The Ultimate Risk—Flawed Liquidity Risk Management

As the global financial services industry heads into 2011 after digesting Dodd-Frank, Basel III and the "flash crash," the question is "Where to now?"

To answer that question, an unscientific gauge of the industry's events may help reveal what is on top of everyone's mind. Assuming these events were crafted in response to regulatory changes aimed to make the global industry safer, more alert to excessive risk-taking, and less needy of taxpayer bailouts, these events, if not predictive, reflect issues that are mostly likely to gain traction in coming months.

Here is a random sample: Enterprise Risk Management: Establishing Confidence as the Financial Crisis Continues; New Beginnings, Bank Systems & Technology Executive Summit; The Future of Finance; Credit Risk Summit; The Trading Desk of the Future; Risk USA conference; Risk Management and Operational Risk.

The common word here is risk. It is in the titles of four of the seven events and managing liquidity risk is on the agendas of the other three.

In 2007, a presentation on managing liquidity risk would probably not have filled even a small room at any one of these events. In that year, Northern Rock collapsed, followed by Bear Stearns. Even though they were profitable and well capitalized, their failure to manage liquidity risk was a major cause of their collapse. The lessons learned from those debacles have brought liquidity risk front and center today. Reducing liquidity risk is the new imperative. One good reason is the need to restore public trust and to hold on to revenues as governments intentionally withdraw stimulus and liquidity support.

"Liquidity risk is currently one of the hottest topics not only in risk management but banking in general," says Iva Dropulic, Department Head, of the European Erste and Steiermarkische Bank. "In view of limited resources, general uncertainty and economical slowdown, precise measurement and management of the liquidity risk is a must for any modern bank."

The liquidity crisis has spawned a cottage industry of books, television documentaries and scientific and academic papers that analyze the crisis. Emerging as a financial best seller is Stress Testing for Financial Institutions, edited by Daniel Rosch. It coincides neatly with July's results of the pan-European bank stress tests in which a reassuring 92.3 percent of banks--84 of 91--passed, to the apparent relief of stock markets everywhere. And in time for seasonal gift giving will be Rethinking Risk Measurement and Reporting, by Klaus Blocker.

However, the cause of the liquidity crisis was complex. Blaming the financial liquidity crisis that began in 2007 on a single thing is like apportioning responsibility for creating a Class 5 hurricane to the sweep of a butterfly's wings. But in February 2008, banks were clearly identified by the Basel Committee on Banking Supervision in its "Liquidity Risk: Management and Supervisory Challenges" report. It declared that too many banks failed to consider several basic priciples of liquidity risk management when there was plenty of liquidity to go around (when liquidity didn't seem to matter). The Basel committee defines liquidity as "the ability of a bank (or other financial organization) to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses." Liquidity risk, therefore, is the risk of not being able to fund assets or re-pay liabilities. Managing liquidity requires bankers to monitor and project cash flows every day to ensure and maintain adequate liquidity.

1 of 2