The New Liquidity Risk Management Paradigm

In the last decade, risk management practices of financial institutions have advanced dramatically. However, the generally favorable economic and financial environment and abundant access to funding sources meant that management of (funding) liquidity risk attracted relatively modest attention. This risk has little visibility when times are good, but its high-severity nature makes it potentially devastating during extreme liquidity events.

The recent subprime mortgage-induced crisis thrust liquidity risk to the forefront of the financial markets. The credit crunch ran across the entire industry, and many financial institutions were caught unprepared due to improper liquidity risk management. Liquidity risk has traditionally been understood and managed in a context where balance sheets were much simpler. Unfortunately, the paradigm shift in financial intermediation to more complex asset structures and less stable funding sources has not led to a commensurate update in liquidity risk management practices.

For our purposes, liquidity refers to the net cash flow situation of a financial institution. Accordingly, Celent defines liquidity risk to be the risk of being unable to meet financial obligations (including those from future business) as they come due. This definition is not dependent on whether the institution is solvent or not. An institution can be fundamentally solvent but suffer from a lack of liquidity to meet financial obligations; similarly, an insolvent institution can buy time if it has access to sufficient cash.

Liquidity risk fundamentally arises from the funding-related aspects of a financial institution's core business model. Because liquidity risk is inherent to the highly leveraged financial system, system-wide elimination of it is not an option.

A fundamental characteristic of liquidity risk is its combined sudden and high-impact nature. Liquidity risk is defined by discrete events that may cause an institution to swiftly fail. This characteristic has strong implications for whether institutions should hold capital against liquidity risk.

Capital helps to instill market confidence in a financial institution. However, the liquidity needs in the case of a serious event are on the order of the institution's liabilities as opposed to its equity. Accordingly, the amount of capital that would alleviate the problem is prohibitively high. Managing liquidity risk is essentially about minimizing the probability of current and future cash flow gaps. Therefore, ensuring continuous access to cash through structural positioning of the balance sheet and/or through funding facilities is key to managing the risks.

As the new realities become established in the marketplace, institutions are seeking prudent next steps in liquidity risk management. Many institutions neglected to match actual practices with the specifics of their own business and the basic principles of liquidity risk. A clear next step in most cases is conducting a diligent review of existing risk-taking behavior—including funding strategy and incentives—and risk management practices.

Unlike most risk management improvements, developing new methodologies is not the main issue concerning liquidity risk. Most players will find that they need to focus on three core issues:

* Clarify risk tolerance articulation and oversight at the most senior level.

* Align the underlying components of risk measurement with business specifics, risk tolerance, and market realities.

* Integrate contingency plans with risk tolerance and stress testing and ensure that they are in place prior to any liquidity event.

Liquidity risk events, by nature, are extreme events that may cause the failure of solvent institutions. Therefore, tolerance to liquidity risk should be set and overseen at the level of the board of directors. Emergency plans commensurate with the risk tolerance levels should be established.

While the set of tools and techniques widely used in the industry is appropriate for liquidity risk measurement, the set of assumptions and inputs used in these tools need a substantial overhaul. These are comprised of position data, cash flow characteristics and most importantly assumptions that define scenarios used for stress testing.

Lack of a thorough understanding of the cash flow profile together with behavioral adjustments, off-balance sheet instruments, other remote vehicles and contingencies is a key deficiency in the marketplace. Developing this view is a prerequisite to prudent liquidity risk management since managing cash flow risks can be effective only with accurate cash flows.

Updating stress testing practices to reflect relevant, significant and plausible scenarios will be key going forward as many institutions either used overly simplistic scenarios or made unrealistic assumptions.

In particular, the subprime mortgage crisis revealed that:

* Liquidity problems can last much longer than envisioned. * The interrelationships of liquidity events should be taken into account. * Funding availability can exhibit erratic patterns, and even sources regarded as extremely safe can disappear.

On the whole, Celent believes the winners will be the financial institutions that move quickly to build up their defenses and signal to the market that they have a robust framework in place that keeps their risks under control.

Author Bios:

Mayiz Habbal is Senior Vice President of the Securities & Investments Group at Celent and is based in the firm's New York office. His areas of research focus on enterprise architectures and aligning business strategy with IT initiatives. He brings with him over 15 years of experience in the management and development of software and engineering of IT strategies, predominantly in the investment banking industry.

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Cubillas Ding is a senior analyst in Celent's securities and investments practice and is based in the firm's London office. Mr. Ding's expertise lies in global financial markets, securities IT strategy, and enterprise risk management.

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