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A New Look at Liquidity Risk: Best Practices Part 2

Federal Reserve Governor Daniel Tarullo recently defended the importance of stress tests and regular capital review exercises in ensuring the safety and soundness of the U.S. financial system. In a speech delivered to the Federal Reserve Bank of Chicago last week, Tarullo said that higher capital standards alone were not enough to do the trick, and that while most banks had passed the latest rounds of stress tests, many could use "significant" improvement, as the tests themselves will be better and more extensive by the time they are held again. 

While last month’s stress test results showed the U.S. banking system was stronger than it was during the 2008 financial crisis, the Federal Reserve is looking for ways to improve the process, noting a "one-size-fits-all" approach simply won’t work. This represents, perhaps, one of the few times regulators and financial institutions have reached a harmonious agreement in a topic fraught with discord since the passage of Dodd-Frank nearly two years ago. Banks worldwide are requesting more appropriate, and, consequently, more efficient, stress testing procedures, as varying levels of assets mean various types of strengths and/or challenges, should we face another downturn. 

New processes and procedures for the upcoming round of stress tests are still being designed, and requirements have yet to be defined, but one thing is certainly clear; change is coming. In this blog, we’ll build off the established best practice of aligning risk and finance within an institution, and focus on what’s needed to prepare for a new era of stress testing, including the flexible IT infrastructure that will be absolutely critical in supporting ever-changing requirements.

Prepare for the Unexpected. Stress testing in this environment is here to stay and will go far beyond the standardized and sweeping industry-wide tests ordered in the wake of the financial crisis. Instead, the industry will see a move to more frequent institution-specific stress testing – including stress testing for liquidity – that becomes a follow-up to regularly scheduled periodic reports. Regulators will expect the results of the tests quickly, often in just a few days, as they will assume that banks will have in place established risk data taxonomy.

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 liquidity rations can be calculated on not just a weekly, monthly, or quarterly basis but on a daily and – in banks trading with complex positions – intraday basis.

In the new reality, stress testing, therefore, has to be baked into a bank’s standard operating procedures. They must be equipped with a risk management infrastructure that enables new levels of agility in setting up, running, analyzing, and reporting on risk scenarios – including those for liquidity risk.

Build an Adaptive Infrastructure. A comprehensive infrastructure for risk management that can provide visibility across the entire enterprise and deliver insight when and where it is needed is another crucial first step in preparing for compliance around impending liquidity risk requirements. Financial institutions will have to supply significantly more data and they will be delivering it to an expanded universe of regulatory authorities with greater frequency than ever before. They must, therefore, build a comprehensive infrastructure for risk management that can provide visibility across the entire enterprise and deliver on-demand, custom insight. Aggregating all of an organization's risk-related data in a single environment is an essential first step. As we saw from the financial downturn of the recent past, the ability to connect developments and indicators in one part of the business with those in other parts of the business is essential to determining an organization's true strengths and vulnerabilities.

New requirements for liquidity risk are on the way. While awaiting final details, forward-thinking financial institutions can take several important steps today to lay a foundation for smooth compliance. As important, these same steps and investments will significantly increase operational visibility to yield immediate, as well as long-term benefits. I welcome your thoughts, as well.  What is your institution doing to prepare for requirements that are largely undefined? Are there any considerations or requirements you view as mission-critical from an industry perspective?


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