Liquidity Risk

What it is and why it matters

Prior to the global financial crisis, financial institutions of all shapes and sizes took liquidity for granted, attaching little or no cost to the availability of funds. But during the crisis, many institutions struggled to maintain adequate liquidity, 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 liquidity. And self-preservation isn’t the only motive for doing so; the consequences of poor liquidity risk management can reach far beyond the walls of any one financial institution to affect the entire financial ecosystem and even the global economy.

Regulatory bodies are doing their part to prevent another financial crisis in the future (Basel III, anyone?), and the onus is now on the financial institutions themselves to shore up liquidity risk management, both for the good of the firm and the economy.

Defining Liquidity

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. Liquidity risk management encompasses the processes and strategies a bank uses to:

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.

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Challenges to successful liquidity risk management

No centralized view of liquidity. Siloed departments and business units limit a firm’s ability to understand its liquidity position or to understand the impact of illiquid assets and asset classes across geographies, business units and asset classes.
Limited analytic capabilities. Without sufficient analytic capabilities, firms have extreme difficulty projecting cash flow 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 closely on the compliance requirements surrounding liquidity risk management, they may overlook the business benefits that can be gained.

Getting liquidity risk management right – three key steps

To institute an effective liquidity risk management system in your organization, follow these three steps:

Establish an analytic framework for calculating risk, optimizing capital and measuring market events and liquidity.
- Minimize the impact of market shocks, as well as look for better arbitrage opportunities, by analyzing the effects of changes in cost and liquidity in near-real time so you can act with precision.
- Quickly find optimized solutions to your firm’s liquidity and capital needs by evaluating market liquidity and firmwide optimization 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 centralized view of firm liquidity 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.

Liquidity risk management – a case study

To compete with other top banks, Ukraine-based Kreditprombank needed to invest in new IT systems. As the bank's retail business grew, so did the volume of customer data. But the bank was unable to collect and analyze that data efficiently. And outdated manual processes could no longer support risk management and lending decisions. So the bank turned to SAS for analytics and platform solutions to manage risk and improve internal processes.

With SAS, Kreditprombank created a centralized system for liquidity risk management, streamlined internal risk management processes, improved the quality of its loan portfolio and reduced the time spent preparing risk reports while improving their quality.

Since implementing SAS, the bank has retained an acceptable level of liquidity while expanding its loan portfolio, which grew by a factor of 6.6 in three years. Meanwhile, time spent on decision support for liquidity management has decreased by two to three times.

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Sophisticated tools increase the accuracy of predictions, as they can analyze a number of factors and scenarios that would otherwise have not been taken into account. The bigger a bank is, the more diverse its products, and thus the more difficult it is to manage risk.

Andrej Hronec
Head of Assets and Liabilities, VUB