Introduction

Liquidity, or the lack of it, is the cause of most of the problems in today’s financial world. Once the credit crunch was in full swing, many banks found that they not able to meet their current and future cash flow needs without impacting on their daily operations or overall financial condition. Many banks failed to perform any liquidity related scenario analyses and did not anticipate that the liquidity inherent in the market would dry up.

Liquidity risk management has now risen as a top concern at many global financial institutions, although some could argue that many firms are now looking to lock the barn door long after the horses have bolted.

With all these new initiatives and attitudes around liquidity many banks are looking at employing additional tools to manage the risk. Those include stress test scenarios, management information systems as well as quantitative and qualitative methods to manage the balance between debt and equity.

Key findings

• FSA Liquidity Adequacy Rule – There is some debate on whether this new rule ignores the true causes of the current crisis.
• MIS Systems - A robust MIS system should be part of any liquidity risk tool set
• Stress tests - Tests employing a wide range of risks and scenarios are the key tool in managing potential risks to liquidity

Conclusion

The purpose of liquidity risk management is to identify potential future funding problems. To do that a bank must have a firm understanding of its net cash flows and the fungibility of it assets. However, there is no one tool to help banks comprehensively quantify liquidity risk. They only way to measure liquidity is by employing a range of tools to asses its current balance sheet and provide analysis of future liquidity positions.

Banks should also not forget about reporting and communication. A large number of banks rely on email for quarterly risk report delivery. A more robust MIS system should be part of any bank’s enhancement to their risk platforms.

However, the most important tool continues to be stress testing. Stress tests should be conducted regularly for several firm-specific and market-wide stress scenarios with the goal of identifying sources of potential liquidity strain. The results of stress tests should also play a key role in shaping the bank’s contingency funding plan.

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Tagged with: 2009, liquidity, Risk Research Report