Liquidity risk management: more than meets the eye

Moorad Choudhry

In this article – the fifth in a series of six – the author explains why liquidity risk management involves significantly more than simply managing liquidity risk.

The above is not meant to imply that managing liquidity is a minor or easy part of the overall process of managing a bank. Maintaining continuous liquidity is the raison d’etre of banking and as such one can never stress its importance too highly. However in the era of Basel III, which imposes on banks the requirement to originate an optimised balance sheet, another point that needs stressing is how integrated the process of managing liquidity risk must be to the operation of the bank as a whole.

Basel I and II did not address liquidity risk in banks, only credit risk. The academic justification for this omission reflected a certain logic: the assumption that banks perceived to be weak in the area of liquidity would struggle to attract retail deposits, so it was in their own interest to maintain a robust funding regime. Of course in an era of globalisation and liquid wholesale markets, this thinking breaks down – as the 2008 financial crisis demonstrated. The turnaround in banking practice, now that a minimum structural liquidity regime is required by regulatory fiat, is outlined below in Exhibit 1:

Exhibit 1: Liquid assets share of the balance sheet: UK banks 1968-2012

Picture1
Source: Bank of England

A wheel with many spokes

An earlier article in this series (published last March) stressed the urgent need for banks to practice strategic asset-liability management (ALM). This in essence is the art of undertaking proactive balance sheet management, rather than the more reactive traditional ALM more commonly observed in banks.

The same applies to liquidity risk. Its domain is no longer confined simply to cash management and maintaining a pool of liquidity – the most obvious manifestation of which is the liquid asset buffer (LAB) or what the Basel Committee termed the high quality liquid assets (HQLA) portfolio. Rather, it now stretches out to every aspect of the business. This is because anything that impacts the balance sheet is of importance to the balance sheet risk manager.

Consider Exhibit 2 below. It is an extract of the syllabus for ‘Module 4’ of the bank treasury risk management (BTRM) professional qualification. Unsurprisingly this module, which covers liquidity risk, is the longest one in the entire programme. Although we say unsurprisingly, it is actually the only one to include each of the different disciplines falling under its purview.

Exhibit 2: BTRM Module 4 syllabus for liquidity risk management

14.      Liquidity risk management I
15.      Liquidity risk management II: Risk metrics and limits; Derivatives and Collateral Management (CVA, FVA, XVA)
16.      Liquidity risk management III: Liabilities strategy, managing the liquid asset buffer (HQLA);  Collateral management part 2
17.      Internal funds transfer pricing (“FTP”) and funding policies; Asset encumbrance policy
18.      Constructing the bank internal funding curve; Intra-day liquidity risk
19.      Liquidity reporting, stress testing and ILAA process

The remit of the ALM desk must extend far and wide if it is to do an effective job over the cycle, managing liquidity and the attendant risk exposure. In addition to the traditional functions of managing funding and gap risk, the discipline requires understanding and expertise – and the ability to wield influence – in the following areas:

  • Addressing the management information (MI) issues, which include determining a fit-for-purpose suite of liquidity metrics.
  • Collateral management, particularly as regards the impact of using derivatives on collateral funding requirements and the credit, funding and capital valuation adjustments (XVAs).
  • Driving an integrated and coherent liabilities strategy that enables an optimum funding mix of the various types of funding in place.
  • Managing the LAB and administering the LAB policy set by the Assets and Liabilities Committee (ALCO).
  • Understanding issues arising from the encumbrance of balance sheet assets.
  • Oversight of the internal funds transfer pricing policy.
  • Constructing the bank’s internal funding curve.
  • Maintaining adequate intra-day liquidity reserves and reporting.
  • Undertaking regulatory reporting.
  • Preparing and presenting the individual liquidity adequacy assessment process (ILAAP).

As the above list demonstrates, this field extends to every corner of the bank. All business lines will – to a greater or lesser extent – impact on at least some of these areas. Consequently, the liquidity risk management discipline extends directly or indirectly to every part of the bank.

Maintaining best practice

The importance of observing robust liquidity risk management practice should be evident from the foregoing, and is the primary reason behind the detailed content that is “Module 4” of the BTRM.

As was suggested in the introduction, it is not incorrect to think of the ambit of the liquidity risk manager as being confined to managing liquidity. However, the post-crash demands on bank balance sheets (most importantly from regulatory authorities) demands that the ALM function in general and the liquidity risk management department in particular take a greater part in influencing the activities of other parts of the bank. It is a vital multi-dimensional discipline.

 

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