The liquidity gap: how to manage interdependencies between solvency risk and liquidity risk

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The financial crisis had many lessons to teach the global banking industry, one of which was that there are deep interdependencies between solvency and liquidity.

Roy Choudhury, Peter Marshall and Hovik Tumasyan in our financial services office discussed this relationship in a recent article for Risk magazine, writing that managing these interdependencies will be the key to future growth.

Choudhury, Marshall and Tumasyan say the interdependencies are best discussed within the context of two management functions: first, the setting of risk appetite; second, integrated balance-sheet management and stress testing.

Integration of liquidity risk into the risk appetite
Banks with more advanced risk and capital management frameworks define a risk appetite for their operations as a whole, and are careful to include all the risks assumed in the course of conducting their businesses. This risk appetite consequently provides guidance for setting up a limit framework for various types of risks, such as credit risk, market risk and operational risk.

Inclusion of liquidity risk in the definition of risk appetite takes an intermediated form through its effect on profit and loss (by identifying the highest acceptable costs for funding), and its impact on balance-sheet structure (by defining the size and composition of the liquidity buffer a bank can afford to hold given the high opportunity cost and negative carrying cost associated with liquid assets).

Integrated balance-sheet management and stress testing 
The financial crisis has highlighted shortcomings in governance frameworks and organizational structures that can prevent the formation of a holistic view of the entire balance sheet. When performed correctly, stress tests can help reveal breakpoints in a bank’s business management and strategy.

Unfortunately, these stress tests are often designed as exercises in creating the highest possible loss number. Stress tests also sometimes fail to capture interdependencies between structural elements of the balance sheet and contagion across risk categories.

An integrated view of the multifaceted nature of a bank’s solvency seems to be the missing ingredient. An integrated stress-testing framework framework should be dynamic and forward-looking, with business growth plans, structural shifts in funding profile and capital strategy factored in.