Funding Liquidity Risk: Addressing the Challenges
Due to the events of the ongoing credit crisis, it is of little surprise that the issue of liquidity, and more specifically, funding liquidity has once again come to the fore. Previous research into liquidity in April 2005 cited that liquidity risk management would hold greater significance with the introduction of the Basel II regulations and that “the key issue for financial institutions now is to make sure that they are fully prepared in situations where liquidity risk does become a problem.” Clearly, given the events of the past year at Northern Rock and Bear Stearns, coupled with the whispers that another major bank is struggling with liquidity issues, some firms are still not adequately prepared for sustained macroeconomic illiquidity.
Lepus research into this area in the past six months has shown that the way funding liquidity risk is perceived in the financial services industry is beginning to change. Without doubt, it has become a far more high profile component of risk management and, as such, it is receiving greater attention from banks and regulators alike. One industry source that Lepus spoke to recently stated that they felt regulators are inevitably beginning to focus on liquidity risk in a bid to prevent a repeat performance of the current liquidity crisis.
Certainly, banks have sought to put in place policies and procedures to aid the management of funding liquidity risk but have often cited a lack of industry standardisation and regulatory guidance on ‘best practice’. More specifically a source from a major tier-1 bank called for the global formalisation of qualitative guidelines for funding liquidity risk and emphasised the need for consistency. This is as opposed to the inconsistent patchwork of regulations that banks are currently forced to adhere to. When the Basel capital adequacy regime was being discussed the potential of a parallel Basel liquidity adequacy regime was also considered. Though this idea was eventually dropped it looks highly likely that it may be looked into again in the near future.
Due to the lack of standardisation or clear guidelines from regulators, it is of little surprise that the current procedures for liquidity risk management vary throughout the industry. Recent Lepus research found that the most common approach is for institutions to have a centralised strategy that is then filtered down through to subsidiaries. However, due to the lack of standardised global regulation, it is also necessary to give some level of responsibility to individual regulated entities. Exemplifying this approach, a bank recently consulted by Lepus indicated that they have a group liquidity policy in place and that they have rolled out a liquidity risk management system to all bank entities. However, they also have local limits and monitoring processes in each entity and foreign subsidiary.
Banks have emphasised to Lepus the importance of using quantitative metrics that relate to the nature of their business. As such, just like the organisational structure, the quantitative metrics employed for funding liquidity risk management vary significantly from bank to bank. The three main approaches taken by banks are:
An industry source that Lepus spoke to highlighted the importance of the diversity of measures used stating that they all offer slightly different insight and visibility. Their approach includes holding a stock of liquid assets as a percentage of liabilities and they have detailed rules in place to define a liquid asset. They also monitor their projected cash flow against various stress scenarios.
Though it is important to have these metrics in place it is not always necessary to assign prescriptive limits. For some metrics, it is preferable to have a more flexible target range or to simply monitor for historical trends. In the current economic climate of almost unprecedented market illiquidity it is vital that limits and targets are monitored and adjusted to reflect market conditions. The bank mentioned previously has limits on the projected cash flow measure for each sight. They monitor but do not limit their advance to deposit ratio and depositor concentration levels.
These metrics are generally incorporated into board-approved documents identifying liquidity limits and approval levels as well as highlighting the individuals accountable for setting limits and exceptions.
Having decided which metrics will be monitored and which will have set limits, it is possible to work towards contingency plans that can be executed once certain limits are breached. It is important that the pre-defined responses are flexible enough to cope with the individual situation, rather than having a rigid step-by-step plan. This point was reflected in the approach taken by a leading bank we spoke to. Rather than having a step-by-step approach they prefer to have a menu of options that can be used to best suit the situation. When they see early warning signs of liquidity issues they step up the flow of information around the bank and hold a contingency funding plan meeting every day to ensure that people know exactly what the situation is and discuss how best to tackle it.
Banks we have spoken to in the past monitor a number of early warning signs including high volumes of withdrawals from ATMs, default probability, credit spreads, and stock prices. Further to this, most banks pay close attention to the views of market experts and front office personnel.
One of the key methods for analysing exposure to liquidity risk is scenario analysis. This area of liquidity risk management continues the theme of varying by business entity and geographical region. Obviously different businesses are affected by a given scenario in different ways. The benefit of scenario analysis is that it allows banks to hypothesise how they will be affected and how they might react to ‘worst case’ market events. Popular scenarios include the stock market crash of 1987, the US liquidity crunch of 1990, the fall of Long Term Capital Management (LTCM) in 1998, and the terrorist attacks of 11 September 2001.
Further to this, banks use geographical crisis scenarios, such as the East Asian crisis or Mexican crisis and also look at market specific scenarios typically involving the impact of downgrades. Given the events of the past 12 months there is little doubt that banks will also use the scenario of the 2007/2008 credit crisis in the future.
One bank that we spoke to stated that they use both firm and market specific scenarios based on some of the aforementioned historic events. Further to this they look at the effect of the bank being downgraded by one and three notches. Following the scenario analysis they model the steps that would need to be taken in order to meet any funding shortfall. This bank considers eight weeks to be the critical time span in a liquidity crisis and they monitor the cash flow over this period.
In the event of a liquidity crisis the responses and contingency plans that were determined from the scenario analysis can be put into action to help minimise the damage to the bank and its customers. It is important to consider how changes to management may be required to ensure the successful implementation of these contingency plans. One such change described by interviewed banks was a central unit taking control of asset sales in order to generate necessary funds. Another change involved adjusting liquidity limits and relying on business units to adjust portfolios accordingly.
One bank representative stated that in the event of a crisis, a central team chaired by the chief risk officer, immediately assumes control for all funding liquidity risk management issues. It was thought that this approach makes them better positioned to deal with changing market conditions as they are able to react immediately.
The past 12 months has seen industry perception of liquidity shift dramatically. Prior to the liquidity problems at Northern Rock, regulators focused far too much attention on solvency and capital adequacy issues. The lack attention and guidance from regulators has forced banks to adopt their own strategies for liquidity risk management, resulting in unclear and disjoined industry standards. It is highly likely that the void of global liquidity regulation will be filled in the not to distant future, as regulators struggle to prevent a recurrence of the current economic downturn. As previously mentioned, the possibility of a Basel Liquidity adequacy regime has been discussed in the past and this is something that may now be looked at far more seriously.
Ultimately, the prevention of another liquidity crisis lies in the hands of the banks. One would hope that other banks will have learnt from the tribulations of Northern Rock and Bear Stearns that relying on financial markets for funding can be dangerous. Indeed, in the wake of the Northern Rock debacle the Governor of the Bank of England cited that in the 1950s banks held as much as 30% of assets in liquid assets, today that figure is closer to 1%.
The only silver lining to the ongoing credit crisis is that liquidity risk is now viewed as a far more high profile component of effective risk management and through greater standardisation and guidance from regulators we may be able to prevent something similar happening in the future.