Liquidity Risk Management. Baird Stephen

paths, leading to variations and fragmentation in an institution's approaches, processes, and infrastructure/support systems.

      Leading institutions are taking a more integrated approach to the management of liquidity risk by recognizing the complex interplay of liquidity risk with market, credit, operational, and other risks. Operationally, firms are focused on addressing both business-driven and regulatory change imperatives by taking a more holistic approach to the design, development, and implementation of the overall risk management framework and its components. They actively seek to further align such risk management operating models, processes, and platforms over time to address the changing scope and scale of its business activities and leverage emerging technologies to meet evolving regulatory requirements. The results have helped improve business and financial performance management (e.g., risk-adjusted performance analysis, and product pricing), forecasting analytics (e.g., stress testing capabilities to evaluate joint potential capital and liquidity impact under severe adverse scenarios), data quality and reporting, and cost efficiencies stemming from increased system automation.

      Apply Rigorous and Effective Challenge in Development of Models and Assumptions

      The importance of forecasting and risk models and associated model management practices has risen significantly over the past several years, particularly given their prominence in regulatory guidance pertaining to enhanced liquidity and capital stress testing requirements. In addition to the overall modeling framework and methodologies, there is significant emphasis on both the numeric values produced by models and the governance processes overseeing those values that are derived and/or determined by expert judgment.

      In validating these model assumptions, leading institutions not only leverage existing model validation groups, but also follow a formalized governance structure in applying effective challenge to the models by involving senior stakeholders from senior management, business, finance, risk, and other support groups. Assumptions are scrutinized and challenged to evaluate their robustness. The focus on both the quantitative results and qualitative controls, including supporting documentation in the form of technical model descriptions, validation reports, and effective challenge session minutes, illustrates the high bar needed to effectively demonstrate sound risk modeling practices.

      Design a Strong LST Framework, Starting with Key Elements, and Enhance Continuously

      The scope and complexity of significantly enhancing or building new LST frameworks and tools can be daunting, particularly given the heightened expectations of regulators and the many challenges that come with such an effort. Few institutions are immune to the various constraints of limited time frames, data quality challenges, scarcity of available resources, and cost containment pressures. Adding to those potential obstacles are the complexities associated with intertwining and aligning different liquidity risk and capital-related methodologies for stress testing, business continuity planning, recovery and resolution planning, and overall enterprise risk management.

      Leading institutions are developing a more strategic view of these enhancements and continuing to enhance their liquidity risk management capabilities, focusing on “core” or key enhancements needed to address immediate issues and/or pending regulatory mandates. They are implementing changes in a modular or phased manner that enables “quick wins” and allows them to maintain momentum by demonstrating success to internal and external stakeholders. Project plans include short-term goals and demonstrate long-term vision; planning horizons capture additional improvement opportunities with approved budgets for forecasted financial and staff resources needed to support the long-run efforts. Leaders in these institutions also take a more strategic and long-term view of liquidity risk management enhancement initiatives, seeing them as part of the institution's continuous improvement efforts rather than “one-off” regulatory compliance projects.

      Intraday Liquidity – Risk Measurement, Management, and Monitoring Tools for Financial Institutions

      Prioritize System Enhancements to Communicate Unanticipated Intraday Liquidity Events

      The batch processing approach used by many institutions captures the liquidity impact only from activities with more predictable cash flows, including loan events, investment banking activity, and securities that settle at known dates in the future. Other events, such as client cash and securities withdrawals, same-day settlement transactions, collateral calls, and clearinghouse payments, may result in unanticipated liquidity impacts that pose challenges for a batch process. To address these issues and improve the institutional awareness of the intraday liquidity position, firms are improving the flow of communication among the treasury, operations, and cash management functions. Before, these communications tended to be manual in nature, by email or phone, as the systems used by these groups traditionally did not communicate directly with each other during the business day to reflect client or firm activity that could unexpectedly impact liquidity.

      By developing linkages between the daily monitoring systems used by treasury, operations, and cash management personnel to account for unexpected activities, leading institutions are now able to have these groups work more efficiently while reducing the potential for intraday liquidity surprises. Firms should continue prioritizing system enhancements for businesses that generate most of the unanticipated liquidity activity, such as prime brokerage, securities clearance, and trading (e.g., fixed-income, exchange traded funds, and commodities). By focusing efforts on these businesses, an institution will capture much of its intraday liquidity pressure points rather than needing to undertake a very costly, extremely time-consuming, large-scale overhaul of its entire transaction processing and risk technology infrastructure.

      Establish Linkages between Intraday Credit and Liquidity Monitoring

      In the years since the crisis, banks have enhanced their intraday credit risk monitoring to better understand risk concentrations across multiple asset classes, particularly with respect to trading counterparties. These efforts have resulted in the formation of specialized groups that monitor counterparty credit quality throughout the day and alert the businesses to declines in credit worthiness.

      Cross-pollinating information between liquidity, operations, and cash management personnel with these credit risk–monitoring functions allows firms to better understand how credit problems can affect projected liquidity and expected cash flows. The credit risk team can alert liquidity managers of a decline in credit worthiness of a counterparty that is expected to settle transactions or make payments previously forecasted as part of the bank's liquidity pool, thereby allowing those managers to respond effectively by altering the liquidity composition and timing of payments of the bank to account for such potential losses. Credit considerations become particularly acute with respect to foreign currency exposure, as late or failed settlements from one counterparty may impact a firm's ability to obtain a currency that it must deliver to another counterparty.

      Incorporate Intraday Exposure Analysis to Size the Working Capital Reserve

      A common approach to estimating working capital begins with projecting the daily liquidity sources and uses for business operations and then augmenting these projections with stress analysis of historical end-of-day exposures. The analysis includes stressing the liquidity reserve to account for potential disruptions in projected cash flows from events such as the failure of an agent bank or financial market utility, tightening of credit provided to the firm, or an increase in failed trades and delayed settlements.

      While this approach highlights scenarios of potential liquidity disruptions during periods of market stress, it may not appropriately estimate the magnitude of these events. A firm's intraday liquidity needs could be significantly higher than its historical end-of-day exposure may indicate. Leading firms have now started to estimate their working capital needs using intraday exposures to account for these large spikes in business activity and the resulting liquidity needs throughout the business day that may not otherwise be reflected in end-of-day metrics.

      The Convergence of Collateral and Liquidity

      Invest in Collateral Management Infrastructure to Gain Cost and Operational Efficiencies and also to Extract Liquidity Risk Management Benefits

      The business case for upgrading collateral management capabilities is bolstered by placing liquidity