MANAGING LIQUIDITY RISK
RC: Looking back, what factors have triggered financial institutions’ vulnerability to liquidity risk in recent years?
Flaunet: The trigger factors of the liquidity crisis can be traced back to various interdependent factors on both a micro and macroeconomic level. Financial institutions took for granted the favourable conditions of low volatility and low interest rates and underestimated the importance of liquidity. Within this environment, banks funded their long-term credit activities short-term, or even overnight, on the interbank market, which created a large maturity mismatch. Only when this funding resource became scarce and mutual trust was lost did banks realise that liquidity was insufficiently considered in their internal strategic and planning processes. Pricing of liquidity was not thoroughly implemented, especially potential liquidity risk in off-balance sheet positions, and refinancing risk in structured products was incorrectly assessed. Consequently, traders were incentivised to take excessive liquidity risk. From a regulatory perspective, liquidity risk was not addressed within the Basel II framework, revealing a weakness of the supervisory requirements and the demand for a modified framework.
RC: How would you describe financial institutions’ approach to liquidity risk in the aftermath of the financial crisis? In your opinion, is there more awareness of the underlying issues?
Lichtfous: Liquidity became one of the major attention points for boards and management of financial institutions. Since the financial crisis, the regulation of liquidity has changed dramatically, hence the lessons learned and their business relevance have increased in significance. Banks have understood that it is necessary to improve their internal liquidity risk management system by establishing qualitative and quantitative measurements and procedures to regularly address the risk. These tools are used to better monitor and control risks. The outcome of the output means they can better address and minimise liquidity risk. Consequently, financial institutions assess their liquidity risk by strengthening their resilience in times of stress and ensuring stability in daily cash management through permanent controls. Liquidity risk became one of the key functions to include in contingency and action plans in the event of an emergency, and is strongly connected to balance sheet management performed and monitored by ALM committees. Indeed, we observed a strong and robust liquidity risk profile among our clients in terms of risk governance and liquidity adequacy assessment.
Oct-Dec 2015 Issue