Liquidity Risk and Impact on Treasury
It is very difficult to find a universally accepted definition of liquidity risk, however, it is commonly accepted that liquidity risk comes in two forms – funding liquidity risk and market liquidity risk. Funding liquidity risk is defined as an institution’s inability to obtain funds to meet cashflow obligations, whereas market liquidity risk refers to the risk that market transactions will become impossible due to market disruptions or inadequate market depth.
Liquidity risk can occur if the liquidity obtained from either asset or the liability side of the balance sheet is less than expected or liquidity needs are more than anticipated. This suggests that liquidity risk may result from credit, market and/or operational risk. It is important for managers to recognise the overlap that exists between and among these different types of risk. The occurrence of these risks can have a considerable impact on a liquidity risk profile of an organisation. Hence, risk managers are generally most concerned with the systemic implications of liquidity risk.
Therefore, there are multiple sources from which liquidity risk can arise, as there are for market or credit risk. Although there is no single source for liquidity risk, there are a number of known market conditions (e.g. the change in interest rates can result in an increase in the cost of funding and the cost of carry).
One of the primary reasons as to why there has been increased attention on liquidity risk in recent years has been due to the anticipated impact of the new Basel Capital Accord. Basel II will have a significant impact on current practices with regards to liquidity risk management, and more specifically, funding liquidity risk. The new Basel II Accord on capital adequacy is intended to ensure that financial institutions have sufficient capital to cover their risks. Organisations are required to allocate economic capital in a way to reflect their risk exposure more precisely. In this context, economic capital refers to the capital that banks have on one side as a safeguard against potential losses that can naturally occur in any business activity.
Basel II presents 14 aspects of liquidity management that financial institutions are expected to address and resolve. These 14 principles were initially laid out by the Basel Committee in its report ‘Sound Practices for Managing Liquidity in Banking Organisations’, published in 2000.
Liquidity risk should not be an issue of ‘business as usual’ – the case that funds can be replaced once they mature, according to a source from a top European bank. The key issue for banks is to make sure that they are fully prepared in situations where liquidity risk does become a problem.
The treasury group has many key responsibilities, one of which is to make sure that the most effective approaches to cash and liquidity management are taken. During times of credit limitations, financial institutions need to be reassured that they have access to liquidity.
For treasurers to fulfil their responsibilities and to achieve optimum cash flow management, they require rich information to parallel the organisation’s cash flow cycle, global cash concentration, automated internal funding mechanisms for deficit positions and investment options to match individual profiles for liquidity, risk and return.
System control frameworks are absolute. Banks need to have a comprehensive and fully functional framework to manage risk. A European bank representative stated that its group treasury function puts in place a risk framework and the group is granted discretions.
Banks are generally required to hold a minimum level of liquid assets, which may be used in the event of a liquidity crisis. Contingency funding plans have been drawn up to ensure that alternative funding strategies are in place to meet any unexpected liquidity needs of the bank.
A key challenge raised relates to systemic risk, through the use of continuous linked settlement (CLS) solution for foreign exchange settlement risk. Although the creation of CLS has been considered a great achievement within the industry, it does demand additional liquidity from banks. As a result of CLS processes, a significant hold-up in one country’s real time gross settlement system could impact liquidity in other countries. This operational risk implies real time management of intra-day liquidity.
Communication can also become a problem if not dealt with appropriately. It is essential for banking institutions to enhance communication between the treasury function and back-office operational areas. In some organisations, for example, the treasury area still depends on informal lines of communication for updates on operational events that could affect funding. Consequently, the treasury area can often be oblivious to a disruptive event until it is either too late or very expensive to cover the resulting funding shortfall.
Almost every banking institution has its own methodology to measure liquidity risk that they are exposed to. A number of techniques are available, ranging from basic calculations to highly sophisticated modelling. It is important for banking institutions to adopt a technique that is most suitable and to take into consideration the nature, scale and complexity of their activities. It has been found that some of the most common methods currently in use amongst the banks are:
As expected, the gap analysis methodology is the most commonly used technique in the market today. Gap analysis is largely scenario driven and the current challenge for banks is to build in all realistic scenarios. Unfortunately, generating realistic scenarios is delayed as a result of constantly changing conditions. Consequently, banks need to pay attention and make certain that the scenarios are adapted accordingly with the current market conditions.
Many institutions have their own proprietary models and such models have a significant part to play in today’s liquidity risk management – their importance should not be undervalued.
Today, in many cases, banking institutions rely less on large numbers of mostly inert retail depositors for funding, and instead depend more on fewer, large risk conscious wholesale depositors. Banks use a variety of funding sources, including long-term debt and credit derivative issuance. In some banks, funding is spilt between different areas of the organisation e.g. retail, capital markets and equities.
Many banking institutions pay close attention to ratios, which are monitored and in most cases the ratios are reported at the end of each day. The methods that are most commonly used to monitor funding include daily liquidity reporting, sterling stock regime, monitoring of cash outflows and daily monitoring of the funding gap.
A source from one investment bank commented that these methods were standard practice and might be expected to be the same with all clearers. A source from a different bank stated that liquidity is not a significant issue for them as the bank does not have so much of it.
Funding diversification is crucial in ascertaining the level of inherent liquidity risk in an organisation. Factors to assess include the proportion of funding from various types of relationships (e.g. brokers), sources of funds providers and the portion of funding sources with common exposures. Organisations should look at their funds providers to ensure that they do not have common exposures.
One investment bank’s rating is AA, and it is only when a situation occurs where A drops to A1 that funding costs would really be hit. It was suggested that this would be the threshold at which the bank would be concerned, however, at present they are not affected. Some industry experts believe that nobody has the capability to quantify the cost of funds in the event of a downgrade, as this is necessarily an unknown factor. Hence, banks are inevitably forced to rely on best estimates.
In most banks, liquidity risk has become a much more important component of the risk management strategies. As a result of stipulations in Basel II relating to good practice in liquidity management, more preparations are being made by institutions to protect themselves against the potential negative effects of funding liquidity risk.