Liquidity Risk Mitigation and Management During a Credit Crunch

In this year’s third annual gtnews cash management survey, Cash Management Survey 2008 Reveals Liquidity is Corporate Priority in association with SEB, over 52% of corporate respondents said that financial risk management and mitigation was a high level of responsibility for them and their treasury department. This was second, only behind cash management, as the area of highest responsibility for treasurers. Clearly a major reason for this is the liquidity crisis in the global markets and the sharp focus that this has brought on liquidity risk.

A New Approach to Risk

The approach to liquidity risk mitigation is the dominant theme in the article The Five Changing Faces of Risk Management, by Philippe Carrel of Thomson Reuters. Carrel explains how different areas of corporate risk, such as valuation risk, settlement risk and regulatory risk, are interlinked as they all have a direct impact on the company through the validation of its balance sheet. “Liquidity is the ultimate reward or punishment for the sound management of the other risks combined,” states Carrel. Issues with liquidity can arise from poor risk management policies in areas such as funding, portfolio and collateral management, counterparty management, failed settlements and other operational issues. It is because of the structural web that interlinks these issues that liquidity risk cannot be seen as a stand-alone area. Rather, it should be perceived as the ultimate operational risk.

Sources of Liquidity Risks

Thomson Reuters’ Carrel highlights three main causes of liquidity risk:

  1. Market liquidity risk – the risks that assets held in portfolio or pledged as collateral may be mispriced or simply impossible to sell due to adverse market conditions. This is made worse in the world of structured finance where, with the lack of transparency of the underlying assets, money managers have stopped investing in these assets thereby drying up liquidity.
  2. Funding liquidity risk – the funding and funding costs associated with the lending books. Reflecting the lack of transparency in the industry banks have limited lending lines in the interbank market leading to a drying up of funds affecting most credit markets.
  3. Counterparty-driven liquidity risk – the liquidity risks related to a counterparty’s unfulfilled obligations, missed or overdue settlements. Causes can stem from either financial problems with the counterparty, connectivity failures and especially from data mismanagement. The latter occurs across straight-through processing (STP) systems linking risk takers with their execution venues, brokers, custodians and administrators. These systems require complex and frequent database alignment. Failure to process transactions in a timely manner may result in payment failures which, in times of extreme market conditions, can disrupt the firm’s liquidity management.

Funding Liquidity Risk

In Funding Liquidity Risk: Addressing the Challenges, Robert Smith, of Lepus, looks at the latest industry trends in this area. Smith describes how research into funding liquidity risk in the past six months has shown that the way it is perceived in the financial services industry is beginning to change. It is now a high profile area of risk management and, as such, it is receiving greater attention from banks and regulators than ever before. “One industry source that Lepus has spoken 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,” states Smith.

With this greater focus, financial services organisations need to establish or enhance their metrics for measuring and managing funding liquidity risk. The approach to this can vary quite significantly depending on the characteristics of the organisation. However, Lepus’s Smith defines three main methods:

  1. Liquid assets approach – the organisation maintains liquid instruments on its balance sheet that can be drawn upon when needed.
  2. Cash flow matching approach – the organisation attempts to match cash outflows against contractual cash inflows across a variety of near-term maturity buckets.
  3. Mixed approach – a combination of the previous two.

In his article, Smith highlights the importance of the diversity of measures used, as they all offer slightly different insight and visibility. The approach of an industry source that he spoke to includes holding a stock of liquid assets as a percentage of liabilities, while having detailed rules in place to define a liquid asset. This source also monitors its projected cash flow against various stress scenarios. In terms of the organisation structure, funding liquidity risk metrics are usually part of board-approved documents that identify liquidity limits and approval levels. These will also highlight the individuals accountable for setting limits and exceptions.

Planning for when the funding liquidity risk metrics have their limits breached, Lepus’s Smith highlights that it is vital to have a flexible response strategy that is able to cope with a variety of possible risk events – such as default probability, credit spreads or stock market volatility. A rigid step-by-step plan may not be able to cope with the variety of these risks, but having a series of different scenario responses prepared can allow management to decide on an appropriate response. This response can also then be tailored to the risk event on an ongoing basis.

Counterparty-driven Liquidity Risk

One of the other main sources of liquidity risk that Thomson Reuters’ Carrel identifies in his article is counterparty-driven liquidity risk. This is related to a counterparty’s unfulfilled obligations, missed or overdue settlements. A recent ruling in the US courts related to counterparty-driven liquidity risk is the focus of How Can US Oversecured Creditors Receive Interest at Default Rate?, an article written by John Francis Hilson and Professor Stephen L. Sepinuck from Paul Hastings. In a decision favourable to secured lenders, the US Court of Appeals for the Ninth Circuit ruled in General Electric Capital Corp. (GECC) versus Future Media Productions, Inc. (Future), that oversecured creditors are entitled to receive interest on their claims at the default rate set in their contract.

The roots of this ruling go back to March 2005, when Future went into default on a US$10.5m term loan and a US$5m revolver from GECC. The loans were secured by a first-priority security interest in substantially all of Future’s assets. The default event caused the interest rate on these loans to increase by 2% per annum. Then, in February 2006, Future filed a Chapter 11 bankruptcy petition. Pursuant to a stipulation agreed to by the parties, GECC agreed to allow the debtor to use its cash collateral and the debtor acknowledged that it owed GECC about US$5.4m, which sum included interest at the default rate. The Creditors’ Committee objected to that stipulation, but to facilitate a resolution of the matter, all of the parties agreed that the debtor’s assets would be sold and about US$5.7m of the proceeds would used to pay off GECC in full, including interest at the default rate through 20 April 2006, subject to a later determination regarding what amount of interest was allowable.

Later, the Creditors’ Committee wanted GECC to return US$165,000, which was the amount it was claimed to have collected over the pre default interest rate. The Bankruptcy Court ruled that GECC was not entitled to interest at the default rate, based on a previous decision from the Ninth Circuit but, when GECC appealed, the Ninth Circuit reversed the decision of the Bankruptcy Court.

This ruling by the court benefits secured lenders in this area of counterparty-driven liquidity risk. As Paul Hastings’ Hilson and Sepinuck explain, the ruling “unquestionably allows oversecured creditors to recover interest on their claims at the default rate, at least in some instances.” However, they are left with a couple of important questions from the ruling:

  1. Which oversecured creditors are entitled to interest at the default rate? Could a creditor whose loan agreement provides for double or treble the interest after default find they have their claim disallowed, either under state law or some bankruptcy principle of equity?
  2. If some oversecured creditors are denied interest at the default rate, does that apply only to both pre-petition and post-petition periods, or only to the accrual of interest post-petition?

No doubt there will be future legal actions in the area of counterparty-driven liquidity risk as oversecured creditors find out how much, if any, interest at the default rate they are entitled to. It’s certainly something worth checking with your lawyer! New developments in the legal and regulatory world, such as this ruling by the Ninth Circuit, occur on a regular basis at national level and also internationally through the regulators. It is therefore important for organisations to keep up to date with these developments in order to ensure that their liquidity risk strategy is compliant and follows best practice.

Mitigating Liquidity Risk

When it comes to a framework for mitigating liquidity risk, Thomson Reuters’ Carrel suggests that organisations should not only prepare liquidity buffers as a counterbalance to the risks, but that they should also carry out a fundamental review of risk factors and their alignment with the risk policy of the firm. “This is not straightforward as the risk factors a firm is exposed to may not be immediately visible, especially where securitisation and derivatives are involved,” advises Carrel.

Every organisation should tailor its own counterbalancing framework in the context of its own exposure, exposure of its clients, and the nature of the business and then align it with the approved risk policy. In order to make this framework operate successfully across the entire organisational structure, there also needs to be transparency. “As the sound management of such sensitivities and the capacity of the risk managers to pre-empt on those risks will be eventually rewarded or punished with liquidity implications, we can conclude that the most important aspect of the new risk management is transparency,” explains Carrel. This transparency should cover pricing models, clarity of processes, counterparty relationships, connectivity and IT setup, regulatory compliance and the adequacy of the overall framework with the shareholders’ collective appetite for risk.

Hopefully, in light of the current sharp focus on liquidity and liquidity risk, the new risk mitigation and management techniques discussed across industry sectors today will be implemented in a thorough and transparent fashion across the entire enterprise, consigning departmental or siloed risk management to the past.

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