Liquidity risk management is key to success in the new economy ahead

(As originally appeared in FEI Canada F.A.R. member e-newsletter, January 2010)

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By Rudolph Persaud, Executive Director and Leader, Risk Management Advisory Services, Ernst & Young LLP and Simona Brancus, Senior Manager and Leader, Quantitative Advisory Services, Ernst & Young LLP

In the wake of the global financial crisis, organizations are learning that an effective liquidity risk management strategy is key to helping them respond quickly in the event of extreme market events. Those leaders who incorporate this lesson from change into their business are set to emerge stronger from the recession — and will be in a better position to succeed in the economic landscape ahead.

Today’s market is in a state of flux as new regulations and reporting standards are emerging, and investors, stakeholders and regulators are taking a more critical look at how organizations are managing their liquidity risk. The market is demanding better governance, management and measurement of liquidity risk and the establishment of higher standards for organizations to implement. Liquidity risk has become one of the top priorities for global regulators — who are requiring more robust liquidity management frameworks, which have become the new industry normal for all organizations.

To succeed in such an environment, leaders need to be prepared to respond quickly to change by ensuring they have the financial resources on hand to meet sudden obligations, such as an increase in raw material costs, a change in the foreign exchange rates, the introduction of a new product to the market, or a change in the pricing strategy for a mature product. A well-planned and -implemented liquidity risk management strategy will help improve the organization’s readiness for unexpected events — boosting market reputation by raising the confidence of investors.

An effective strategy of this sort involves leadership from senior management who need to continually monitor and revisit the organization’s liquidity position, and ensure a buffer of liquid assets is in place to meet sudden funding gaps. For the longer term, it’s a good idea to hold additional capital reserves to enhance the solvency of the organization.

If your organization hasn’t already done so, now is the time to develop a liquidity risk strategy that reflects the challenges of today’s environment — and takes into account the possibilities in the future economy. Here are some key risk issues directors should be thinking about now:

  • Implement a board-approved liquidity risk policy statement, and be sure it is continually updated and improved.
  • Incorporate a sound process for senior management to identify, measure, monitor and control liquidity risk, and report to the board on a regular basis regarding the development of these issues. Your organization should be ready to fulfill payment obligations at any time throughout the day.
  • Establish a secured liquidity contingency plan that addresses the responsibility of each business unit and the actions to be taken in the event of a crisis.
  • Secure diversified external funding sources, and test them during normal operations.
  • Consider and discuss the impact of a credit downgrade on your organization’s unsecured funding sources.
  • Establish an internal transfer-pricing system for liquidity risk that would charge back the cost of funding to your business units. The costs to maintain a maturity funding structure and standby lines should be passed back to the business origination units. 
  • Look at ways in which you can best communicate the importance of liquidity risk to your leaders and to your people.

The economy may be back from the brink today, but doing business has changed for good. A new performance agenda is emerging as companies respond to the new normal and prepare for the future. Managing risk of all kinds has become a major focus for the global business community, government and regulators. Organizations that are adaptable and able to respond quickly to change and opportunity are succeeding. And it takes a risk plan that accounts for all scenarios to make this possible.

It’s time for directors and senior management to re-evaluate their business model and ensure liquidity control structures, risk governance, modelling, stress-testing contingency planning and reporting provide an adequate level of protection.