Getting liquidity risk management just right

When it comes to liquidity risk management, financial institutions suffer from the Goldilocks syndrome.  In the fairy tale, Goldilocks first tasted a bowl of porridge that was too hot, then she tasted a bowl that was too cold and finally she found a third bowl that was just right. It is the same with the balance of liquidity for financial institutions. Too much of it reduces earnings for financial institutions and too little has the detrimental effect of reputation risk and potential institutional failure. How then do banks get liquidity management ‘just right’?

Traditional measures of liquidity including the long accepted ratio of loans to deposits (LTD) have been found to be seriously lacking in determining an institution’s true liquidity position. Institutions need more than just ratio measurement and trend analysis.  Sound measurement requires utilisation of  a variety of ‘what-if’ scenarios to identify, measure and present an integrated view of risk. Global financial institutions are now facing (or for some, anticipating) more stringent standards required by Basel III regulation for liquidity and capital levels.  Simply put, these regulations require more and better quality of both capital and liquidity for all financial institutions. To confront this regulatory challenge, banks need scenario analysis acumen and must acquire the right technology tools to create a robust liquidity plan as the first step to increasing visibility and to achieve not just regulatory compliance but sound governance as well.

This liquidity plan has to set clear objectives for liquidity management as well as establish limits and guidelines and delineate measurement tools. From there it is essential for the plan to clearly designate accountability to measure and monitor trends, develop alternative liquidity sources, perform stress testing and scenario planning and review forecast assumptions’ validity

With a liquidity plan in place, financial institutions will gain practical insights into the right measurement and management. Taking a comprehensive, forward-looking approach to risk management that gives comprehensive visibility to all types of risk including liquidity risk, interest-rate risk, operational risk, market risk and credit risk as well as economic capital ensures effective corporate governance. Only comprehensively stress-tested capital is the true determinant of a financial institution's safety and soundness. With regulatory scrutiny and business model complexity ever increasing, getting this ‘just right’ is paramount to ensure that an institution has a comprehensive enterprise view of risk.