Winston Ngan: Liquidity’s new prominence on the risk agenda

Recent events in the global financial markets are a poignant reminder that financial institutions have exposures that extend beyond the assumed risks. The recent crisis has prompted a thorough re-examination of liquidity risk, and how financial institutions should manage it more comprehensively. Now, more than ever, liquidity risk is on par with market, credit and operational risks. In the past, markets were flushed with liquidity and easily available credit, encouraging complacent attitudes towards liquidity risk. However, the financial crisis changed all that. Suddenly, there was a realization that the lack of liquidity could cause the collapse of not only specific institutions but an entire system.

The market looks at liquidity risk broadly at two levels: at the institutional level, in other words an issue with a bank, or on a regulatory level, in response to broader market or systemic risk. On an institutional level, financial institutions are reviewing the type of assets they hold, whether they need to be lowered in order to boost liquidity, the maturity of those assets, and the currencies in which they are denominated (for example, US dollars). They are also assessing their funding sources, particularly non-domestic institutions and the degree to which they are dependent on liquidity funding from headquarters. The latest thinking on liquidity management is that each location should have means to raise liquidity or have access to it by itself.

Stress-testing
Generally, institutions are evaluating their entire liquidity picture to see if and how they can efficiently strengthen liquidity. In doing that, institutions need to recognize the importance of a robust risk management framework, including stress-testing. Stress-testing allows an institution to identify the impact of liquidity events that it can encounter, thus providing insight into potential liquidity shortfalls and the strategies needed to maintain an appropriate liquidity position. Although institutions have used stress-testing in the past, lessons learnt from the crisis have highlighted the inadequacies and failure of its prior practice to thoroughly quantify potential liquidity risk. Institutions are now prompted to re-think the stress-testing scenarios of their liquidity positions. Rather than looking at liquidity for funding, they now incorporate impact on the entity's overall balance sheet that is likely to be brought about in a crisis situation. For example, the impact on asset value in an illiquid or severely stressed market, and the consequence on capital and confidence.

Financial institutions now perform stress-tests on their liquidity profile on a regular basis to ensure that a strong credit stress-testing policy is not only in place, but continually enhanced. Stress-testing processes, approaches and methodologies also need to include an expanded number of stress-test scenarios to evaluate the accuracy of projections. Maintaining liquidity targets to ensure that funds are available even under adverse conditions to cover customer needs, maturing liabilities, and other funding requirements is essential in managing liquidity risk across all classes of assets and liabilities. Management must not only recognize the need for change but also quickly and effectively execute programs and reshape the business to make sure they are in a position to respond and adapt.

Evolving regulations
Previously, due to a lack of industry-standard key risk indexes, evolving regulatory guidance and possibly no integrated view of an institution’s global liquidity position, it has been a challenging task for boards of directors and the C-suite to provide investors and regulators with an efficient flow of liquidity risk information. However, there have been steps towards liquidity regulations, including Financial Services Authority (FSA) rules on liquidity for banks operating in the UK. Regulators now demand that stress-testing considers forward-looking information and qualitative insight in order to identify and consider liquidity events for which there are no precedents. They also expect institutions to be able to perform certain ad hoc analyses in a timely manner. Given the recent events of global financial markets, such external pressures and internal demands are not likely to let up in the years ahead.

Global regulatory regimes are still evolving, and it remains to be seen the extent to which they will be reshaped in Asia. In Singapore, the Monetary Authority of Singapore has said that it will continue to work on strengthening the risk management systems and processes of financial institutions, to assess vulnerabilities and fine-tune measures for them to mitigate financial stresses. These include building up prudent capital buffers to absorb losses when necessary. Many financial institutions here have already begun to identify scenarios that pose the greatest risk to the long-term viability of their business and have started to develop contingency plans that will help manage their business through a crisis. They are also beginning to review their scenario analysis capabilities to ensure that they have the ability to model a variety of short-term and protracted institution-specific and market-wide stress scenarios and assess specific vulnerabilities and systemic effects.

While it is clear that the global financial crisis has brought unprecedented turmoil to many financial institutions with a landscape that continues to evolve, positioning the organization to emerge stronger from the crisis is now vital, as opportunities still exist for efficient and agile companies. No longer just the purview of the asset and liability committee of a bank, liquidity risk should now be an integrated part of the overall risk management function that requires a coordinated management approach by all who oversee risk - from the board of directors, chief risk officers, senior management as well as risk committees and other lines of business. Coupled with a potent cocktail of proper processes and tools that are aligned with liquidity risk programs to gather liquidity information across the organization, financial institutions will be better equipped for any future crunches and be able to hold competitive advantage.