.
The preparation of the first ILAA for banks was step change in risk management and required significant resources. In many cases it indicated hidden or unanticipated liquidity risks and in this respect the discipline of undertaking the assessment has been considered beneficial.
Not Theory
This is not a theoretical exercise. In order to determine whether there is a shortfall in liquid resources the firm must compare its actual liquid resources with those that would be required under the given stressed conditions.
Typically this is determined by measuring “days of survival”. This measures how many days the bank can survive before it runs out of money.
Regulators have made it clear that liquidity risk is a board responsibility. In this respect a board needs to establish its liquidity risk appetite and articulate this to the business. This is normally expressed as days of survival under stressed conditions. This has often coincided with the two weeks and three month timeframes set by the regulator.
Buffers
In times of stress cash outflows increase and therefore banks must hold a ready pool of liquidity to meet the possibility that there will be a sudden and sharp increase in outgoing payments.
Only higher quality assets (easily converted into cash by sale or repo) now count towards these liquidity buffers.
High quality assets are generally considered as government bonds (gilts) and reserves at the central bank. In a more recent concession pre-positioned assets at the central bank that permit access to funding from the authorities can also be counted towards buffer assets. Further concessions may ensue.
Funds Transfer Pricing
Post 2007 it was evident that banks had mispriced liquidity risk. For example they had offered no cost liquidity guarantees to off-balance sheet companies they had established.
The regulator’s view is that failing to take into account the cost or price of liquidity risk when designing and pricing products leads to banks transacting at a price that does not reflect the true risks. Furthermore under-price risk leads to greater volumes of business. Banks must therefore have a clearly defined approach and policy on how liquidity risk is priced into individual products.
Outcome
The overhaul of liquidity has been a major component in the new regulatory regime. Banks must now analyse and understand the liquidity risk on their balance sheet.
This includes what happens under stressed conditions. Liquidity adequacy dictates that sufficient high quality buffers must be held. These buffers are expensive in that their returns are low. This means the cost of managing liquidity has increased.
The levels of liquidity originally considered by regulators post 2007 have now been scaled back. This is a reflection of regulators reassessing the role of both liquidity and solvency with the latter proving to be the root cause of bank failure. New rules around liquidity coverage and net stable funding will continue to refine the regime.
First Published by Barbican Consulting Limited 2014