Liquidity Risk Management after the Crisis

Abstract

This paper discusses challenges that financial institutions face in the area of liquidity risk measurement and management. The SAS response to these challenges is to deliver an integrated risk solution, SAS® Risk Management for Banking, that can meet the immediate requirements banks have while providing a framework to support future business needs. Lately, liquidity risk has received serious attention from regulators, banks and investors alike. And rightly so, as everyone witnessed how an exogenous credit crisis compounds itself into a major liquidity crisis (or funding problem), propagating very quickly through the global financial markets, leading to insolvency of major financial institutions. Management of liquidity risk has therefore become a subject of vivid discussion in bank boardrooms. The Basel Committee, the Committee of European Banking Supervisors and the UK Financial Services Authority are among the regulatory bodies that have taken the initiative to define a sound framework for its supervision. The objective of all these discussions is to equip banks with adequate liquidity going forward as per their funding profiles as well as to create a liquidity buffer comprising highly liquid assets that can be used to counterbalance a period of liquidity stress. To comply with the latest liquidity risk regulation in Basel III, banks need to prepare for a paradigm shift – moving from routine liquidity management (cash management) activity to a sophisticated liquidity risk management practice in an analytical framework that takes into consideration the stochastic nature of its expected cash flows as well as stress testing of behavioral and market components and the quality and liquidity of the pool of counterbalancing capacity assets. This paper puts in perspective the analytical components of liquidity risk management that are needed to address the new Basel III era of liquidity risk management. Its key components are the cash flow scenarios as a method to measure cash outflow of encumbered assets at any given time horizon, hedging capacity of the unencumbered counterbalancing portfolio, and creating and implementing the stress testing of market and behavioral features that may negatively affect the access to liquidity.