Liquidity Risk-A Little Stress Now to Avoid Headache Later

As the industry prepares to implement Basel III's liquidity risk provisions, it's important to begin the journey with a solid understanding of the minimum standards required by the Bank for International Settlements (BIS), industry best practices, and the distance between them.

BIS requirements for the liquidity coverage ratio ("LCR") and the net stable funding ratio ("NSFR") have been adopted by the European Central Bank as part of their requirements for banks active in the Euro zone. Many other countries and jurisdictions, including the United States, are expected to follow suit.

The LCR requires that a bank maintain a sufficient stock of high-quality liquid assets that would enable it to survive a 30-day period of net cash outflows under an acute stress scenario. The acute stress defined by Basel III is a reflection of several circumstances that were evident in the banking environment leading up to the 2007/2008 financial crisis. As with all such matters, the devil is, however, in the details.

Basel III is prescriptive in its definition of high-quality liquid assets and the concentration of each type of asset. For example, no less than 60 percent of these high-quality assets can be in the form of cash, central bank reserves (to the extent that these can be drawn on in times of stress), and marketable securities on certain classes of sovereigns and banks.

The remaining 40 percent of high-quality assets are subject to a minimum of 15 percent reduction in market valuation to account for their perceived lesser quality, and include other classes of banks and corporate bonds with a minimal rating of AA- which, in non-stressed periods, represents a probability of default so small as to be almost negligible. Between 1987 and 2006, there were zero default events of corporate bonds rated AA-.

BIS requirements also provide specific conditions for outflow, specified with two classifications of viscosity of retail and small-and-medium-size-enterprise (SME) deposits, which are assumed to be either "stable" or "less-stable," with 5 percent or 10 percent minimum run off of totals held at the start of the acute stress. In the interests of prudence, any retail and SME deposits held in fixed-term accounts are excluded, although if withdrawal is allowed, then again these receive a minimum 10 percent run-off rate.

Detailed as these requirements are - and these include a mere précis of the 103 paragraphs covering the requirements - they represent the bare minimum requirements of BIS.

In the same way that investors and regulators may require additional liquidity assets to be held beyond the 100 percent required of liquidity coverage, regulators are likely to act as a proxy for investors, and it is expected that any erosion from the base requirement will force intervention.

This moves banks and financial institutions on to a separate course, and this new course is the requirement that will be lead by investors - corporate, institutional, and retail - to "test to destruction" both the bank and its portfolios. This mandate would likely assist shareholders in understanding how close to failure any given position is, and thus, lead to better and more controlled risk on the part of financial institutions.

With thousands of possible simulated events that could lead to portfolio failure, there needs to be a root-and-branch transformation of the allocation of both assets and liabilities within asset and liability management, to ensure that LCR can be calculated not just weekly, monthly or quarterly but on a daily and - in banks trading with complex positions - on an intraday basis.

The new LCR requirements, while prescriptive in nature, have the potential to give senior management and investors much-needed visibility into positions, providing an important management tool that can translate into more sound and stable financial institutions moving forward.

This blog was contributed by John Christiansen, a senior director of sales consulting for Oracle Financial Services Analytical Applications. With 17 years of experience in the measurement and management of risk in the financial services industry, he has developed stress testing approaches adopted by global regulators. John is an alumnus of the University of Glasgow (where he became a member of faculty, post-graduation), the Royal Military Academy Sandhurst and the Royal Marines Officer Training Course. In his spare time he lectures in risk measurement techniques at the University of the West of England in Bristol to both undergraduate and post-graduate students.