Managing risk of liquidity: a new dimension of risk management

Abstract

Prudent liquidity risk management is a critical component of contemporary complex financial risk management. In the aftermath of the world financial crisis that started in 2007 the liquidity risk area received close attention from financial firms and regulators. The article begins with an introduction of the concept of liquidity risk management, a key component of the Basel III framework. The concept is discussed in the context of the definition provided by the Basel Committee. The author then introduces five levels of liquidity risk management: tactical, structural, funding, market, and systemic as they relate to the implementation of the three-step approach to cash flow analysis in a bank, also introduced in the article. The three-step approach starts with contractual cash flows, then continues with ‘business-as-usual’ flows, and finishes with stressed flows. The flows are classified with regard to the dynamics of liquidity type (actual or potential) and flow type (predetermined or triggered). The author summarises the best practices of liquidity risk-management that are already in place, and lists problems that a practitioner would face in developing and implementing state-of-the-art liquidity risk management.