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A New Look at Liquidity Risk: Best Practices Part 1

The financial services industry stands on the threshold of a new era for liquidity risk.  As seen in recent weeks, the reality of the new financial landscape – currently fueled by lingering debt issues in Europe and this month’s announcement that four “too big to fail” banks had failed the latest round of stress tests – has warranted a laser-like focus on liquidity risk. 

On the tailwind of two rounds of three-year emergency loans made by the European Central Bank (ECB) to some European financial institutions in hopes of promoting healthy levels of liquidity as prescribed by Basel III, many bankers are raising a flag as they remind the ECB of the risks in providing funding to banks that might not be able to continue to stand on their own, and suggest they develop a plan – and quickly – for a path forward in withdrawing the funds in a smart yet timely manner to control inflation risk. 

For bankers and economists on the other side of the pond, this is an all too familiar situation.  Last week, four of the biggest U.S. banks failed the latest round of Federal Reserve stress tests, which might require them to go hat in hand to shareholders to raise more capital. The Fed's goal is to make sure these banks are liquid enough to survive another financial crisis, to decrease the likelihood for another round of government bailouts, circa 2008.

While not fully defined, many in the industry expect that Dodd-Frank requirements for liquidity risk will align with those under Basel III, which requires banks to set minimum liquidity based on a stress test using standardized calculations. Basel III introduces a Liquidity Coverage Ratio (LCR) that requires banks to maintain a stock of "high-quality liquid assets" sufficient to cover net cash outflows for a 30-day period under a stress scenario. In addition, the agreement establishes a net stable funding ratio (NSFR) test, which will measure the level of liquid assets to the level of liabilities that mature in a year or less – a contributing factor to the large loans provided by the ECB.

While many of the specifics of new liquidity requirements are still under debate, banks cannot afford to sit idly by. Those that begin to lay an agile foundation will ease compliance and gain a competitive advantage in the market. But, where do they start?  This blog will take a best practices approach in focusing on the first step needed to develop an infrastructure – be it operational, IT, or otherwise – that supports the new reality of liquidity risk.

Begin to realign. Over the past few years, banks have faced the reality that that there is a non-severable link between risk and profitability, which are really just two sides of the same coin. As we have seen many times in recent history, miscalculating any type of risk – including liquidity – can lead to significant financial loss. Better alignment between a bank's risk and financial functions is an important step toward compliance.

Closer alignment can also help to drive improved performance, as documented by a 2011 study by the Economist Intelligence Unit (EIU). The global survey (which included nearly 200 senior banking and risk executives from financial institutions, as well as in-depth interviews with 16 finance and risk executives, corporate leaders and other experts) found that financial institutions scoring themselves highly on their ability to align risk and finance functions appear to be doing better financially than their peers.

In some cases, organizations may decide to realign reporting duties to have risk and finance executives reporting to the same C-level entity. Cross-functional teams will also be increasingly important, especially as stress tests become more complex and comprehensive. For example, regulators may ask a financial institution to assess the impact of a particular scenario, not just on risk-weighted assets, but also on liquidity risk and profitability – which live squarely in the finance domain. Today, in many organizations, the resources needed to fulfill regulatory requirements might reside in separate teams that do not regularly collaborate. Moving forward, some organizations may want to have individuals who span both the risk and finance teams to improve communication and support collaboration.

In the upcoming weeks, we’ll take a look at additional steps needed to facilitate more streamlined, effective, and compliant liquidity risk management throughout the enterprise. In the meantime, have you started to re-evaluate the roles of functional teams in your organization?  What challenges have you faced? Or perhaps you’re still examining how to best align your human capital with strategic goals and regulatory requirements. I welcome your thoughts.

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