Liquidity Risk Management

Measuring, monitoring and mitigating liquidity risk

The financial turmoil shows how much the importance of liquidity management has been underestimated over the last years. This is why local and international efforts to put in place a much more robust liquidity risk management framework have taken a big stride over the last few months.

On May 28, 2009, the CSSF issued a new Circular (09/403) related to the management of liquidity risk. At the end of April, the BCL already issued its own regulation (2009/N°4 on liquidity supervision). If new BCL & CSSF regulations are qualitative, the CSSF is preparing new quantitative rules which will replace the current table B 1.5 (CSSF Circular 93/104). These new rules will be based on the results of the CEBS Consultation Paper on Liquidity Buffers & Survival Periods (“CP28”) issued in July 2009.
In this context, Luxembourg institutions have to review their liquidity (risk) management and tolerance. Gauging where you stand makes sense and because such a task is best performed with a fresh look, input from an external expert can prove valuable.

The Challenge

Liquidity risk arises from both assets and liabilities:

• The asset liquidity risk, or market/product liquidity risk, appears when transactions cannot be conducted at quoted market prices;
• Funding liquidity risk, or cash-flow risk, occurs when the institution cannot meet payment obligations.

The Truth is that…

• liquidity has been the forgotten component of risk in the banking sector amongst all the enthusiasm surrounding the implementation of Basel II / CRD;
• the size of assets writedowns combined with the longevity of its credit crunch was outside the scope of existing stress tests (if any performed locally);
• liquidity risk has to be considered in the ICAAP (Pillar II), but capital is no defense against a liquidity crisis;
• a liability-driven balance sheet may be dangerous in terms of liquidity if your reputation is hit (client deposit withdrawals), which is more likely to occur during a financial turmoil.

PricewaterhouseCoopers’ Liquidity Health Check for Banks

PricewaterhouseCoopers has developed a tailored Liquidity Health Check for Banks targeting 10 key areas:

1. Risk Strategy profile (appetite and tolerance)
2. Nature of business and (marketable) asset types
3. Funding strategy and Independence
4. Measuring and reporting (and use of maturity mismatch approach or maximum cash flow approach)
5. Behavioural adjustments
6. Quality of Management Information
7. Skills in Treasury Area and ALM and costs / revenues optimisation
8. Political, economic or geographic factors in relation to the group or parent and the bank’s primary customer base
9. Liquidity Contingency Planning (early warning indicators, roles and responsibilities, management coordination and escalation of issues, channels of communication, communication with the Regulators, scenario planning and testing, etc.)
10. Customer base and reputation risk.

Luxembourg: a financial place that is not concerned?

The new liquidity regulation is currently in the implementation process in Luxembourg with new rules on:

• The importance of establishing a liquidity risk tolerance;
• The maintenance of an adequate level of liquidity, including an adequate buffer of liquid assets;
• The necessity of allocating liquidity costs, benefits and risks to all significant business activities;
• The identification and measurement of the full range of liquidity risks, including contingent liquidity risks;
• The design and use of severe stress test scenarios;
• The need for a robust and operational contingency funding plan;
• The management of intraday liquidity risk and collateral;
• Public disclosure in promoting market discipline, etc.

Why PricewaterhouseCoopers Luxembourg?