Overview
Risk management is the process of identifying, assessing, and controlling threats to an organization's capital and earnings. These threats, also known as risks, could come in the form of financial uncertainty, legal liabilities, strategic management errors, accidents and events beyond the control of the organization. Risk management strategies are designed to minimize the potential negative effects of such risks and to maximize the potential positive outcomes.
The risk of a financial institution's ability to fund its assets or to meet its obligations as they become due without unacceptably high costs or losses is known as liquidity risk. Liquidity risk has several components, including:
The danger that a financial institution won't be able to meet its financial obligations on time during the day is known as intraday liquidity risk.
The danger of a financial institution's inability to pay obligations when they are due without significantly impairing either its ongoing business operations or financial situation is known as funding liquidity risk. The maturity gap between assets and funding, which results from the maturity transformation contained in commercial banking activity, is the source of funding liquidity risk.
Market liquidity risk is the possibility that a financial institution won't be able to quickly fulfill its liquidity needs by selling at the market price or liquidating a position through securities lending due to insufficient market depth, price depreciation, or market disruption. Asset and derivative markets are where market liquidity risk manifests;
The risk associated with financing cost is that a financial institution will only be able to fund its assets at greater costs to replace expiring funds.
The impact of a financial commitment or transaction on a bank's liquidity risk is almost universal. Liquidity risk is mostly caused by unstable deposits or unplanned withdrawals of deposits. Unexpected loan growth could potentially be a source of this danger. A bank's liquidity risk may also be significantly impacted by off-balance sheet commitments and other contingent liabilities, such as commitments to undrawn loans.
Under the direction of the Asset-Liability Committee (ALCO), the funding liquidity risk is divided into two categories: short-term (up to one year, with a strong emphasis on the period up to one month), which is typically managed by the financial institution's treasury department and/or treasury committee, and long-term (more than one year), which is typically managed by the asset liquidity management (ALM) department.
Financial institutions should monitor their liquidity and financing position across the entire spectrum of maturities, from the shortest to the longest, although there are no particular ratios spanning the periods under one month, between one month and one year, or intraday liquidity.
A financial institution needs the right organizational structure, strategies, rules, and processes, as well as boundaries, indicators, monitoring, and reporting systems, in order to manage liquidity risk effectively. In order to effectively monitor its liquidity and to withstand a variety of stress events, such as the loss or impairment of both secured and unsecured funding sources, it will also need an adequate information system. This system should also include a cushion of unencumbered, high-quality liquid assets.
Related Topic: Credit Risk Management
Organizational Structure
The units or committees responsible for analyzing the risk profile and approving the risk strategy and appetite should be included in an organizational framework with clearly defined tasks and responsibilities for the liquidity risk management and control functions.
A bank should implement an organizational structure that is based on the three lines of defense strategy and is properly integrated into the bank's overall risk management process in order to develop a strong liquidity risk management framework.
The Liquidity Risk Management function plays a key role in the development of Liquidity Risk Management Policies and is involved in daily monitoring of Liquidity Risk Levels, timely reporting of important Liquidity Risk Related Information, and other related activities. It should be independent and directly report to the Chief Risk Officer.
The Asset-Liability Committee (ALCO), typically a senior management committee made up of the managers of the units that take on liquidity risks, should provide the board with periodic updates on both short- and long-term liquidity risks.
Strategies, Policies and Procedures
A financial institution should develop a liquidity risk management strategy that is specific to its institutional structure, organization, activities, products, and clients in light of its risk profile. The planned mix of assets and liabilities should be described in the strategy, together with any implications for liquidity risk. In comparison to banks that rely largely on retail funding, banks that rely more on wholesale funding should keep a substantially higher share of unencumbered, highly liquid assets. If significant, the handling of intraday liquidity risk needs special consideration.
The first step in developing a consistent liquidity management and liquidity risk management system is for the financial institution to examine its own situation and profile with respect to liquidity risk. This is followed by establishing its liquidity risk strategy and risk appetite. This evaluation of the risk appetite, risk strategy, and risk profile should be defined in qualitative and quantitative terms, taking into account both changes in company plans and forward-looking features of prospective hazards.
The existing and desired liquidity situation, for instance, a maximum loan-to-deposit ratio or a maximum reliance on the liquidity (and funding) markets, could be included in the liquidity risk strategy. Under various stress scenarios, the liquidity risk appetite should at least manifest itself as minimum survival times (both with and without access to NRB cash).
A bank should have a funding plan that effectively diversifies the sources and duration of funding as part of its strategy for managing liquidity risk. Financial institutions should maintain strong bonds with funds providers in addition to their ongoing presence in their chosen funding markets in order to effectively diversify their sources of funding. The bank's strategy and annual budgets should be compatible with medium- to long-term funding plans. It should also have a plan for spending money while taking liquidity risk into account.
A bank must research the structure, maturity, and diversification of its deposit base. In order to improve its ability to survive a range of severe institution-specific and market-wide liquidity shocks, it should also find alternate sources of funding. Alternative funding options could come from:
- New issues of short-term and long-term debt instruments,
- Drawing down line of credit with other banks,
- Borrowing from the central bank,
- Lengthening of maturities of liabilities,
- Repo of unencumbered, highly liquid assets,
- New capital issuance, sale of subsidiaries
The financial institution should explicitly define and clarify the risk management techniques it intends to employ for the evaluation, monitoring, and control of its liquidity risk in its policies and procedures. It is important to convey and document the procedures used by these tools across the company. Liquidity risk metrics should be incorporated into the policies as well. Financial institutions may start using indicators like the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio in the future (NSFR).
The roles and duties of persons and groups conducting tasks related to structural balance sheet management, pricing, marketing, management reporting, and lines of authority and responsibility for liquidity choices should be clearly defined in policies.
Limits and Early Indicators
A financial institution should set limitations on funding concentration by counterparty, product type, currency, geographic market, etc. to control its exposure to liquidity risk and vulnerabilities.
Under both normal and stressful circumstances, limits should be employed to manage daily liquidity within and across the business lines. A financial institution should consider measures to ensure that it can continue to operate during a period of market stress, institution-specific stress, or a mix of the two while evaluating how limits would perform under stressful conditions.
A financial institution should also create a set of indicators to help this process in order to spot any emerging risks or weaknesses in its position with regard to liquidity risk or potential funding requirements. Such early warning indicators should identify any negative trend and cause an assessment and potential response by management in order to mitigate the bank’s exposure to the emerging risk.
Early warnings can be qualitative or quantitative in nature and may include (but not be limited to):
- Rapid asset growth funded by unstable large deposits,
- Growing concentrations in either assets or liabilities,
- Deterioration in quality of credit portfolio,
- Significant deterioration in earnings performance or projections,
- Increasing retail deposit outflows,
- A large off-balance sheet exposure,
- Deteriorating third party evaluation (negative rating) about the financial institution and negative publicity,
- Unwarranted competitive pricing that potentially stresses the financial institutions.
Measurement and Monitoring
There is no single statistic that can fully assess liquidity risk, so a financial institution should use a variety of tailored measurement tools, or metrics. A bank should employ measures that evaluate the balance sheet's composition as well as metrics that forecast cash flows and future liquidity positions, taking into consideration off-balance sheet risks, in order to generate a forward-looking perspective of liquidity risk exposures.
The vulnerabilities across normal and stressed conditions over various time horizons should be included in the risk measurement tools. Under normal circumstances, prospective measures should identify demands that could result from anticipated outflows in relation to regular funding sources. Prospective measures should be able to pinpoint financial deficits at different horizons while under stress.
Assumptions play a crucial part in liquidity gap research when estimating future cash flows. A financial institution should take measures to ensure that its assumptions are suitable, documented, reviewed, tested, and authorized on a regular basis. When there is a liquidity crunch, it is especially crucial to make assumptions about the length of demand deposits, revolving loans, and other off-balance sheet items with uncertain cash flows as well as the availability of alternative sources of funding.
A financial institution should have a dependable management information system built to deliver timely and forward-looking information on the bank's liquidity condition to the board of directors, senior management, and other appropriate officials. Additionally, the banks should have a set of reporting requirements that outline the content, format, and frequency of reporting for different audiences (including the board, senior management, and ALCO) as well as the parties in charge of creating the reports.
Reporting
For efficient liquidity risk management, timely and adequate reporting of risk-related information is particularly crucial. The flash reports on liquidity risk from the financial institution's MIS itself should be accessible to the top management. The management must decide which reports—including regulatory reports—should be sent to the board and/or senior management, as well as how often they should be sent. Further, the board-level risk management committee should be informed of the main topics discussed and decisions made during ALCO meetings.
Contingency Funding Plan
A contingency funding plan is a set of procedures, steps, and precautions to be performed in the event that liquidity issues manifest. Plans for contingencies are created to deal with short-term financial shortages in emergency situations like those envisioned in stress scenarios. They therefore only have true value if they are integrated into the group's operational and liquidity management framework, periodically tested, and reviewed, and define roles and contain a set of doable activities. They must be evaluated and updated on a regular basis to reflect shifting market conditions as well as the bank's operations and risk profile.
A Contingency Funding Plan (CFP) must be created and implemented by financial institutions in order to meet funding requirements during stressful situations. When under pressure, dependable funding can become substantially disturbed. Thus, such a funding strategy is essential for the long-term viability of the financial organisation. The complexity, risk profile, range of activities, and function of the financial institution in the financial systems in which it participates should all be taken into account when determining CFPs. CFPs should clearly outline a variety of viable, easily accessible, and flexibly deployable potential contingency funding measures for maintaining liquidity and making up cash flow shortfalls in a variety of challenging circumstances.
Financial institutions should take into account two different types of liquidity crises when creating a liquidity contingency plan: idiosyncratic, which refers to a liquidity issue specific to the financial institution, and market-wide, which refers to a liquidity crisis affecting the entire financial system.
Read More: Nature and Function of Profit
