Liquidity Risk – What it is and why it matters

Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank’s inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).

Prior to the global financial crisis, financial institutions of all shapes and sizes took liquidity and balance sheet management for granted. But during the crisis, many institutions struggled to maintain adequate liquidity and appropriate balance sheet structure, which led to both bank failures and the need for central banks to inject liquidity into national financial systems to keep the economy afloat.

As the dust from the crisis began to settle, one thing became clear: Banks and capital markets firms need to do a better job managing their liquidity and balance sheets. And self-preservation isn’t the only motive for doing so. The consequences of poor asset-liability management can reach far beyond the walls of any one financial institution. It can affect the entire financial ecosystem and even the global economy.

Regulatory bodies are doing their part to prevent another financial crisis in the future. The onus is now on the financial institutions themselves to shore up liquidity risk and balance sheet management, both for the good of the firm and the economy.

Liquidity risk management defined

Liquidity risk management and ALM encompass the processes and strategies a bank uses to:

Ensure a balance sheet earns a desired net interest margin, without exposing the institution to undue risks from the interest rate volatility.
Plan and structure a balance sheet with a proper mix of assets and liabilities, to optimise the risk/return profile of the institution going forward.
Assess its ability to meet its cash flow and collateral needs (under both normal and stressed conditions) without having a negative impact on day-to-day operations or its overall financial position.
Mitigate that risk by developing strategies and taking appropriate actions designed to ensure that necessary funds and collateral are available when needed.

The role of balance sheet management

Balance sheet management, through strategic ALM, is the process of managing and optimising assets, liabilities and cash flows to meet obligations. Effective ALM not only protects financial institutions against risks of falling net interest margins and funding crunches, it also offers an opportunity to enhance value by optimising reward versus risk. Thus, it broadly covers portfolio accounting, analytics and optimisation. It relies on a suite of tools for transaction capture, forecasting, interest rate risk measurement, stress testing, liquidity modelling and behavioural analytics.

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3 forces driving modern asset liability management strategies

Challenges to successful balance sheet management

No centralised view of balance sheet management. Siloed departments and business units limit a firm’s ability to understand its balance sheet positions (especially those which involve optionality and customer behaviour) or effectively assess the impact of illiquid assets and asset classes across geographies, business units and asset classes.
Limited analytic capabilities. Without sufficient analytics, firms have extreme difficulty projecting cash flows and net interest margins for underlying transactions, particularly when those transactions number in the millions.
Insufficient stress testing. Because too many firms have commonly ignored trading and funding liquidity considerations in stress testing, they are unprepared for the impacts of market shocks, making it hard for them to get out of positions easily or to attract new funding.
Overcoming the compliance mindset. If firms focus too much on the compliance requirements surrounding balance sheet management, they may overlook the business benefits that can be gained.

3 steps to successful liquidity risk management and ALM

To institute an effective liquidity risk management and ALM system at your organisation, follow these three steps:

Establish an analytic framework for calculating risk, optimising capital and measuring market events and liquidity.
- Minimise the impact of market shocks, and look for better arbitrage opportunities, by analysing the effects of changes in cost and liquidity in near-real time so you can act with precision.
- Quickly find optimised solutions to your firm’s liquidity and capital needs by evaluating market liquidity and firmwide optimisation scenarios using rapid, on-demand scenario analysis based on the most complex portfolios, positions and instruments across multiple time horizons.
Manage your data.
- Gain a centralised view of firmwide interest rate and liquidity risks by integrating the latest market information, portfolio updates, capital returns and a market view of liquidity on an intraday scenario basis.
Integrate your risk management processes.
- Value complex portfolios and asset classes by integrating portfolio valuation and scenario analyses on a single platform. And instantly assess the potential impact of future market shocks and scenarios on liquidity.