Managing Liquidity Risk – The 2007 Crisis

The whole question of Liquidity Risk Management has become very topical of late spurred on by the initial liquidity crisis in 2007, which occurred in the early stages of the subsequent financial collapse. More and more frequently I find myself being asked the same question or a variation of it “what is the best way to ensure that my bank’s Liquidity Risk Management is on a sound basis?”

The subject is vast. And depending on exactly what you are trying to achieve, so too are the answers.

Before even attempting to paint a broad picture as to the key issues to be addressed in ensuring sound Liquidity Risk Management, I would like to take a step or two back – and explain some of the key principles and issues the surround liquidity management.

Liquidity in the first instance depends on the exact use that the word is being put to. Let me explain. In a pure sense liquidity is defined as the ease and certainty with which an asset can be converted into cash. Money, or cash on hand, is the most liquid asset.  Market liquidity on the other hand is the term that refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value of the underlying asset.

Accounting liquidity is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.

In banking and financial services, liquidity is the ability of a bank (or other financial organization) to meet its obligations when they fall due. Managing liquidity is a daily process (in fact in today’s real-time world, this has become a real-time process too) requiring bankers to monitor and project cash flows to ensure that adequate liquidity is maintained.  In a banking environment that liquidity may be needed to fund customer transfers and settlements or to meet other demands generated by the banks business with its clients (advances, letters of credit, commitments and other business transactions that banks undertake). 

There are many other definitions of liquidity too. Suffice to say that the brief summary above should serve to explain the concept and to illustrate the notion that there are many variations of this.

Almost every financial transaction or financial commitment has implications for a bank's liquidity. Liquidity risk management helps make certain of a bank's ability to meet cash flow obligations. Remember that this ability can be severely affected by external events and the behavior of other parties to the transaction. Liquidity risk management is critical because a liquidity shortfall at a single bank can have system-wide repercussions, called systemic risk. The inability of one bank to fund, for example, its end-of-day payment system obligations could have a knock-on effect on other banks in the system, which could lead to financial collapse. Indeed, the central bank, as the lender of last resort, stands ready with a safety net to help out individual banks (or even the greater “system”).  We witnessed this on a massive scale over the past two years in the U.S., Europe, Asia and elsewhere. However getting this assistance often carries an almost impossible price – reputation. Banks that get themselves into this sort of trouble pay a terrible price in terms of the loss of confidence amongst members of the public, investors and depositors alike. Often this price is so high that the stricken bank does not recover.

The market turmoil that began in mid-2007 brought into very sharp focus the importance of liquidity to the effective functioning of financial markets as well as the banking industry. Before the crisis, asset markets were buoyant and funding was readily available at low cost. The sudden change in market conditions clearly showed just how quickly liquidity can disappear and that the lack of liquidity (the correct term is illiquidity) can last for a very long period of time indeed.

So we arrive at the summer of 2007. From August onward the worldwide banking system came under severe stress. To make matters worse developments in financial markets over the previous decade had increased the complexity of liquidity risk and its management. The result was widespread central bank action to support the functioning of money markets and, in some cases, individual banks as well.

It was pretty clear at this point that many banks had failed to take account of a number of basic principles of liquidity risk management. Why? Well in all probability, in a world where liquidity was plentiful and cheap, it didn’t seem to matter much.

Many of the banks that carried the greatest exposure did not even have an adequate framework that satisfactorily accounted for the liquidity risks required by their individual products and business lines. Because of this, incentives at the business level were out of alignment with the overall risk tolerance of these banks.

Many of these banks had not really considered the amount of liquidity they might need to meet contingent obligations because they simply dismissed the notion of ever having to fund these obligations as being highly unlikely.

In a similar vein many banks saw as highly unlikely too, any severe and prolonged liquidity disruptions. Neither did they conduct stress tests that took account of the chance of a market wide crisis (that is one that affects the whole industry rather than just a single other participant) or the depth or duration of the problems. Banks also did not link their contingency funding plans to the results of their stress tests. And to add insult to injury they also sometimes assumed that irrespective of what happened their traditional funding sources would remain available to them.

With these events still fresh in the minds of banks and bank regulators the BIS (Bank for International Settlements) based “Basel Committee on Banking Supervision” published a document entitled “Liquidity Risk Management and Supervisory Challenges” during in February 2008.

The crisis had revealed many of the critical issues, outlined above, that had patently been overlooked. Based on this, the Basel Committee has conducted a basic review of its earlier “Sound Practices for Managing Liquidity in Banking Organisations”, which had been published in 2000. In their new document their guidance has been significantly expanded in a number of key areas such as;

• the importance of establishing liquidity risk tolerance,
• the maintenance of an adequate level of liquidity,
• the need to allocate liquidity costs, benefits and risks to all important business activities,
• the identification and measurement of the full range of liquidity risks,
• the design and use of severe stress test scenarios,
• the need for a vigorous and workable contingency funding plan
• the management of intraday liquidity risk and collateral, and
• the public disclosure in promoting market discipline.

So what is this new guidance all about? I will be covering Basel Committee’s advice on these key issues and the subsequent industry response in more detail in a series of subsequent articles.