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Liquidity Risk Management
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Liquidity Risk Management

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  • 1. 1     With  continuing  market  volatility  and  the  associated  reductions  in  available   funding,  risk  managers  have  to  stay  firmly  on  top  of  their  liquidity  requirements.   Careful  system  selection  that  delivers  the  appropriate  reporting  tools  is  an   essential  component  in  a  successful  liquidity  risk  management  strategy  -­‐  without   this  in  place,  there  is  a  very  danger  of  getting  caught  without  the  appropriate  cash   flow  required  for  efficient  operation.   The  risk  landscape  is  getting  ever  rockier,  as  the  global  market  turmoil  continues  and   regulation  gets  even  tougher.  The  fact  remains  that  regulation  is  only  going  to  get   tougher,  irrespective  of  whether  organisations  have  failed  to  apply  sufficient  risk   mitigation  strategies  in  the  past,  or  whether  the  new  regulations  demand  too  much   complexity  too  quickly.  This  process  is  certainly  going  to  be  further  accelerated  by   the  damaging  impact  of  activities  as  illustrated  in  the  recent  UBS  news  headlines.   Organisations  that  fail  to  face  up  to  the  new  regulatory  world  are  at  best  only   postponing,  or  at  worst  augmenting  the  cost  and  challenges  of  addressing  it.   It  is  therefore  no  surprise  that  'risk  framework'  is  the  corporate  buzzword  of  the   moment.  Everyone  wants  one,  reflecting  recognition  of  the  pressing  need  to  ensure   that  liquidity  risk  strategies  are  robust,  effective  and  flexible.  Risk  needs  to  be   properly  tasked,  funded  and  governed.  There  are  a  myriad  of  options  to  weigh  up,   and  ever  more  complex  regulations  to  contend  with  -­‐  as  illustrated  by  the   introduction  of  Basel  III,  with  its  potentially  conflicting  implications  for  both  liquidity   and  solvency.  Liquidity  operations  represent  a  key  element  to  any  risk  framework.   Overall,  the  challenge  is  to  develop  an  effective  risk  management  policy  that  reduces   exposure  without  constraining  business  flexibility,  matching  an  appropriate  structure   and  risk  appetite  to  an  organisation's  selected  markets,  trading  environment  and   business  objectives.   The  Impact  of  Recent  Events   Post  Lehman's  bankruptcy,  the  financial  market  suffered  a  liquidity  crisis  that  had   not  been  experienced  since  the  Great  Depression  of  the  1920s.  With  financial   institutions'  balance  sheets  heavily  exposed  to  sub-­‐prime  debt,  inter-­‐bank  liquidity   disappeared  as  institutions  felt  that  they  could  not  expose  themselves  further  to   possible  bankruptcy  from  others.  Central  banks,  as  lenders  of  last  resort,  created   financial  facilities  (through  the  Troubled  Asset  Relief  Programme  (TARP)  and   quantitative  easing  (QE))  to  enable  liquidity  by  purchasing  any  securities,  regardless   of  rating.  This  led  to  a  crisis  of  confidence,  where  the  normal  overnight  market  no   longer  trusted  each  other's  ability  to  meet  their  funding  commitments.  Three  years   on,  the  market  still  has  liquidity  issues,  due  to  the  possible  default  of  European  
  • 2. 2   sovereigns.  Central  banks  have  again  stepped  in  to  provide  US  dollar  funding  that   institutions  need  in  order  to  ensure  their  funding  commitments  are  maintained.   The  credit  crisis  taught  us  that  there  was  a  clear  need  for  fundamental  changes  in   risk  management  practices.  And  the  learning  curve  is  still  continuing.  It  is  too  early  to   tell  whether  the  recent  UBS  issue  was  due  to  a  lack  of  a  structured  approach  to  risk   or  was  purely  brought  on  by  fraudulent  activity.  A  risk  framework  cannot  prevent   such  eventualities  such  as  the  lack  of  adhering  to  controls,  fraudulent  activities  or   rogue  traders.  It  can,  however,  highlight  them  at  a  much  earlier  stage  through   accurate  reporting  based  on  a  structured  framework,  thereby  limiting  the  impact.  It   stands  therefore,  that  any  risk  framework  needs  to  have  the  correct  level  of  controls   associated  to  it,  taking  into  account  organisation's  operation  and  its  appetite  for  risk.   Devising  an  Effective  Risk  Framework:  The  Considerations   There  is  no  easy  route  to  realising  a  liquidity  solution.  The  often-­‐adopted  belief  that   implementing  a  liquidity  risk  control  will  result  in  a  liquidity  solution  is  completely   false.  It  is  essential  to  define  a  structured  approach  to  risk  as  a  whole,  throughout  an   organisation,  and  as  such  liquidity  risk  forms  in  integral  part  of  an  entire  risk   framework.  Even  the  Financial  Services  Authority  (FSA)  has  demonstrated  its   acceptance  that  it  is  not  possible  to  remove  risk  entirely  from  the  financial  system.  It   does,  however,  regularly  review  how  much  risk  it  is  prepared  to  tolerate.  The  same   applies  to  corporations  -­‐  where  risk  will  always  exist  to  a  certain  degree.  The  level   needs  to  be  effectively  determined,  managed  and  reviewed  via  a  well-­‐conceived  and   executed  structured  risk  framework.   When  dealing  specifically  with  liquidity  risk,  the  regulations  clearly  state  that   committed  credit  or  liquidity  facilities  cannot  be  leveraged.  During  the  2007-­‐2008   credit  crises,  many  organisations  decided  to  conserve  their  own  liquidity  or  reduce   their  exposure  to  other  banks.  This  strategy  can  cause  a  knock-­‐on  effect  that  sends   shockwaves  through  the  financial  institutions,  making  those  that  are  over-­‐leveraged   in  serious  danger  of  default  or  collapse.  As  a  result,  the  ability  to  report  clearly  on   current  status  and  liquidity  exposure  has  never  been  more  important.   The  regulations  clearly  stipulate  that  an  organisation  must  not  be  over-­‐leveraged.  It   follows  that  in  order  to  effectively  manage  its  liquidity  risk,  an  organisation  must   ensure  that  it  has  the  effective  means  of  which  to  monitor  and  report  on  it.  This   requires  the  correct  monitoring  tools  and  metrics  to  be  put  in  place,  with  readily   available  reporting.  As  liquidity  risk  covers  the  reflection  and  management  of  open   market  positions  and  commitments,  it  is  a  prerequisite  to  implement  an  effective   system  in  which  to  report  such  positions.  This  is  where  an  effective  risk  framework   comes  into  its  own,  providing  the  tools  to  not  only  highlight  the  risk,  but  also  to   report  on  and  provide  meaningful  up-­‐  to-­‐the  minute  information.  Never  has  the   phrase  "knowledge  is  power"  been  more  appropriate.  With  the  correct  knowledge   base,  it  is  within  an  organisation's  power  to  manage  and  mitigate  any  upcoming  risks   truly  effectively.  
  • 3. 3   We  have  also  seen  another  paradigm  shift  with  the  recognition  that  liquidity  is  no   longer  restricted  to  just  emerging  markets  or  obscure  stock,  but  can  in  fact  be   widespread.  This  has  been  witnessed  with  increasing  regularity  even  in  the  most   established  of  markets.   As  already  stated,  a  successful  risk  framework  must  effectively  control,  manage,   escalate  and  in  turn  mitigate  or  process  any  associated  risk.  A  miss-­‐sold,  incorrectly   designed  or  wrongly  implemented  framework  can  have  long-­‐lasting,  detrimental  and   potentially  catastrophic  effects  -­‐  actually  reducing  a  large  corporation's  revenue   stream  if  it  is  too  risk  averse,  or  placing  unnecessary  risk  on  a  trading  structure  that   witnesses  very  little  gain.  Devising  an  appropriate  risk  framework  is  about  achieving   balance  and  harmony  within  an  organisation,  enabling  proactive  risk  management   without  restricting  growth  or  adding  layers  of  red  tape  to  any  trading  process.     Figure  1:  An  Effective  Risk  Framework   System  Considerations   There  are  many  risk  platforms  and  systems  in  the  market,  offering  varying  degrees  of   complexity  and  solution-­‐based  processes  in  and  around  risk  management.  Finding   the  most  appropriate  solution  for  a  particular  organisation  relies  on  a  careful  process   of  review  and  needs  assessment.  There  is  a  very  real  danger  associated  with  driving   risk  management  by  system  selection,  leading  to  the  misconception  that  investing  in  
  • 4. 4   the  'best'  system  is  a  simple  way  of  resolving  all  risk  management  issues.  As  with   enterprise  risk  planning,  customer  relationship  management  (CRM)  and  other   business  enterprise  systems,  it  is  imperative  to  understand  both  your  business  and   the  data  you  need  in  order  to  get  the  best  out  of  the  system.  There  are  many   systems  on  the  market,  but  experience  shows  us  that  when  defining  an  all   encompassed  risk  management  framework,  it  is  imperative  to  understand  the   business  requirement  before  going  down  the  system  selection  route.   Getting  to  Grips  with  Liquidity  Risk  Management   With  regulators,  investors,  shareholders  and  boards  all  demanding  a  much  more   structured  and  transparent  approach  to  risk  management,  what  are  the  options  on   the  table?  There  are  many  risk  management  systems  in  existence  that  offer  the   ability  to  develop  and  build  specific  scenarios  relating  to  liquidity  risk,  thereby   ensuring  that  any  funding  gaps  are  negated.  A  system  also  needs  to  be  able  to   forecast  funding  and  liquidity  requirements  accurately  over  various  time  horizons.   In  the  future,  liquidity  risk  will  only  become  more  regulated,  with  tighter  controls   being  enforced  on  organisations  to  ensure  they  have  adequate  funding  and  reserves   to  meet  their  cashflow  commitments.  The  painful  lessons  of  the  past  three  years   have  demonstrated  the  need  to  ensure  that  not  only  are  interbank  facilities  in  place   to  ensure  that  funding  can  be  met,  but  also  that  internal  controls  are  well-­‐defined,   supported  by  good  systems  to  enable  the  liquidity  risk  profile  to  be  well  understood   by  all  levels  of  management.  This  latter  point  was  recently  enforced  by  London  risk   manager  Daniel  Geoghegan,  when  he  was  quoted  as  saying:  "Best  practice  in  risk   management  through  a  well-­‐defined  risk  framework  needs  to  be  constantly   monitored  and  refined,  so  that  it  is  in  adherence  to  any  new  regulations;  and   therefore  it  is  imperative  that  any  new  framework  be  allowed  to  reflect  any  new   regulations.  This  requires  organisations  to  take  a  strong,  dynamic  and  pragmatic   approach  to  their  liquidity  risk  operations  to  ensure  that  there  is  no  exposure  to  the   organisation  in  mitigating  any  potential  risk  losses."   Conclusion   With  continuing  market  volatility  and  the  associated  reductions  in  available  funding,   risk  managers  have  to  stay  firmly  on  top  of  their  liquidly  requirements.  Careful   system  selection  that  delivers  the  appropriate  reporting  tools  is  an  essential   component  in  a  successful  liquidity  risk  management  strategy  -­‐  without  this  in  place,   there  is  a  real  danger  of  getting  caught  without  the  appropriate  cashflow  required   for  efficient  operation.    

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