Clock’s ticking on liquidity risk management

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Viewpoint: clock’s ticking on liquidity risk management
By Peter Marshall

From American Banker, 23 June 2010
[reprinted with permission from SourceMedia]

The Basel Committee on Banking Supervision has made it clear that banks around the world must act to improve liquidity risk management strategies. But if they are to be effective, the improvements must be executed throughout an organization.

Timing and components of proposals
When it comes to managing new capital and liquidity standards, banks are under the gun. In December, the Basel Committee released for comment a package of proposals designed to strengthen global capital and liquidity standards. The Basel Committee intends to issue formal liquidity risk guidelines by early 2011. This timetable hastens the need for banks to review and possibly reform their measurement and management of liquidity risk to assure regulators and shareholders that they can withstand future strains.

Individual national supervisors are also developing guidance on liquidity risk management for their banks. And while some regulators may set different time frames, the good news is that there is a global trend toward convergence around the Basel Committee’s proposed liquidity risk management principles and metrics.

The committee’s December proposals feature key ratios for liquidity risk, including: a liquidity coverage ratio to assess the short-term risk profile of an institution to ascertain if it has enough high-quality, liquid resources to survive a period of acute stress lasting one month; and a net stable funding ratio, intended to promote longer-term structural liquidity for less liquid and longer-term assets.

How banks should respond
To respond to these proposals, banks must work to improve certain areas. The increasing empowerment of chief risk officers (CRO) is changing how the treasury function manages liquidity risk. In the past, many banks left tactical risk decisions to a director of liquidity management, who reported to the treasurer. However, many CROs will be expected to provide more information about capital and liquidity to both the board and chief executive officer.

Banks must develop a framework — led jointly by risk and finance — that integrates liquidity risk management with market, credit and operational risk management, as well as economic and regulatory capital management. This will entail day-to-day involvement from the CRO in liquidity management, including defining stress-testing approaches and assumptions.

Leaders from finance and risk will also play a role in improving data quality and timeliness. Today, individual departments have differing abilities to produce granular information that can be used to capture enterprise-wide liquidity risk.

Data convergence requires consistent data tagging and formatting, which makes standardized comparisons possible. Poor data quality can retard the development of enterprise-wide, stress-testing tools.

The formulation of flexible systems for stress-testing purposes is part of a trend toward integrating risk management processes. Indeed, banks will need standardized data for multiple uses.

Charging for liquidity within a bank has often been performed too simplistically or at the wrong level in the management hierarchy to effectively influence business-line behavior. But the regulatory pressure on business lines to mitigate liquidity risk could change this dynamic. Bank executives will need to ensure that internal prices reflect both the true cost of funding and any contingent risk. Accurate and consistent transfer pricing will be a key component in any contingency funding plans that regulators require.

Stress testing for capital and liquidity
The proposals make clear that regulators believe liquidity and capital must be addressed to “strengthen the resilience of the banking sector.” While capital is not typically regarded as an effective mitigant for liquidity risk, some stress scenarios can jointly impact both capital and liquidity. And with new regulatory liquidity ratios to complement existing regulatory capital minimums, balance sheet management needs to consider both constraints.

In response, banks are developing dynamic balance sheet analysis integrated with stress testing. This analysis, performed over longer time horizons (e.g., three to five years), provides senior management with insight into the combined impact of economic, market and other factors on liquidity, capital, earnings and solvency.

Tying compensation to risk
Boards and CEOs are moving to make compensation more risk-based. Delivering effective liquidity risk management plans should be a benchmark for senior bankers, not just for finance and risk officers. However, new metrics will be required to gauge the effectiveness of managers.

Liquidity risk management metrics
The two key metrics the Basel Committee cited as fundamental to gauging liquidity risk — liquidity coverage ratio and net stable funding ratio — should not be viewed as entirely distinct. As with instilling a culture of enterprise risk management, banks will need to make liquidity risk management a priority and ensure that it measures resistance to potential short-term stresses and supports longer-term funding and capital management strategies.

Even if the economic recovery moves toward the more optimistic end of predictions, as demonstrated by the recent market events in Europe, it is clear that liquidity is a core risk that must be managed by banks.

Download the original article from American Banker.


Peter Marshall is a principal in the Financial Services Office of Ernst & Young LLP. Peter is based in New York and can be reached at +1 212 773 1983 or petermarcchall04@ey.com