The Management Of Liquidity Risk In Financial Groups Finance Essay

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Every bank has to face several types of risks, such as credit, market, operational and liquidity risk. In this perspective, liquidity risk has been under evaluated since the turmoil of 2007, which has moved the spotlights over this issue. When it comes to liquidity, a clear definition has to be made in order to understand exactly what happened, the reasons and what could be made to improve any weakness. Liquidity can be defined as the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. Furthermore, a financial firm is considered liquid when it has ready access to immediately spendable funds at reasonable cost at precisely the time those funds are needed. Everyday all firms have to balance supply and demand of liquidity, in case of liquidity deficit they have to raise additional funds, vice versa, when liquidity surplus arises, managers have to find the best investment to cover the opportunity cost deriving from divested funds. In 2007, at the dawn of subprime mortgage crisis, some of the major banks experienced a severe deposit runoff, that in conjunction with a sensitive decrease of incomes belonging to customer deposits, caused a huge lack of liquidity for some firms. The evolution towards a global and systemic market, increased the severity of default of a singular firm, causing a domino effect. Therefore, the Basel Committee issued in September 2008 some principles for sound liquidity risk management and supervision. The aim of the document is to provide general rules on how liquidity can be measured and estimated. We can divide those principles in three parts:

Standard measures,

Common monitoring tools,

Application issues,

In the first part, two ratios are introduced. The aim of the liquidity coverage ratio is to provide a short term measure of the liquidity position, whereas the net stable funding ratio is used to promote resiliency over longer term. The second part includes common monitoring tools, which are additional metrics to capture specific information related to cash out flows, balance sheet structure, available unencumbered collateral and certain market indicators. The third part explains some common issues which could raise in the application of the ratios given in the first sections. The Northern Rock case provides the best example of liquidity risk, being one of the most involved banks during the turmoil of 2007. Northern Rock, the country's fifth-largest mortgage lender, triggered the first run on a British bank in more than a century. In summer of 2007 the bank was bailed out by the bank of England with emergency loan, and the following guarantee issued by the government to mitigate mass withdrawals brought the firm in 2008 to be finally nationalized.

Bank risk manager have to face everyday liquidity problem, which means to balance the supply and the demand side. In order to keep a correct net position, they should avoid excessive surplus which triggers opportunity costs for those divested assets. On the contrary, a deficit causes the need to raise additional funds that may be an expensive activity. Managers have to consider this trade-off between liquidity and profitability. Demands for liquidity includes:

The case of Northern Rock shows how the increase of demand, especially customer deposit withdrawals, also known as deposit runoff, and at the same time, the decrease of supply (in particular the reduction of incoming customer deposits and the inability of selling bank assets), caused a huge deficit position bringing the firm near to default. Therefore, it is known that rarely demands for liquidity are equal to the supply at any particular moment. Before 2007 liquidity risk and its management didn't receive the same level of importance as other risk areas. In order to fill the gap, the Basel Committee on banking supervision issued principles for sound liquidity risk management and supervision to achieve two objectives: The first is to promote short-term resiliency of the liquidity risk profile institutions by ensuring that they have sufficient high quality liquid resources survive on acute stress scenario lasting for one month (Liquidity coverage ratio). The LCR identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute short-term stress scenario specified by supervisors. As stress scenario it is meant as a downgrade of the institution's rating, a sensitive loss of deposits and unsecured funding, an increase in secured funding haircuts, an increase of purchases of contractual and non-contractual off-balance sheet exposures. The LCR ratio consists of two components:

Value of the stock of high quality liquid assets in stressed conditions

Which are meant to be assets that can be easily and immediately being converted into cash at little or no loss of value (such as cash and Central Bank reserves).

Net cash outflows, calculated according to the scenario parameters set by supervisors. It is the difference between the cumulative expected cash outflows (retail deposit run off, unsecured wholesale funding run off, secured funding run off and additional requirements) and cumulative expected cash inflows (retail inflows, wholesale inflows, reverse repos and secured lending, lines of credit and other inflows).

The second objective of the document issued by the Basel Committee is to promote resiliency over longer term, creating additional incentives for banks to fund their activities focusing on more stable sources of funding (Net stable funding ratio)

This metric sets a minimum amount of stable funding, based on liquidity characteristics of an institution's assets and activities over a 1-year time horizon. NSFR is structured to ensure that investment banking inventories, off-balance sheet exposures, securitizations pipelines and other assets and activities, are funded with at least a minimum amount of stable liabilities in relation to their liquidity risk profile.

Stable Funding are those types and amounts of equity and liability financing expected to be reliable sources of funds over a 1-year time horizon under conditions of extended stress. The total amount of stable funding of an institution's capital, preferred stocks and liabilities with maturity of equal to or greater than 1 year and stable deposits with maturity of less than 1-year that would be expected to stay with the institution in a stress event, is called available stable funding. The amount of stable funding required by supervisors is to be measures using supervisory assumptions on the broad characteristics of the liquidity risk profiles of an institution's assets, off-balance sheet exposures and other selected activities, is called required stable funding.

In addition to the metrics outlined, the monitoring tools capture specific information related to the bank's cash outflows, balance sheet structure, available unencumbered collateral and certain market indicators. The metrics that are going to be presented are the following:

Contractual maturity mismatch: this metric identifies the distance between contractual inflows and outflows over a defined time band. This metric indicates the potential need of raising liquidity in every time band, supposing that all the flows occur at the earliest possible date for the period considered.

Concentration of funding: this metric encourages the diversifications of funding sources because it highlights those wholesale funding which are of such significance that withdrawal of this funding could trigger liquidity problems.

Available unencumbered assets: This metric provides supervisors with data and key characteristics, of available unencumbered assets.

Market-related monitoring tools: these are early warning indicators of the potential liquidity difficulties in the banking sector.

The application of these ratios and monitoring tools are not free of issues. First of all, the frequency of calculation and reporting has to be defined. Normally, banks are expected to meet the requirements of the standards continuously (monthly). However, under stress scenario, the time frame may be reduced on a weekly or daily basis. Secondly, the scope of application has to be set. These measures are applied to all internationally active banks. Thirdly, currencies play a crucial role during the consolidation process, this because in optic of a consolidated report in a common currency, supervisors and banks have to be aware of liquidity needs in every single currency. Last but not least, the public disclosure has become more and more important in order to be transparent. The information that should be included are the value and level of the metrics, the size and composition and the drivers behind them.

When it comes to liquidity risk management, an important decision has to be taken in order to administrate the degree of centralization. Centralized liquidity risk management benefits for common language and methodology, adding also central management resources and expertise to local and subsidiary level, often this model is used from securities firms. On the other hand, a decentralized model tend to grant a large measure of autonomy to individual operating units, in the practice this model is adopted by insurance firms.

In the management of liquidity risk, different approaches may be used. The decision consists whether to use a liquid assets approach where the firm maintains liquid instruments that can be drawn up upon when needed, a cash flow approach, where the firm attempts to match cash outflows against contractual cash inflows, across a variety of near-term maturity buckets or a mixed approach, which combines elements of both the previous approaches by facing short-term outflows with most liquid assets and facing later time buckets with those who are less liquid.

Some different issues may rise in the application of liquidity risk management:

Cross-border issues: sometimes it happens that a number of groups differentiate between different jurisdiction, some of them can have hard or non convertible currencies.

Cross-currency issues: this is the risk the arises when a firm relies on a cash inflow or asset in one currency to meet an obligation in another currency, often in another time zone.

Cross-affiliate issues: in a stress scenario a key issue is the extent to which the parent or subsidiary units of a group, would provide liquidity to affiliates. This issue can also have implication on cross-affiliate transfers of funds and collateral across national borders, sectors, and currencies.

Once the strategies, the various approaches and the measures are well defined, liquidity strain sources have to be identified and classified to make it easier to complete and conduct the liquidity risk management. The first source of liquidity strain can be defined as an event-driven source. The origin of this liquidity lack can be found in external events such as: rating downgrades and other loss of market confidence, systemic events, catastrophes and others are the most significant. Another driver of liquidity strain can be found in transaction and product, such as derivatives and other off-balance sheet instruments, and on-balance sheet insurance contracts with embedded optionality. Another important force which may influence in a significant way the liquidity risk, is the movement to more volatile funding sources and ability of depositors to switch funds among accounts with electronic means, which has complicated liquidity risk management, is called market trends sources.