The acute liquidity crunch in the days and weeks following the failure of Lehman Brothers in the autumn of 2008 has shown the importance of liquidity to financial institutions in general, and banks in particular. Traditionally, banks have taken on significant duration risk by continuously rolling short-term borrowings to fund long-term businesses. Mainstream media has used every opportunity to fault banks for this ‘short-termism’. It wasn’t as if banks weren’t aware of the risks of funding long-term business with short-term money. Ever since the dawn of banking, but more so since the late 1980s, banks have incorporated processes to assess that the risks they take are covered by the capital they hold. This was certainly true for the duration risk arising from the funding model adopted by them. However, the recent crisis has shown a new avenue for failure. A bank could be extremely well capitalised, but inadequately liquid – as with Northern Rock in 2007.
When inter-bank lending froze in the wake of the failure of Lehman Brothers, it quickly became apparent that capital was an inadequate response to a liquidity crisis. Regulators have been quick to note this, and a slew of regulations are now expected around liquidity risk management. The Financial Services Authority (FSA) in the UK was the first regulator to act, with the release of a consultation paper (CP-08/22 – Strengthening Liquidity Standards) setting out new liquidity standards for banks operating in the UK in December 2008. The FSA has subsequently released two more papers in 2009 – one in April 2009 and the other in June 2009. A paper outlining the FSA’s policy statement on the new liquidity standards was issued on 5 October 2009, which reaffirmed the FSA’s intent on going through with the new liquidity standards it had consulted on before.
Other regulators appear to be close to releasing similar regulations around liquidity risk management. The Committee of European Banking Supervisors (CEBS) published their draft guidelines on liquidity buffers in a consultation paper (CP28) issued in July 2009. Besides the absence of a self-sufficiency clause (the most contentious aspect of the FSA guidelines), the CEBS paper’s approach and guidelines are very much along the lines of the guidelines issued by the FSA. The Basel Committee has issued what could be an addendum to Basel II covering liquidity risk in December 2009 – a prescriptive paper rather than the principles-based papers issued in the past. Thus far, the FSA’s paper is the most significant as it clearly outlines an approach to managing liquidity risk and also clearly lays out a timeline to implement by.
While regulatory requirements will vary across regions and regulatory jurisdictions, there are two aspects that appear to be common to all regulations emerging around liquidity risk. First, companies are required to hold a buffer of liquid assets to cover unexpected liquidity demands. Regulators are keen on ensuring that the assets held in these buffers are adequate given the business and that the assets are not only liquid now, but will also be as liquid in a crisis. It appears that the only assets that would qualify are high-quality government bonds, with even cash held in a bank being considered to be subject to liquidity risk. The second aspect is to do with determining the size of the liquid asset buffer a company has to hold.
While neither the FSA nor CEBS has outlined a methodology that companies could employ to determine the amount of liquid assets they need to hold, both bodies agree clearly that stress-testing is an important component of this. Companies will be required to stress their liquidity profiles to determine the extent of risk that is sustainable by the company, which the regulator could compare to the companies’ peer group to determine the extent of risk the company poses from the perspective of the financial system. The FSA in the UK has termed this process the Supervisory Liquidity Review Process (SLRP), the outcome of which will be an Individual Liquidity Guidance (ILG) to the company. Besides giving companies insight into the FSA’s opinion of the companies’ liquidity profile relative to their peers, the ILG is also expected to outline to each company the FSA’s expectation of the size of the liquidity buffer they expect the company to hold. The supervisory process in other regions will probably not vary significantly from this.
State-of-the-art Liquidity Risk Management
Besides the regulatory aspect, there is the fact that a company that is better at managing its liquidity will improve its competitiveness in a market that is already seeing unprecedented stresses. The liquidity buffers companies are now expected to hold mandatorily add to the cost of doing business, while margins are already stretched in difficult circumstances. Therefore, companies need to not only optimise the size of the liquidity buffer they need to hold, but also to leverage this buffer in the best way possible. Companies will also need to understand to what extent each of their product groups or organisation units contribute to this cost. Besides the cost of holding liquid assets, the new requirements also pose new challenges and costs to companies in terms of implementing these new requirements. A key challenge lies in establishing the appropriate mechanism of determining the company’s liquidity profile and in stressing this for adverse conditions.
On a day-to-day basis, the primary source of liquidity risk in a company would be any payment mismatches on its assets and liabilities. A company hits a crisis when that mismatch grows significantly and unexpectedly against the company, i.e. the company faces massive payment demands or outgoing cash flows, to a point where the company cannot match demand and therefore fails to meet obligations in the short-term. Such a crisis is serious even if the company may be otherwise solvent; the company will then need to take drastic measures to survive that would most certainly result in an erosion of value. The asset liability committee (ALCO) of a company has traditionally looked to mitigate and manage this risk with gap and duration analyses available in most asset liability management (ALM) software.
While this may have worked in the past, gap analysis and duration analysis have proven inadequate in terms of being prepared for a crisis, as the credit crunch in late 2008 showed. Companies have taken on enormous duration risk by increasing their reliance on wholesale funding markets, based on the assumption that those markets would always function. ALM looks at duration risk from the point of view of earnings and, as a consequence, capital. Companies generate a spread by borrowing short-term and lending long-term, but this spread is exposed to interest rate change. Spreads could tighten if short-term interest rates go up, leading to lower earnings or even a loss, and consequently to an erosion of capital. Gap analysis, on the other hand, looks at the impact of mismatched cash flows, which brings it close to assessing the risk of illiquidity. However, the assumption has traditionally been that liquidity would always be available and the impact of cash flow gaps is to increase costs (and as a consequence reduce earnings). The possibility of liquidity simply being unavailable is no longer remote, and traditional gap analysis needs to be taken further.
Liquidity products on the market can address these particular gaps in a traditional ALM solution by quantifying this ability of a company to bear adverse cash flow demands. It does this with the use of scenario analysis, so that companies could not only determine their liquidity profile on an ongoing basis, but also helps the company understand the impact to its liquidity profile in stressed conditions.
The fundamental principle this type of product is based on is the fact that capital is an inadequate response to a liquidity crisis. The most relevant means of countering a liquidity squeeze are to draw down on any credit lines available to the company and to repo/sell assets on its balance sheet. Of these, the regulators’ preference is for companies to hold portfolios of highly liquid assets explicitly for the purpose of countering liquidity squeezes, as credit lines are typically revocable and therefore not reliable. We refer to this buffer of credit lines and liquid assets as the company’s ‘counterbalancing capacity’.
Given this, companies need to determine their liquidity exposure and then compare this to their counterbalancing capacity. A situation where the liquidity exposure exceeds the company’s counterbalancing capacity would be disastrous for the company. Companies must focus on the their liquidity exposure and counterbalancing capacity to determine the circumstances that could cause failure due to illiquidity. The first step in this is to determine the company’s liquidity exposure.
The risk to liquidity a company faces arises from the businesses it undertakes. This is more so with financial institutions, as every part of the business is dealing with money, which makes the flow of money all that more vital. Determining the liquidity exposure of a company, therefore, begins with a projection of the cash flows within its various organisations or business groups. Financial institutions typically tend to run their treasury functions centrally, as it gives them leverage of their size or on costs. Even if the treasury function is federated, it is bound be working with multiple organisation units as it is impractical for every organisation unit to have its own treasury function. Liquidity risks would therefore manifest themselves at the treasury department even though the source of such risks is elsewhere. Also, it is the treasury department of a company that holds the liquid assets and has access to the credit lines that form the company’s counterbalancing capacity. As a consequence, it is important that companies are able to aggregate cash flow or transactional data from across its various businesses to determine the company’s liquidity exposure and to compare this to its counterbalancing capacity.
Projecting Cash Flows
A key aspect of determining a company’s liquidity exposure is in projecting cash flows resulting from transactions and behaviour (of counterparties and depositors) across the organisation.
The cash flow projections are typically of a daily granularity and the projections are combined into buckets as they go out in time. For example, the cash flows for the first month may be of daily granularity, while cash flows further out than that could be grouped into monthly, quarterly or annual buckets as required, so that users can easily view cash flow and liquidity profiles to maturity. The cash flows for each bucket are typically broken down into three groups:
- Deterministic or fixed cash flows, i.e. without optional portions.
- Non-deterministic or floating cash flows, i.e. of all positions with optionality.
- Hypothetical or simulated cash flows, i.e. synthetic cash flows or simulated effects of stress scenarios.
These cash flow projections are then translated into a liquidity exposure. This liquidity exposure is compared to the company’s counterbalancing capacity to determine if there is a shortfall of liquidity even after taking the company’s liquid asset buffer and funding sources into account. As a further step, all of these (the cash flows leading to the liquidity exposure and the counterbalancing capacity) can be stressed for different scenarios so that the company can determine what conditions could be disastrous to its operation.
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