Liquidity Risk; a priority

Liquidity Risk; a priority

Liquidity risk, one of the main ingredients of the credit crunch, has never seemed as important to the regulators and financial institutions as it does now.

The Committee of European Banking Supervisors (CEBS) published its draft guidelines on liquidity buffers, known as CP28, in July 2009. This is a first draft to define and enforce liquidity asset buffers and enhance stress testing.

The CEBS’s step will certainly result in a pan-European regulatory framework very similar to the one introduced by the Financial Services Authority (FSA) in the UK in December 2009. However, the FSA took a much bolder approach with the
publication of CP09/16, titled Strengthening Liquidity Standards, in October last year.

This paper was based on two main principles:

  • Adequate liquidity (funding), ultimately determined by the size and quality of a liquidity asset buffer.
  • Self-sufficiency, enforcing UK subsidiaries of non-UK firms to demonstrate enough liquidity regardless of group liquidity. This principle-based regulation targets a clear pattern of the issue: inability of liquidating assets in a stress event, inadequate stress testing, inadequate contingency funding plans, over reliance on short-term wholesale funding, and over reliance on securitization funding.

“The new regulation addresses the implementation and upgrade of risk management systems as a priority”

Regardless of who the regulator is, the content of the regulation focuses on three topics.

  • Firstly, it defines the size and composition of the liquidity asset buffer, with government bonds playing an important role.
  • Secondly, risk factors are identified to enhance stress testing. These risk factors concern wholesale funding, retail funding, intra-group, cross-currency, and off -balance sheet liquidity risk, as well as other areas. In addition, stress tests are mandatory regarding firm-specific risk, market risk and a combination of both. Based on these stress tests, firms will have to create their contingency funding plans.
  • Thirdly, the need to improve data and reporting is also identified as a requirement to be met.

Though the definition of relevant data is not set out by the new regulation, firms must make it possible to have access to granular data, and to integrate massive amounts of data from different sources. The quality of data has to allow firms to report on a weekly, monthly or annual basis depending on the topic, and even on a daily basis in case of firm-specific or market liquidity crisis.

Last but not least, the new regulation addresses the implementation and upgrade of risk management systems as a priority.

Even though funding liquidity risk seems to be the main target of the new regulation, it should not be considered independently of market liquidity risk. For instance, if a loss is experienced in a margin position, and that loss is funded by reducing other positions, this could, combined with other factors, cause price volatility.

Such a scenario could cause a liquidity spiral, whereby margins are pushed up further, resulting in further losses, and positions are reduced in order to fund them.

Another example of market liquidity risk is the need to collateralize exposures due to fluctuations in market prices. Furthermore, the standardization of OTC markets in the US may push firms to reallocate vital cash to margin accounts. Meanwhile, stress testing is not the only area that needs to be looked at. Liquidity risk also needs to be taken into account by risk measures and pricing models.

For instance, VaR has to reflect the fact that if my scenario expects markets to become more illiquid, it will take longer to liquidate my positions. Hence my VaR will better reflect that with a holding period of more than one day. In addition, (market) liquidity risk management can also be enhanced in pricing models. One way to achieve this is by taking into account trading costs in order to use net returns instead of gross returns.

For financial institutions under the jurisdiction of FSA or CEBS, to meet the deadlines to comply with the new requirements implies a significant cost. Add to this the opportunity cost of foregone yields – due to being enforced to hold a bigger size of less risky, more liquid assets – and also higher cost of capital – by extending the maturity of short term liabilities to reduce the size of the required liquidity asset buffer.

These measures, though, are not enough in isolation. In combination with other regulations and policies, they will result in a financial market less likely to crash and, if so, doing it with less severity for the real economy.