Liquidity risk in a nutshell

Published: 10th June 2010 by William Webster

Depositor confidence in the banking system is crucial. It's why banks borrow short term and lend long. Damage this sentiment and the size of cash withdrawals will threaten individual banks and the system as a whole. Hence the new regulatory measures being taken to ensure banks hold sufficient liquid resources to meet just about all eventualities. This is a very brief explanation of the new liquidity regime.

1. Firms must identify what causes liquidity risk: A firm must identify all the items and factors in its balance sheet that cause it to have liquidity risk. These can come from a number of different sources. Maturity transformation is just one such source. But it's more complicated than this. Money from wholesale markets is considered less stable than retail money. Some types of retail deposits are more prone to withdrawal than others. The contractual and behavioural aspects of products can differ. Future commitments to lend create a pipeline. Excessive reliance on one market or product for funding heightens risk. Derivatives can lead to collateral calls.

Taking all of these into consideration how many days you can survive before you run out of cash? Hopefully a long time because your analysis isn’t under any pressure. So what could happen under stressed conditions, when markets and products behave very differently? This is what we are interested in.

2. Firms must stress test the sources of liquidity risk: The regulator insists that firms now stress the identified sources of liquidity risk. This includes a mandatory short term stress on the firm (two weeks) and longer term market wide stress (three months). Under the short term stress no management action can be brought to bear. In the longer run scenario management action can be considered. One thing is certain; under stressed conditions you get a nasty shock. The amount of short term liquidity you need to hold to meet all eventualities increases substantially.

3. Firms must hold a minimum level of buffer assets: The level of buffer assets is determined by the stress testing. (In many firms this buffer requirement can be in the range of 15%-25% of the balance sheet). What the regulator counts as buffer liquidity is restricted to a narrow range of instruments that can be sold or repoed even in the most extreme market conditions. These include central bank deposits, government and supra national debt. All of these have very low returns unless you extend the duration which incidentally also increases your market risk.

Five points for senior management

Have you identified all the things that potentially create liquidity risk in your balance sheet?
Does your stress testing meet the severity expected by the regulator?
How good is your contingency funding plan? Does it effectively mitigate some of the risks you have identified in stress testing?
Does your time of survival meet your risk appetite?
Do you need to pass the cost of holding buffer assets on to the products that create the liquidity risk in your balance sheet?

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A contractual cash flow report for a bank will show you that liabilities have shorter maturities than assets. That's because running liquidity risk generally makes money. But it has risks. Lack of confidence can lead to a real shortage of cash. That's why banks hold liquidity buffers. But measuring liquidity risk goes beyond what is contracted. It needs to assess the behaviour of markets and individuals. It's why stress testing is in vogue. Stress testing can't predict the future but it can give you an estimate for your liquidity buffer. It's likely to be a lot bigger than previously and it's going to cost your firm more, that's unless you can pass the cost on through transfer pricing.

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Regulation > Policy Statement 09/16 Stengthening liquidity standards October 2009

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Policy Statement 09/16 Strengthening liquidity standards refers to earlier consultation papers CP08/22, CP09/13 and CP09/14 and the comments received. In general whilst the FSA acknowledges many of the issues raised little has altered in the final policy. Firms will be expected to be self sufficient for liquidity purposes. Senior management is responsible for reviewing the level of liquidity, compliance and reporting to the Board. The FSA highlights that many firms have been unable to identify and report contractual cash flows on a regular basis. This will be unacceptable. Non compliance will be treated with regulatory sanction. How a firm is subject to Individual Liquidity Adequacy Standards (ILAS) depends on the size of the firm and the risks it presents. The ILAS framework comprises an Individual Liquidity Adequacy Assessment (ILAA), a Supervisory Liquidity Review Process (SLRP) and Individual Liquidity Guidance (ILG). Firms are obliged in the ILAA to undertake robust stress testing. The purpose of this is to show that the firm fully understands its liquidity risk. ILAS firms will need to report the stress test results in their ILAA. Liquidity management systems, controls and stress testing are all board responsibilities. The ILG is the amount of liquid resources the FSA expects a firm to hold. This will contain "guidance" on the amount of the liquid asset buffer and the firm's funding profile. As an incentive for firms to improve their systems and controls, the FSA will increase the amount of liquidity the firm must hold. Deposits at the central bank and tradable securities issued by the central bank will count towards the buffer. Holding currency denominated bonds should take into account potential problems in the FX market. For this reason a domestic bank with mainly sterling liabilities must hold its buffer in gilts. The FSA now require firms to price the cost of liquidity into products. This should mean that the cost of holding the liquidity buffer is passed on to those customers that create a stressed outflow requirement. The new regime will be phased in. The scope and application of the new rules will depend on the importance of the firm and its ability to create systemic risk.