Liquidity Risk Management

• Liquidity risk is the potential inability of a depository institution to meet obligations when due, without unacceptable losses.
• It stems from timing mismatches between cash inflows and outflows.
• Managing liquidity risk is vital for depository institutions' stability and solvency.

Sources of Liquidity Risk

• Liability-side liquidity risk arises when depositors or creditors demand cash.
• Asset-side liquidity risk arises when borrowers draw on credit lines, or assets cannot be sold quickly near book value.

Measuring Liquidity Risk

• Net liquidity position is a basic measure: liquid assets minus potential drains.
• Liquid assets include cash, marketable securities, and readily saleable assets.
• Potential drains involve deposit withdrawals, loan demand, and other obligations.

Liquidity Coverage Ratio (LCR)

• The LCR is a regulatory requirement under Basel III.
• Banks must hold enough high-quality liquid assets (HQLA) to cover projected net cash outflows over a 30-day stress period.
• HQLA includes assets like cash, central bank reserves, and certain government securities.
• LCR = (HQLA / Total Net Cash Outflows) ≥ 100%

Net Stable Funding Ratio (NSFR)

• The NSFR is a Basel III metric to ensure long-term funding stability.
• Banks must maintain a stable funding profile relative to their assets and activities.
• Available stable funding (ASF) includes capital, stable deposits, and long-term funding.
• Required stable funding (RSF) is the amount of stable funding needed to support assets, based on their liquidity characteristics.
• NSFR = (Available Stable Funding / Required Stable Funding) ≥ 100%

Liquidity Risk Management

• Effective liquidity risk management involves policies, procedures, and controls.
• This includes identifying and measuring liquidity risk, setting risk limits, early warning indicators, developing contingency funding plans, stress testing, monitoring, and reporting.

Contingency Funding Plan (CFP)

• A CFP outlines strategies for addressing liquidity shortfalls in emergencies.
• It identifies potential funding sources like asset sales, borrowing lines, and interbank loans.
• The CFP should be regularly tested and updated.

Stress Testing

• Simulating adverse scenarios assesses the impact on an institution's liquidity position.
• Scenarios include loss of deposits, credit rating downgrades, and market disruptions.
• It helps identify vulnerabilities and refine risk management strategies.

Regulatory Oversight

• Banking supervisors monitor liquidity risk through on-site examinations and off-site surveillance.
• They assess the adequacy of practices and compliance with regulatory requirements.

Impact of Liquidity Risk

• Failure to manage liquidity risk can lead to fire-sale of assets, loss of depositor confidence, increased borrowing costs, regulatory intervention, and ultimately, bank failure.

Interbank Lending

• Banks borrow from and lend to each other in the interbank market to manage short-term liquidity needs.
• The interest rate on these loans is often a benchmark for broader market liquidity conditions.

Deposit Insurance

• Deposit insurance (e.g., FDIC) helps mitigate liquidity risk by assuring depositors, reducing the likelihood of bank runs.

Central Bank Role

• Central banks act as lenders of last resort, providing emergency liquidity to banks facing solvency issues.
• This stabilizes the financial system during stress.

Asset-Liability Management (ALM)

• ALM coordinates asset and liability management to control liquidity and interest rate risk.
• Effective ALM ensures an institution can meet its obligations as they come due.

Early Warning Indicators (EWIs)

• EWIs signal potential liquidity problems before they escalate.
• Examples include declining liquid asset levels, increasing reliance on short-term funding, deteriorating credit ratings, and adverse media coverage.
• These indicators trigger management action and further investigation.

Funding Diversification

• Diversifying funding sources reduces reliance on any single source of liquidity.
• Funding sources include retail deposits, wholesale deposits, interbank loans, and debt issuance.
• Diversification enhances the stability of the funding base.

Collateral Management

• Effective collateral management is crucial for accessing secured funding sources like repurchase agreements (repos) and central bank lending facilities.
• Institutions should have systems to value, monitor, and manage collateral efficiently.

Intraday Liquidity Management

• Intraday liquidity risk arises from the timing mismatches of payments throughout the day.
• Institutions must have sufficient liquidity to meet payment obligations without disrupting operations or payment systems.

Liquidity Risk and Bank Runs

• A bank run occurs when many depositors simultaneously withdraw funds, fearing insolvency.
• Effective liquidity risk management can reduce the likelihood and severity of bank runs.

Securitization and Liquidity

• Securitization can both create and mitigate liquidity risk.
• It can create liquidity by converting illiquid assets into marketable securities.
• It can also create liquidity risk if the institution relies too heavily on securitization and the market for these securities dries up.

Model Risk in Liquidity Management

• Liquidity risk models forecast liquidity positions and assess the impact of stress scenarios.
• These models are subject to model risk from errors in design, assumptions, or implementation.
• Model validation and independent review are essential for managing model risk.

Governance and Oversight

• Strong governance and oversight are critical for effective liquidity risk management.
• The board and senior management should set the tone, establish a risk appetite, oversee policies and procedures, and ensure adequate resources.
• Independent risk management functions should provide oversight and challenge to the business lines.

Training and Awareness

• Regular training is essential to ensure employees understand their roles and responsibilities.
• Training should cover liquidity risk concepts, policies, procedures, EWIs, and contingency funding plans.

Communication and Coordination

• Effective communication and coordination are essential across the organization.
• This includes sharing information, coordinating activities across different business lines, and communicating with regulators and other stakeholders.

Technological Infrastructure

• Robust technological infrastructure is essential for supporting liquidity risk management.
• This includes systems for tracking and monitoring liquidity positions, tools for stress testing, platforms for collateral management, and reporting capabilities.

Liquidity and Solvency

• Liquidity and solvency are related but distinct.
• Liquidity is the ability to meet short-term obligations.
• Solvency is the ability to meet long-term obligations, with assets exceeding liabilities.
• An institution can be solvent but illiquid, and vice versa.

Global Considerations

• Liquidity risk management is complex in a globalized financial system.
• Institutions must manage liquidity risk across multiple currencies, jurisdictions, and legal entities.
• Cross-border liquidity management requires careful consideration of regulatory requirements, transfer restrictions, and market conditions.

Technological Innovations

• Fintech innovations present both opportunities and challenges.
• New technologies can improve efficiency, provide access to new funding, and create new forms of liquidity risk.
• Institutions must carefully assess and manage the liquidity risk implications of fintech innovations.