Smart About Risk  
Liquidity risk management

Liquidity risk management

Newsletter 01/2024

Liquidity is defined as the debtor’s ability to meet their maturing obligations or the ability of an asset to be converted into cash at market price. Liquidity risk consists of a lack of liquidity to meet maturing obligations (the reverse situation, i.e. when liquid assets are in disproportionate surplus, is not discussed below). In the case of a bank, the lack of liquidity can lead to panic, run on the bank, and even its collapse, as it did in March 2023 for Silicon Valley Bank or Signature Bank. According to the Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, one of the main causes of the bank's collapse was a failure in the management of the bank's liquidity risk and interest rate risk in the banking book (IRRBB).
 
According to regulatory requirements, banks must calculate and report Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). LCR measures short-term liquidity (stock of high-quality liquid assets / net cash outflow over the next 30 days), while NSFR provides a view liquidity in 1 year horizon (available amount of stable funding / required amount of stable funding). Both ratios must be higher than 100 %.
 
In December 2023, the EBA issued a Risk Assessment Report. Based on the submitted data the EBA has reached the following conclusions:
 

  • The LCR and NSFR are high but gradually declining, e.g. the LCR between December 2021 and June 2023 fell from 174.5 % to 160.9 %.
  • The LCR peaked in 2021 mainly due to the accommodative monetary policy of central banks in response to the COVID-19 pandemic.
  • The decline in liquidity was mainly due to the outbreak of the war in Ukraine, the removal of remaining amounts of targeted longer-term refinancing operations (TLTRO-3), and the ECB's quantitative tightening.
  • Discussions are ongoing as to whether the ECB will increase the minimum reserve requirements ratio from the current 1 %. An increase would negatively impact both the bank’s NII and LCR, as the required reserves do not count towards the LCR.
  • A potential problem for European banks may be low liquidity in USD.
  • The EBA expects a further decline in the liquidity of European banks.

At this point, it should be stressed that the regulatory LCR and NSFR should be seen more as minimum requirements that a bank must meet. However, compliance with them does not automatically mean that the bank manages its liquidity well and that it will always be able to meet its maturing obligations. Other methods should be used to assess whether the bank has sufficient liquidity, in particular the projection of expected cash flow and, for example, balance sheet liquidity analysis.
 
Balance sheet liquidity analysis is based on the rule that long-term assets should be financed by stable liabilities. It is carried out by classifying assets and liabilities according to liquidity (i.e. time it takes to change the assets into cash) into, for example, highly liquid, moderately liquid, and illiquid, and then comparing the different categories against each other. For example, the following ratios are used:

  • highly liquid assets / highly liquid liabilities,
  • liquid assets / total assets,
  • highly liquid liabilities / total assets,
  • loans / deposits,
  • demand liabilities / deposits.

To manage liquidity risk effectively, it is advisable to set limits for each ratio. 

This analysis should also be supplemented by an estimate of the net cash outflow and the value of liquid assets within a specified time horizon or future scenario. Both deterministic and stochastic cash flow modeling should be included to better understand and predict liquidity under different scenarios.
 
In the context of liquidity risk management, ARM can offer you:

  • Development / validation of models relating to the actual maturity of assets, liabilities and off-balance sheet items
  • Development / validation of models to determine the minimum required amount of liquid assets
  • Design / assessment of liquidity risk stress testing
  • Design of the definition and methodology for using risk indicators to signal an increase in liquidity risk (Early Warning Indicators)
  • Design of a methodology for setting limits on liquidity risk management, both in individual currencies and in aggregate (for all currencies combined)
  • Design / assessment of a plan of action in the event of a liquidity crisis (what should be done in the event of a crisis and who should do it)
  • Assessment of the methodology for calculating the LCR and NSFR
  • Assessment of the overall liquidity risk management system
  • Workshop Silicon Valley Bank – Lessons from the Crisis
  • Workshop on liquidity risk management
[Back]