Why Liquidity is Important for Banks
Banks across the globe are facing problems with the liquidity crisis because of poor liquidity management. As every transaction or commitment has implications for a bank’s liquidity, managing liquidity risks are of paramount importance. Liquidity risk has become one of the most important elements in enterprise-wide risk management framework. A bank’s liquidity framework should maintain sufficient liquidity to withstand all kinds of stress events that will be faced. Constant assessment of liquidity risk management framework and liquidity position is an important supervisory action that will ensure the proper functioning of the bank.
Many banks failed to take account of a number of basic principles of liquidity risk management when liquidity was plentiful. Many banks did not have an adequate framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines, and therefore incentives at the business level were misaligned with the overall risk tolerance of the bank. Many banks had not considered the amount of liquidity they might need to satisfy contingent obligations, either contractual or non-contractual, as they viewed funding of these obligations to be highly unlikely. Many firms did not conduct stress tests that factored in the possibility of market wide strain or the severity or duration of the disruptions. Many banks do not have contingency funding plans (CFPs) and even though some banks have CFPs, they were not linked to stress test results.
Liquidity risk is the current and future risk arising from a bank’s inability to meet its financial obligations when they come due. A bank might lose liquidity if it experiences sudden unexpected cash outflows by way of large deposit withdrawals, large credit disbursements, unexpected market movements or crystallisation of contingent obligations. The other cause may be because of some other event causing counterparties to avoid trading with or lending to the bank. A bank is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk has a spiraling effect and often tends to compound other risks such as credit risk and market risk. If a trading bank has a position in an illiquid asset, its limited ability to liquidate that position at short notice will lead to market risk. A position can be hedged against market risk but still entail liquidity risk. In the case of the Metallgesellschaft debacle in 1993, futures were used to hedge an over-the-counter obligation. Liquidity crisis was caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions that ultimately ended in bankruptcy.
The Basel Committee on Banking Supervision (BCBS) has recently revised the guidance that was published in 2000 substantially in light of the lessons learned from recent market turmoil. The revised principles for sound liquidity risk management and supervision are robust and intended towards establishing a sound framework for liquidity risk management. The revised principles underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management framework. The Basel Committee’s principles seek to raise standards in the following areas:
The Basel Committee wants the principles to be implemented in commensurate with the size and nature of the bank’s operations. The revised principles also envisage a greater role for supervisors in terms of supervisory review and intervention at an appropriate time by the supervisors.
Even though there is no capital charge on account of liquidity risk management, the guidelines are so robust that liquidity risk management qualifies as a separate branch in the risk management space like credit risk, operational risk and requires a lot of attention from all corners of the bank for its survival. The threat of becoming insolvent or subjected to bad publicity and reputational damage if the liquidity risks are not maintained properly is what banks least want to happen.
BCBS has recently issued guidelines for management and supervision of liquidity risk. The principles have been categorised under different areas:
A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources.
A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.
There have been many incidents in the recent past that necessitated the implementation of robust liquidity risk management framework. Recent market turmoil highlighted the loopholes in the entire liquidity risk management framework of the banks. Regulators across the globe have identified liquidity risk as yet another important area that needs to be addressed immediately. Illiquidity will have a direct bearing on the bank’s day-to-day functioning and will lead to reputation risk.
Liquidity risk needs to be managed in addition to credit, market and operational risks. Because of its tendency to compound other risks, it is all the more important to manage liquidity risk effectively. Setting up an asset liability management framework is a first step towards this. Day-to-day analysis of future cash inflows and outflows will provide useful information in this regard. Also, stress testing is an important measure that will aid the systematic cash flow analysis. If a bank is overly exposed to the markets, scenario analysis is one important way by which a reasonable understanding on liquidity positions can be achieved. Multiple scenarios can be created for various market movements and default structures and scenarios can be developed based on this.
1Principles for Sound Liquidity Risk Management and Supervision, June 2008, Bank of International Standards.
Related reading: What are the objectives of liquidity management?