Embedding the Culture of Comprehensive Liquidity Risk Management

Treasury-run banks continue in their steadfast objective of monitoring mismatch between outflows and inflows to ensure sufficient liquidity to meet funding requirements. It was liquidity, not capital adequacy, which triggered the 2008 crisis. To learn lessons from the crisis and handle Basel III norms that demands higher spreads/volatility and introduces higher costs for liquidity – all in a market that has less confidence – banks now are focused in managing optimal liquidity.

When fervent regulatory imperatives, such as the Basel III Pillar II Internal Capital Adequacy Process’ (ICAAP) demands of quantitative measures and reporting, are added in and complimented by improved transparency, monitoring and controls, liquidity necessitates closer, tighter management.

Banks have realised that they are now far beyond just asset liability management (ALM) and capital computation. Today it is about managing various aspects of liquidity in addition to managing ALM. Over-the-counter (OTC) derivatives have posed a huge risk and the significant lesson from the crisis is to have strong systems that can keep track of assets, along with related collateral management. It is imperative for banks to have a total view across all dimensions, including the management of cross-currency risk, price risk, OTC exposure risk, intra-group liquidity flows between legal entities, and also the processes and controls around the intra-day management of liquidity. These are the broad practices also recommended by the Basel III guidelines.

Real-time Liquidity Information

The need of the hour is a comprehensive approach towards improved governance and control frameworks around liquidity. A strong liquidity risk management (LRM) focus is key for banks to ensure smooth functioning at optimal liquidity cost. A strong LRM focus should provide for the following:

  • Cash is king: gaining real-time cash visibility across bank accounts to do active intra-day liquidity/LRM for optimal use of funds, reduced cost of borrowings and make critical funding decisions.
  • Handle short-term while having clear view of the long-term: make informed and correct long-term strategic funding decisions to withstand severe crisis by generating projected balance sheets and conducting regular stress tests with various assumptions and scenarios.
  • An eye on the OTC derivatives pie: comprehensive counterparty risk management for OTC derivatives with continuous monitoring.
  • Co-operative collaterals: counterparty risk mitigation through collateral and monitoring via margin maintenance, stress testing and reporting.

In addition, the trading book capital adequacy can complement computations for a complete view of the enterprise-wide LRM.

A Room with a View

The chief risk officer (CRO) needs instant information to take decisions. The best way is with a liquidity risk dashboard, which should consist of the following three elements:

  1. A single view of all risk measures, with different measures for various profiles of people.
  2. Effective LRM that involves a comprehensive drill-down facility that provides data at summary, as well as at a granular level, for effective decision-making and root cause analysis.
  3. Early warning indicators on various risk measures for timely action.

Effective LRM requires both top-down and bottom-up approaches. Strategy, principles and objectives are set at board and management levels. It is important to understand that data is the key. Data aggregation across multiple levels (transactional, product, business line, legal entity and firm-wide level) is important to support the daily cash/liquidity management, perform stress tests, and comply with regulatory reporting. The CRO knows that this will help enhance liquidity services to customers.

It is imperative, therefore, that banks build liquidity risk dashboards to better monitor positions and support the need for historical data and analytics. They also need adequate external reporting and analytics capabilities that many other banks lack. The liquidity risk dashboard must provide a unique and aggregated view of liquidity risk that perfectly matches compliance and management needs at the strategic level.

It is All There in the Data

Data is the big challenge in ensuring right the LRM decisions. A number of critical data management issues continue to impede an effective LRM strategy, and these issues can only be resolved through collaborative solutions to maximise the potential of business in today’s challenging environment.

Risk monitoring and decisions should be based on accurate, comprehensive, reliable and timely information. Such large and complex data challenges could be addressed to some extent by having:

  • Multiple modes of data interface from various disparate systems.
  • High performance tools, such as data bunching and volume benchmarking, to support all this with well-built hardware.
  • Using various mapping methodologies to save on the time needed for data format migration.

Conclusion

Given today’s stringent regulations, which are getting tougher day-by-day, liquidity risk is clearly an area that will be given a lot of attention by banks. CROs are looking to implement better systems and controls for Basel III compliance and LRM, which involve pricing of liquidity risk, management of collateral, funding diversification, managing stocks of liquid assets as buffers to mitigate liquidity risk, stress testing, etc. Banks need to have strong data feeds that link up with the CRO’s vision for a comprehensive LRM programme.

16 views

Related reading