As liquidity risk moves to the forefront of the regulatory agenda, financial institutions face a new compliance and business reality. While final details remain in flux, there is no question that Basel III and Dodd-Frank will bring more structured and stringent liquidity requirements as well as greater compliance complexity to the industry. Further, the focus on high-quality assets to fulfill liquidity requirements will drive up costs and limit options for many institutions.
Financial institutions are gearing up to address new liquidity risk management challenges. A top priority is to extend their risk management frameworks and procedures to ensure compliance with impending regulations. The challenge does not end there, however, as banks look to balance compliance requirements without impairing their ability to optimize liquidity across the enterprise or jeopardizing profitability.
Both objectives are important priorities as financial services organizations begin to assess and rethink their liquidity risk management environment. Those that create a framework that supports compliance and optimization stand to gain an important competitive advantage in the years ahead

The impact of the global financial downturn has changed the liquidity risk landscape for financial services organisations, especially for banks. Basel III is prescribing the path forward, introducing a liquidity coverage ratio (LCR) that will require banks to maintain a stock of “high- quality liquid assets” sufficient to cover net cash outflows for a 30-day period under a prescribed stress scenario. In addition, the accord proposes a net stable funding ratio (NSFR) test that will require banks to lengthen their funding profiles to better support their balance sheets. While U.S. legislators and regulators continue to debate the specifics of Dodd-Frank, many still expect that the law’s requirements for liquidity risk will align with Basel III

A 2010 report by McKinsey & Company attempts to quantify the impact of Basel III’s liquidity requirements,1 and the results are striking. The report’s authors estimate that the industry would have to hold an additional €2 trillion in highly liquid assets and €3.5 trillion to €5.5 trillion in long-term funding. Of this, the top 16 banks would need to raise €700 billion in highly liquid assets and €1.8 trillion in long-term funding. Equally important, McKinsey projects that new costs for additional capital and funding could lower the industry’s return on equity (ROE) in 2012 by five percentage points or 30% of the industry’s long-term average 15% ROE. It is important to note that these figures are just the capital costs associated with achieving compliance. One also must consider operational expenses – such as investment in stress test development and execution, analysts and analysis, regulatory reporting, and monitoring the ratio – across the enterprise to meet individual country requirements. The list continues to grow. Banks are taking stock of the magnitude of this challenge. According to Ernst & Young’s 2012 study “Progress in Financial Services Risk Management: A Survey of Major Financial Institutions,” liquidity and capital management are at the top of senior management agendas for survey participants, which included 69 banks and six insurance companies. The study, conducted by the Institute of International Finance, revealed that 65% of executives surveyed said they are evaluating their portfolios to understand how new LCR requirements will impact each segment and product, and 54% predict the proposed LCR requirements will significantly impact the cost of doing business. “Almost half (45%) of all respondents indicated that they are moving away from complex, less liquid instruments into more stable asset-based funding sources. One-third (30%) of respondents, particularly in Europe, report they are exiting or selling part of their business to reduce the impact of the new rules. Some are exiting certain countries and moving business back to their home countries. Others note the importance of diversifying into new investor bases, such as retail banking and new global markets, to tap new capital and funding sources for long-term planning.” In addition, 49% of study respondents report they are now including the cost of the liquidity buffer in their internal pricing, which means that businesses will experience up-front charges for generating risks that contribute to the buffer

When one considers the cost of acquiring and managing liquidity, optimisation becomes essential moving forward. To continue to compete profitably, banks must gain the ability to play out and assess various liquidity scenarios and options in terms of direct and opportunity costs, as well as risks – just as they are beginning to do with stress testing today. With this insight, they can confidently assess each scenario and evaluate the associated impact of each of its strategies on the liquidity profile. Banks, in their endeavours to optimise their liquidity, will need a critical appreciation of the interaction of market, credit, and operational risk, and how these factors translate into liquidity risk. Operationally, this requires a significant volume of market data and a range of risk factors that need to be integrated onto a single data platform coupled with an adaptive analytical layer, which allows the bank to model and analyse the underlying risks in a more transparent and efficient manner. While most financial institutions are focused, first-and-foremost, on creating a foundation for achieving and managing their LCRs and NSFRs, it is important to avoid a “quick fix” approach when creating a platform to manage liquidity risk. Instead, banks should also look ahead and begin to plan for future optimisation needs. Liquidity risk management, and ultimately, optimisation require a flexible IT infrastructure that can adapt to an ever-changing regulatory landscape and business objectives. To accurately calculate liquidity risk, as well as model options for how best to optimise it, banks must effectively integrate the liquidity risk framework and the governance of other risk, including credit and market risk via a unified data model and enterprise analytical platform. Many firms, however, retain a stove-piped environment filled with point solutions that preclude visibility and hinder data consistency, traceability, and availability. In addition to adopting an enterprise-platform approach, banks should consider the following to create an analytical environment that facilitates regulatory compliance and sets a solid foundation for future liquidity optimisation

Does the bank have full and timely visibility into the balance sheet and all cash flows? A financial institution cannot manage or optimize risk until it has visibility into in its entire balance sheet – spanning retail, commercial, and wholesale operations. As such, its risk management platform must capture this information daily to enable daily dynamic cash flow tracking, including identifying unexpected outflows or inflows. Moving forward, banks will need to view this data not only at the group level but also for individual entities.
Does the bank have visibility into contingent exposures, including off balance sheet exposures? Tier one banks with significant collateralized off balance sheet exposures realize that increased market volatility will create additional margin requirements, which is a major drain on funding. Banks need to know, at the most granular level, what exposures they have on and off the balance sheet, by product, currency, counter-party, and more. They also must be able to see how changes in macroeconomic or other risk factors will impact the performance of a particular portfolio and the resultant liquidity requirements

Can the bank rapidly create liquidity risk stress testing scenarios? Stress testing is here to stay, and banks can count on it to be more rigorous and frequent, with regulators specifying much faster turnarounds. As such, financial institutions require analytical solutions that enable them to rapidly define scenarios, adapt them as needed, and store them for reuse. Scenario creation in many institutions, however, remains a largely manual process, requiring dozens of skilled analysts and multi-week development cycles. This approach and pace are simply not up to the rigor of the new regulatory environment. Ideally, banks should be working toward the ability to run on-demand stress testing, and they require a platform that can support this objective

Can the solution estimate liquidity gaps in business as usual (BAU) conditions, as well as under various extreme conditions scenarios? Banks are looking to define specific BAU and shock conditions at various levels of granularity and then apply them to contractual cash flows either as absolute value or percentages to estimate the liquidity gap under normal and extreme conditions. A bank’s risk management framework should support a wide range of assumptions, including rollovers, run-offs, prepayments, asset value changes, recoveries from delinquent accounts, and asset book growth. It also should provide flexibility to model and apply multiple shocks of varying magnitude to the BAU assumptions and then compare between scenarios to identify the most plausible conditions to use when making strategic decisions

Can the solution calculate liquidity ratios and funding concentrations enterprise-wide and for each currency, product, and counterparty? A liquidity risk management solution should give financial institutions the flexibility to calculate the liquidity coverage ratio and net stable funding ratio using their specified parameters for liquidity horizon, liquidity haircuts, and funding factors to support compliance. Because Basel III will require banks to calculate LCR at both enterprise and local operations levels, banks must be able to produce the group level ratios while simultaneously outputting the local metrics and information on funding concentrations.

Does the solution enable the bank to model and analyse various options to address liquidity shortfalls? Banks require the ability to model counterbalancing strategies to combat liquidity gaps under normal and stressed business conditions. With the ability to define multiple counterbalancing strategies on the same baseline and stressed liquidity gap reports and analyze them across multiple dimensions, banks can readily identify and adopt the optimal course of action as part of their liquidity management strategy

Does the bank’s liquidity risk management framework create a foundation for analytical analysis that will enable banks to continually optimize liquidity under normal and stressed conditions? Flexibility, scalability, and a unified data model are essential to future optimization initiatives. To optimize liquidity options, organizations must be able collate a wide spectrum of relationship data and process it rapidly to yield a set of strategies that reflect the dynamics of the current market environment. Essentially, a trader or risk manager requires the ability to quickly assess options regarding what action is deemed appropriate to steer the bank away from a liquidity crisis without having to incur punitive costs in doing so. Arriving at the correct decision is fraught with complexity, since an emerging liquidity strain could quickly develop into a full-blown crisis, as a result of a breakdown in relationships between risk factors, directly impacting pricing models and valuations.ConclusionWhen it comes to liquidity risk, the stakes are high for today’s financial institutions. It is important that they create an infrastructure that not only meets short-term compliance requirements but also lays a foundation for future needs, including additional regulatory requirements, as well as the compelling desire to optimise liquidity management.