Impact of the Credit Crunch on Liquidity Risk Management
History is littered with hubristic assertions that ‘this time things are different’. Just as the collapse of communism heralded a new world order where nationalism and ideology would play no further part in geopolitical affairs, and the dot com boom seemingly undid the historical relationship between price and earnings, so the inexorable rise in credit derivatives characterised a world where risk was spread so thinly that no one would be caught out should the cycle turn.
As a sailing instructor once told me (reassuringly) – the seabed is covered with the wreckage of ill-fated optimism. The recent publications from the Global Public Policy Committee, a collection of the world’s largest accounting companies, and significantly from the Basel Committee on Banking Supervision, the body of G10 banking supervisory authorities, can leave no one in any doubt – if the billions of dollars in losses suffered by some of the world’s leading financial institutions hadn’t already (which a leading economist thinks could top US$1 trillion in total1 – that the ramifications from the recent market turmoil will be with us for some time to come.
For someone reasonably well versed in the theoretical and practical machinations of Basel II, the regime implemented by banks to align their capital base with real economic risk that has swallowed hundreds of millions of IT implementation dollars over the last five years, it is somewhat ironic that even well capitalised institutions have struggled with a problem as fundamental to their existence – liquidity.
If you need profitability (retained – in the form of capital – to absorb losses in future years) to sustain a viable business, then you also need cash flow to ride the peaks and troughs of the business cycle. And that is as true for a self-employed plumber as it is for a tier one global investment bank. So why are some of the world’s most sophisticated financial institutions getting caught out by an issue as fundamental to managing a business as cash?
As ever, the answer lies not in a single reason but in a number of dynamics that have been in play over a number of years. While taking some years to materialise, they precipitated a series of shocks – 25 standard deviation events in a week, according to one commentator – during a period in late summer of last year almost unprecedented in recent history.
Cash, in the form of liquidity, defined as the ability to fund increases in assets and/or the ability to meet obligations as they fall due, is at the forefront of this severe market disruption.2 And while triggered by defaults on a relatively small slice of the US mortgage market, that of ‘sub-prime’ borrowing in the latter half of 2006/early 2007 (brought on by a period of monetary tightening by the US Federal Board during 2006), the widespread use of, and investment in, structured securities and leveraged financing has ensured global fall out across debt, equity and derivative markets.
As credit losses materialise, on both direct and indirect exposure to sub-prime and securitised loans, so institutions become much more circumspect about their exposure across the board, including the extension of funding liquidity to other market participants. As the sentiment to hoard cash starts to prevail, levels of market liquidity tighten exacerbating the fall in the value of financial instruments – a double liquidity hit which only concerted central bank and policy maker intervention can attempt to mitigate.
And set as a backdrop to this ever more tangible crisis – witness the recent UBS extraordinary general meeting (EGM) to hear the voices of real shareholder anger at the perceived culpability of senior managers gambling the capital of the firm ‘in an exotic casino’ – are a series of developments that the BCBS determines have transformed liquidity risk in recent times.
Using our definition of funding liquidity from above, it is possible to view the aim of liquidity risk management as ensuring an institution’s continued ability to fund assets and meet obligations as they fall due. Estimating future cash flow requirements therefore lies at its heart, in both benign and stressed conditions. Two key developments have clouded that forecasting – the rapid increase in asset securitisation and the use of complex financial instruments over the past decade.
Devised as a way to sell on illiquid assets hitherto tied to the balance sheet, either their own or third party (i.e. as a revenue stream), banks as originators are often committed to providing liquidity to the holders of the securities in the event of certain pre-agreed conditions occurring. That contingent funding liability can happen at a time when the funding picture is already stressed and can arise unexpectedly. The process of securitisation i.e. pooling assets, selling to a special purpose vehicle, obtaining credit ratings and issuing securities, in itself takes time, ingenuity and investor confidence which with market difficulties can result in a bank warehousing (and funding) the underlying assets for far longer than planned.
The increasing complexity of financial instruments makes liquidity forecasting particularly challenging. Difficulties in pricing highly bespoke instruments, the lack of historical track record in predicting their cash flows and correlations with other instruments, as well as ’embedded optionality’ clauses and features complicates an assessment of liquidity profile.
Volatility in liquidity demand further distorts the funding horizon, as the collateral attached to underlying exposure – most likely in the complex instruments referred to earlier – is frequently called on an intra-day basis and through its very nature is subject to the vagaries of the wider markets. And even cash transfers – in the form of payments – are frequently performed intra-day and cross-border, adding operational risk to the transfer. Additionally, the trend for greater reliance on capital markets to meet funding requirements – in the form of money market instruments, such as commercial paper and repurchase agreements, for example, which typically has shorter maturities than other more traditional forms of liability (such as deposits) can add significant spikes to demand. In a stressed market the maturity mismatch can unnerve creditors, ultimately causing them to pull financing and forcing the hapless institution to the lender of last resort – the central bank (with all the associated moral hazard).
The congruence of these trends spells danger for institutions that span a multitude of business lines, markets and geographies, not least for those that have added large investments in asset backed securities, particularly real estate, to their balance sheets (whether on or off). The regulators, and bodies that inform them such as the BCBS, are set to issue guidelines (seemingly at the more ‘prescriptive’ end of the spectrum) in the near future. EU internal market commissioner McCreevy has confirmed that amendments to Basel II to reflect liquidity risk (and large exposures) will be issued to EU member states no later than October this year. Focus appears to be directed to the following areas: stress testing and analysis, liquidity planning, reporting and disclosure, and policy.
The validity and use of financial models have come in for particular criticism by those caught unawares by the nature, magnitude and duration of the shock across the financial system. Conveniently ignoring the siren voices predicating a turn in the credit cycle as early as June 2007, when the rising yield on 10 year US treasuries over the Federal funds rate marked the end to an era of rock bottom financing, there is mileage in their claim that the parameters for stress testing were set far too narrowly. Focussing on idiosyncratic or firm-specific shocks is one thing, capturing the implications of market wide events or affecting multiple markets or currencies simultaneously would have been much more valuable. More rigorous and comprehensive stress testing will be called for.
As institutions struggle to raise cash, including it is rumoured some of the more venerable names of Wall Street,3 the existence of and access to contingent funding is paramount. A modification/ strengthening of contingent funding planning, including better integration with the ‘what if’ outcomes arising from stress testing and a more realistic assessment of the market liquidity of certain structured products, are seen as requisite actions. Moreover, the dents to reputation suffered by institutions having to bail out off balance sheet vehicles for example need to be incorporated into assessing liquidity buffers, as part of the planning.
Stronger links between treasury departments and business lines, in assessing the liquidity risk of new products and business practises, and more generally the internal transfer pricing mechanism used to fund asset accumulation, are being emphasised. Just as capital allocation decisions depend on an understanding of risk adjusted return from the business, so the cost of funding that return including its implication for liquidity will have to be considered. Institutions that have invested in an infrastructure that considers the funding picture across asset classes, tying the views of trading, funding projection and treasury teams into a more centralised whole are the ones that will prosper.
Just as for capital adequacy under Pillar 3 of the Basel II Accord, greater scrutiny on the reporting and disclosure of liquidity risk will be a key theme for supervisors. The UK regulator has been severely criticised for not detecting the ticking time bomb that was the asset/liability mismatch inherent in Northern Rock’s business model. Both regulatory bodies and the market will demand enhanced monitoring, control and scrutiny of the funding and liquidity profile of businesses.
And weaving these strands together is an expectation for an overall liquidity strategy, comprising elements ensuring adequate information systems, processes to assess future cash flows and net funding requirements, specific approaches for the management of foreign currency flows, stress tests, limits, independent review and communication.
The prevailing theme then is a consideration of cash as an instrument that needs to be managed extremely tightly, in terms of funding and liquidity risk. Global treasury departments, fresh from the challenges of complying with the Basel II Capital Accord in relation to regulatory capital calculation and disclosure, now face growing scrutiny in their management of cash capital. Those with cash management stamped to their corporate DNA are going to find the path to stability a lot easier, as market, regulator and shareholder pressure increases.
By and large banks that have suffered falls in profitably or in extremis full year losses have been pretty adept at repairing balance sheets and restoring capital solvency. Less clear will be their ability to address challenges over liquidity and the management of cash.
1 Financial Times, 25 February 2008, Gillian Tett (FT Global Markets Editor) interview with George Magnus (UBS Senior Economic Adviser).
2 From ‘Sound Practices for Managing Liquidity in Banking Organisations, BCBS, February 2000.
3 At the time of writing, the events surrounding the ‘fire sale’ of Bear Stearns to JP MorganChase had not yet materialised.