Identifying Liquidity Risk for Financial Stability

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The global financial crisis highlighted the importance of liquidity in functioning financial markets. Pre-2008, market participants received easy access to readily available funding and were ill-prepared for events that transpired during the credit crisis. Failure to adequately assess and manage liquidity underpinned major market turmoil, triggering unprecedented liquidity events and the ultimate demise of Bear Stearns, Lehman Brothers and other financial institutions previously thought too big to fail.

Identifying Liquidity Risk for Financial Stability

 

The global financial crisis has promoted a renewed focus on managing liquidity risk. Lack of liquidity, in the midst of all the panic, left many firms unable to raise sufficient funding, forcing them to liquidate their positions at huge losses, further fueling the fear of a systemic crisis. In an attempt to avert a meltdown of the banking system and deep global economic recession, central banks had little choice but to inject liquidity into the financial markets. Almost 10 years on, awareness of liquidity risk has become the norm and its management essential to the viability of financial institutions. Looking ahead, effective risk management strategies must address the major issues that compromised firms during the drawdown. Liquidity should not be viewed as a short-term operational issue, but as a central component of long-term business strategies.

 

Types of Liquidity

Liquidity risk is the risk that a company or bank may be unable to meet short-term financial demands. This usually occurs due to the inability to convert a security or hard asset to cash without a loss of capital and/or income in the process. There are two distinct types of liquidity: Market and Funding. Market Liquidity incorporates key elements of volume, time and transaction costs (bid/offer spread). These dimensions equate to the amount of assets that can be sold at any time within market hours, with minimum losses and at a competitive price. Market liquidity can be difficult to measure depending on the asset type, whether the asset is fungible, and the time horizon to liquidate the asset.

 Funding Liquidity is the ability to settle obligations on short notice. To do this cash can be raised by the sale of assets or new borrowing. Accurate and timely forward cash flow projections are crucial to effective liquidity management to maintain adequate funding.

Traders provide market liquidity. Their ability to do so depends on funding availability. Funding for traders is affected by market liquidity. Under stressed conditions, both market and funding liquidity reinforce each other, leading to liquidity spirals. See Figure 1.

Figure 1: Liquidity spirals

The Collateral and Liquidity Challenge

Institutional Liquidity

One of the core functions of banks is to take deposits and turn them into loans and securities. In order for this to go well, banks have to maintain enough cash on hand to meet their usual rate of individual withdrawals when depositors want access to their cash. If banks fail at this, they may have to sell assets quickly to raise cash. That can depress the market for what is being sold, if participants perceive a crisis in certain asset classes.

Central banks have often stepped in to provide short-term liquidity to banks under duress, resulting in a shift on how banks treat certain types of lending, therefore, leading central banks to consider providing liquidity to nonbank financial firms. Private lenders and credit providers have stepped into certain parts of the market where banks have stepped back as a result of new regulation. This has helped maintain liquidity, but it also means that central banks may have to expand their lending policies accordingly.

This prospect raises an important question:

How should institutional liquidity, in nonbank financial firms, be regulated? Even though traditional banks provided the bulk of market liquidity leading up to the crisis, large-scale withdrawals from prime money market mutual funds also played an important role. Since then, the Securities and Exchange Commission (SEC) has taken measures intended to reduce the risk of money fund illiquidity.

There is also growing concern about the risk that other types of open-ended mutual and managed funds could face under liquidity pressure in a future crisis. Mutual funds cannot fail per se as losses are passed to shareholders. The concern is instead that large and rapid investor redemptions across a significant number of funds could trigger sales of assets with low market liquidity, in turn, driving momentous price declines and transmitting financial stress to other institutions.

In response to these concerns, a new SEC proposal requires open-ended mutual funds (other than money market mutual funds) to establish liquidity management programs and increase disclosure on the liquidity of their asset holdings and practices related to meeting investor redemptions.

 

Market Liquidity

Market supervisors have recently increased the minimum amount of cash on hand that banks must hold in order to keep overall risk to the market at a minimum. The way a bank determines how much capital must be kept back is through the use of the Supplemental Leverage Ratio, outlined in the Basel banking rules. Certain derivatives and repo rules further add to the amount of liquidity banks must have at any time.

The goal of these changes was to guard against underestimations of risk over time. One of the critiques to emerge out of the great financial crisis was that both banks and regulators viewed most banking activities as innately low-risk activities and, thus, allowed risk-based requirements to remain too low.

However, changes in regulation always come with consequences. Banks were used to keeping a certain amount of cash on hand and, somewhat, suddenly had to significantly increase their liquidity. To do that, they abruptly pulled back from parts of the fixed-income market, among other things. When the banks acted together, as a result of new rules, overall market liquidity was diminished. Or was it? Market participants must determine if it is an empirical reality that liquidity has declined and where. Are there private players that can step in? Can markets adapt? We must be clear on the reality of markets today.

Figure 2: Key characteristics of a...

Central Bank Liquidity

Central banks have taken on an increasing role in guiding financial markets through monetary policy. Radical policy shifts, like negative interest rates, have created new realities for market participants raising questions about the role of high-quality collateral and its availability. Demand for high-quality collateral is likely to continue to increase as more derivatives activity happens on exchanges, requiring counterparties to post low-risk collateral in order to mitigate credit risk. Central bankers will be under pressure to ensure the availability of high-quality collateral to keep markets moving.

 

Transaction Cost Analysis (TCA)

For investors that are interested in bonds, they need to take into account transaction cost analysis. Essentially, this means evaluating a potential bond investment on certain intrinsic characteristics such as how long the bond will take to mature. If an investor plans to trade a bond before it reaches maturity, measuring liquidity can be tricky. Using volumes alone may not take into account adverse circumstances like forced selling.

A comprehensive TCA will look at factors like price sensitivity, transaction volume and any excess return. Taking all of these measurements together can give you a better profile of a given bond or basket of securities regardless of how often they trade.

 

Portfolio Construction

Liquidity risk can be difficult to hedge against because unlike other forms of risk, it cannot be diversified away. But, it’s not all bad news. Historically, illiquidity happens in the market on an episodic basis. So, if investors hold a security to maturity, they won’t pay the liquidity cost as they might if they move in and out of a security before maturity. Asset managers can also help by creating portfolios that handle illiquidity in certain asset classes such as private debt, whereby creating a specific portfolio sleeve that will capture the premiums for holding these assets to maturity, while adding diversification to the overall portfolio.

 

Swing Pricing

Swing pricing is another mechanism asset managers can use to provide a smooth return to investors. When an asset manager uses swing pricing they will move the Net Asset Value (NAV) of a portfolio up or down depending on the direction of net asset flows. In practice, this may mean that investors enter a product at a slightly higher price, but to redeem the cost to exit will be lower. Investors will have to be savvy about why they redeem from a fund with swing pricing, because the use of the mechanism can create a slightly higher tracking error, even if the risk profile of a given fund hasn’t changed.

 

Regulatory Impact

Sell-Side Regulation

Sell-side institutions are obliged to comply with multiple regulatory requirements across the various jurisdictions in which they operate. Supervisory authorities, including the Basel Committee, the Committee of European Banking Supervisors and the Federal Reserve Bank have issued guidelines in an effort to establish sound, system wide liquidity management practices.

Basel III introduced two key ratios – Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) – to provide guidance to banks to ensure short-term and long-term financing remains resilient, which the Fed have also gone on to adopt.

The LCR metric aims to ensure that “a financial institution maintains an adequate level of unencumbered, high quality assets (see Figure 2) which are sufficient to cover outflows in a defined survival period, 30 days, under acute short-term stress scenarios” defined by the regulators:

LCR =

The NSFR ratio seeks to calculate the proportion of long-term assets which are funded by long-term, stable funding.

NSFR =

  • Stable funding includes: customer deposits, long-term wholesale funding (from the interbank lending market), and equity.
  • Stable funding excludes short-term wholesale funding (also from the interbank lending market).

By introducing new ratios, the Regulators seek to achieve the following goals (see Figure 3):

  • Promote short-term resilience of bank’s liquidity risk profile
  • Improve the banking sector’s ability to prepare for financial and economic stress
  • Provide a sustainable maturity structure for assets and liabilities
  • Incentivise banks to fund their activities with more stable sources of funding

 

Buy-Side Regulation

Fund managers are under increasing pressure to ensure strong liquidity risk management practices are being carried out. Regulators such as the SEC, FCA and ESMA have outlined guidelines on liquidity risk management practices that funds should apply.

Additionally, the Securities and Exchange Commission (SEC) proposed a set of liquidity risk management requirements for registered open-end mutual funds and ETFs. The proposal is part of a broader SEC agenda to modernise the Investment Company Act of 1940 (’40 Act) and to address perceived systemic risk concerns relating to the asset management industry. The program includes four key components:

  • Maintain a classification of portfolio securities into six liquidity time buckets, based upon how quickly the securities can be converted in to cash.
  • Calculate and maintain a capital requirement under the “three-day liquid asset minimum”.
  • Have the fund’s board directly approve, oversee, and periodically review their fund’s liquidity risk management practices.
  • Provide enhanced disclosure in both new and existing reporting (such as Form N-1A, N-PORT and N-CEN).

Under ESMA, the AIFM Directive requires that authorised AIFMs must (except in relation to unleveraged closed-ended AIF):

  1. Adopt appropriate liquidity management procedures for the AIFs that they manage;
  2. Ensure that the liquidity profile of each AIF’s investments is aligned with the AIF’s obligations, for example, in relation to redemptions;
  3. Ensure that an AIF’s investment strategy, redemption policy and liquidity profile are consistent with each other; and
  4. Monitor each AIF’s liquidity risk, including in light of regular stress tests against both normal and exceptional liquidity condition

 

Mitigating Liquidity Risk

Liquidity risk can never be fully mitigated. It has to be managed along with market, credit and other risk factors. Given its tendency to compound other risks, it is almost impossible to isolate liquidity risk.

The best line of defense is a strong liquidity policy and management framework where liquidity risk is robustly measured, monitored and managed. Liquidity management should be viewed as an integral part of a firms’ long-term enterprise strategies. This should include a plan to manage risk both in normal operating environments as well as under the occurrence of extreme liquidity risk circumstances.

To ensure best practices are met a firm must look to target the following areas:

  • The right tools to provide detailed liquidity classification for internal and regulatory reporting.
  • A flexible technology framework for firms to implement their own strategies, i.e. scenario analysis and stress-testing.
  • Subject matter experts that can advise on what best practices should be undertaken for their business model.
  • Asset Optimisation: the ability to track the movement of assets, especially in a large institution, to ensure assets are used in the most cost effective way.
  • Comprehensive data infrastructure to manage and maintain data to ensure a high degree of accuracy.
  • Exploring Liquidity in the marketplace.
  • Liquidity management requires identifying the optimal balance between liquidity risk and profitability.

A study from Deloitte (see Figure 4) shows the difficulties in managing Liquidity Risk can be for a sell-side client:

Figure 3: Net Stable Funding Ratio...

What Tools Can Help?

Treasury:

Treasury has a very important role to play within the banks. They are responsible for ensuring the banks financial obligations and regulatory requirements are met. Treasury requires accurate projection of multi-currency cash positions out to several weeks or even months. The more transparent and readily available information is for them the more effective managing liquidity risk will be, as they are better placed to minimise external borrowings by funding shortfalls in one place with any available surpluses in other.

 

Risk officers:

Liquidity risk has become a key fundamental part of the risk officer’s role and responsibility. By building a set of stress scenarios, a risk officer can run tests based on idiosyncratic, systemic and combined stress to determine the impact this may have on the firm’s balance sheet. However, risk officers often face challenges when it comes to having adequate data available to estimate liquidity. Many firms have opted to set rules to group particular assets into categories in order to help aid segregation and tracking.

 

Tools:

Liquidity needs to be managed on an ongoing basis. This demands a new approach to liquidity risk management, as firms need to adopt a more holistic view to meet their regulatory compliance and business objectives. To do this effectively, firms are increasingly relying on technology providers that can provide a single integrated solution, incorporating reporting, scenario modeling to support stress testing, data management and analytics. With advanced analytics, such as stress testing, scenario analysis and survival horizons, firms can capture and measure exposures that may impact their liquidity position. Monitoring liquidity risk positions has increased the emphasis on automation and timeliness of data integration. Automated and customisable reporting, that allows segmentation and tagging of positions based on the liquidity in your corresponding markets, is also necessary. This information can be utilised to quantify and report liquidity risk at different levels of aggregation.

Figure 4: How challenging is each..

Enterprise Risk Management Framework

There is no one set model to manage liquidity. However, firms that adopt an enterprise risk management framework that addresses the market, credit and liquidity will be able to manage risk based with an integrated view of all the risks impacting their portfolio. As a leading provider of risk, analytics and trading solutions, Quantifi has strong liquidity risk management capabilities.

 

Cash Flow Management

  • Project future cash flow across a defined period of time. As a result, being able to make decisions based on the forecasted balances.
  • Monitoring intra-day liquidity positions against expected activities and available resources.
  • Capture the average daily volumes of trades per asset class to monitor the time to liquidate at the position or portfolio level.
  • Build a set of stress scenarios, based on idiosyncratic, systemic and combined stress to simulate the cost of liquidity and funding.
  • Include IM and VM calls on cash flow balances to provide a further level of accuracy.

 

Treasury/Risk Controls

  • Categorise assets in various classes depending on asset type. For example, users will be able to classify HQLA asset classification sets under Basel III making the LCR ratio calculation a seamless process.
  • Create several stratifications based on asset types - such as country of risk, rating, currency, maturity and date of issue.
  • The ability to match maturity concepts for both assets and liabilities.

 

Conclusion

Liquidity represents the ability to rapidly trade large amounts of securities with minimal impact on market prices. Regulation is placing new limits on market making activities within banks and forcing asset managers to account for liquidity risk when constructing client portfolios.

As the credit crisis demonstrated, ignorance of liquidity risk is dangerous. Sourcing and transferring risk in the secondary market has, consequently, become difficult. This should be a concern to all market participants. Credible analysis of transaction liquidity and associated cost is difficult, but not impossible. New technologies offer a deeper understanding of liquidity drivers in the market and, in turn, can help improve market activity. Asset managers can and should prepare for future liquidity events, but preparation alone will not prevent extreme volatility of asset prices. Fixing the structural imbalance and fortification of market infrastructure is what is truly required.

 

References:


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