Why Liquidity is Important for Banks

T.Vijay Kumar, BMR Advisors - 12 August 2008

Due to its tendency to compound other risks, liquidity risk must be managed effectively by banks. This article looks at the causes of liquidity risk and offers advice on how to manage these factors.

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.

What is Liquidity Risk?

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.

Figure 1: Causes of Liquidity Risk

 

Basel Committee's New Guidelines

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:

  • Governance and the articulation of a firm-wide liquidity risk tolerance.
  • Liquidity risk measurement, including the capture of off-balance sheet exposures, securitisation activities, and other contingent liquidity risks that were not well managed during the financial market turmoil.
  • Aligning the risk-taking incentives of individual business units with the liquidity risk exposures their activities create for the bank.
  • Stress tests that cover a variety of institution-specific and market-wide scenarios, with a link to the development of effective contingency funding plans.
  • Strong management of intraday liquidity risks and collateral positions.
  • Maintenance of a robust cushion of unencumbered, high quality liquid assets to be in a position to survive protracted periods of liquidity stress.
  • Regular public disclosures, both quantitative and qualitative, of a bank's liquidity risk profile and management.

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 Principles for the Management and Supervision of Liquidity Risk

BCBS has recently issued guidelines for management and supervision of liquidity risk. The principles have been categorised under different areas:

Fundamental principle for the management and supervision of liquidity risk

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.

Governance of liquidity risk management
  • A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.
  • Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity.
  • A bank should incorporate liquidity costs, benefits and risks in the product pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.
Measurement and management of liquidity risk
  • A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk.
  • A bank should actively manage liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.
  • A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding.
  • A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.
  • A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets
  • A bank should conduct stress tests on a regular basis for a variety of institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank's established liquidity risk tolerance
  • A bank should have a formal CFP that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations.
  • A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources.
Public disclosure

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.

The role of supervisors
  • Supervisors should regularly perform a comprehensive assessment of a bank's overall liquidity risk management framework and liquidity position to determine whether they deliver an adequate level of resilience to liquidity stress given the bank's role in the financial system.
  • Supervisors should supplement their regular assessments of a bank's liquidity risk management framework and liquidity position by monitoring a combination of internal reports, prudential reports and market information.
  • Supervisors should intervene to require effective and timely remedial action by a bank to address deficiencies in its liquidity risk management processes or liquidity position.
  • Supervisors should communicate with other supervisors and public authorities, such as central banks, both within and across national borders, to facilitate effective cooperation regarding the supervision and oversight of liquidity risk management.
The importance of revised guidelines

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.

Conclusion

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.

Reference

1Principles for Sound Liquidity Risk Management and Supervision, June 2008, Bank of International Standards.

Back to top