03 September 2014

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Ziauddin Ishaq - Oracle

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A Lesson In Liquidity Risk Management For All Of Us

08 May 2014  |  1690 views  |  0

A little over a year ago, I discussed the progression of BCBS 188: Basel III: International framework for liquidity risk measurement, standards and monitoring and how financial institutions must handle this challenge.  Fast forward to April 2014, and the debate is still going strong – are we any closer to being prepared and incorporating this into our daily risk lives?

Regional jurisdictions took a closer look at the Basel regulation, and have determined how they will address this.  The US has taken an aggressive approach when compared to other regions.  They have tightened “supervisory expectations in ways that will compel banking companies to address fundamental aspects of liquidity risk management, including stress testing, integration with capital planning, and data collection.” The Basel committee finalized their standard on the Liquidity Coverage Ratio back in January 2013, but also recently set out in January 2014 the ratio’s disclosure requirements

Given the severity of the recent liquidity crisis, the US has placed greater emphasis on how banks manage their liquidity risk and consequently have taken a more draconian approach, by way of constraining what can be deemed ‘high-quality liquid assets’, (leaving USD billions of PSE issued securities on the shelf because they are deemed ‘not liquid’ enough) being more conservative on the treatment of cash inflows and outflows.  Although the requirement won’t be finalized for at least another year, you can expect stern industry resistance, to what in effect will put a dent in banks’ bottom line and erode overall shareholder value.    

What is interesting to note is that, despite the stress testing fatigue felt across the industry, regulators are unrelenting and now want to supplement the regulatory liquidity ratios with much deeper, detailed quantitative and qualitative information, which if a bank could harness in one transparent location with ease, actually does make good sense.  Supervisors expect banks to intrinsically know what the key risk and business drivers are to their Liquidity Coverage Ratio (LCR), how they interact, the impact they would have on Stock High Quality Liquid Assets (SHQLA), likelihood of a liquidity drain from collateralized derivatives exposures or how a funding concentration could evolve.

To avoid a liquidity meltdown, a bank, in essence, must look at its liquidity profile in a far more dynamic and questionable way like it has not done before and to do that will require even more data collection and analysis.  And if that wasn’t enough, the regulatory train is slowing heading towards a platform that currently does not exist, namely ‘integrated liquidity & capital.’  Yes, banks do have separate liquidity and capital platforms, but that does not mean they are integrated either at the data extraction or reporting level. 

Building such an integrated platform is no mean feat, given the industry’s legacy silo based approach to risk management.  There is broad acceptance that change is needed, as the less than robust data governance frameworks where data is scattered across disparate applications, stored in multiple formats, refreshed at varying frequencies with varying consistency is not likely to achieve regulatory endorsement or help financial performance.

Heading back to Europe, banks may find that the Asset Quality Review could bring some nasty funding surprises, since the European Central Bank (ECB) effectively wants to conduct a ‘lift the floorboards’ review on banks’ balance sheets.  Transparency, repair/restore and confidence building are the objectives of this ominous review.  For some banks, their valuation assumptions for hard to value assets will come under the spotlight and rightly so, because at the height of the crisis, many of these securities were defined as ‘high quality’, but in reality liquidations  were executed well below perceived market values. 

Why all the fuss about liquidity risk?  Well it’s a risk that is precarious to manage and literally can appear out of nowhere, snowball out of control and do grave damage to the bank’s capital position.  A good example occurred not too long ago: a customer walked into a branch of a Chinese agricultural bank and requested to withdraw some of his hard earned cash, only to be told ‘no’ – not the right answer! In this day of real-time social media, rumor spread like wildfire that the bank in question was in trouble and perhaps other local banks were not far behind.  Before the bank realized the ramifications of its operational blunder, hordes of customers showed up demanding access to their cash.  Bank management gave assurances that there was nothing to worry about, but the damage was already done and ironically it had to resort to shipping in physical cash by the truckload and place it in clear view of the doubting customers. 

Such a scenario is not considered an outlier event and is applicable to all banks in all regions and goes to show that the drivers for a liquidity crisis could emanate from a localized event, but quickly spiral out of control.  Building a credible stable liquidity position takes time and comes at great cost, but can evaporate in a matter of minutes, regardless of what reassuring messages are given.  Being able to stay ahead of the liquidity risk curve is paramount, hence regulators feel they have a more than an active part to play to ensure, that if a bank was to hit the liquidity buffers, it does not take all the other banks with it along with customer deposits.  

According to José Viñals, Financial Counsellor and head of the IMF’s Monetary and Capital Markets Department, we still have our work cut out for us.  He states that advanced economies still rely too much on easy liquidity conditions; perhaps the regulators agree and have tightened the reigns because of this. He continues that if we are ever going to have an environment of self sustaining growth, then we need to reduce our reliance on monetary and liquidity supports. 

So what does all of this mean and where do we go from here?  From the start we know that liquidity management cannot be viewed as a regulatory burden, but rather a part of everyday life for the banks. 

Here is a list of challenges that must be addressed in order for this to become daily life:

  • Decrease the reliance on debt and rely more on funding sources such as shareholder equity
  • Integrate capital and liquidity stress testing and planning
  • Incorporate timely data collection across all lines of business
  • Ensure adequate enterprise-wide technology is up to date

The challenges are big, but the benefits can be even bigger

Does the journey end here?  No, not by any stretch of the imagination because the next liquidity crisis will have some unique characteristics about it, which we will only get to know about it when we’re in the middle of it, fire-fighting and once it’s over.  Question is will the banks have the right risk management architectures to make the fight easier? 

As always, I look forward to reading your thoughts and comments.

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Ziauddin Ishaq

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Global Solutions Lead for Liquidity Risk

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Oracle

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