Skip to Main Content
Access your saved content
It is increasingly clear that the current downturn is fundamentally different from recessions of recent decades.
Many believe that we are experiencing not merely another turn of the business cycle, but a restructuring of the economic order. For some organizations, near-term survival is the only agenda item. Others are peering through the fog of uncertainty, thinking about how to position themselves once the crisis has passed and things return to normal.
This paper discusses liquidity management and the challenges created by the new regulatory requirements. It also suggests six pillars on which to build a robust framework for a liquidity program.
In addition to the aggressive financial environment, new rules on bank capital and funding have been issued by the Basel Committee on Banking Supervision.
Nowadays, banks in Europe and in the United States face the challenge of finding ways to substantially boost their capital and funding under these new rules, which are intended to make the international banking system more resilient by addressing many of the flaws that became apparent during the liquidity crisis.
Liquidity risk management is part of the larger risk management framework of the financial services industry, which concerns all financial institutions. Studying liquidity risk management issues is a critical but complex subject. Failure to address the matter may lead to dire consequences, including banking collapse, and by extension, the stability of the financial system. In fact, most bank failures are due to issues around managing liquidity risk.
This is also the reason why regulators are very concerned with the liquidity position of financial institutions and many financial industry professionals believe that the current thinking among regulators appears to center around the strengthening of a bank’s liquidity framework.
To help properly define and measure its main program objectives, banks may want to consider a robust framework for a liquidity program built upon the following six pillars:
Strategy: Establish an efficient liquidity risk management framework in relationship to the bank’s strategy.
Governance: Assess current situation and develop a broad liquidity program covering short-term (survival horizon, regulatory requirements) and long-term liquidity management goals.
Processes: Set up and standardize a sound process for identifying, measuring, monitoring and controlling liquidity in order to produce efficient internal and regulatory indicators and develop or enhance cash flow forecasting capabilities.
Methodology: It may be advantageous to define and implement a limited and representative number of monitoring indicators:
During the last few years, the Basel Committee on Banking Supervision (BCBS) has reviewed its capital adequacy standards and the Basel III Accords are the outcome of that review. One main evolution of Basel III (versus Basel II) revolves around the imposition of multi-dimensional regulations and supervision using capital, liquidity and the leverage ratios, which covers the bank’s entire balance sheet.
These new requirements will take effect around March 2014. Full implementation will be mandatory on January 1, 2019. The Capital Requirement Directive 4 (CRD4) proposal helps implement Basel III in Europe while also covering other areas, such as governance and transparency of financial institutions. The CRD4 contains the Capital Requirements Regulation (CRR) that will be directly applicable and concerns Pillar one (leverage ratio) and Pillar three (market discipline) and the CRD, which would be implemented through countries’ national laws, and which concerns Pillar two (risk management and supervision).
Because one of the major contributors to the financial crisis was the inability of banks to roll over their short-term financing, Basel III introduces two new ratios: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), in order to help improve the banks’ short-term (LCR) and long-term (NSFR) balance sheet resilience.
Banks continue to work on getting their organization ready to support the new strategies to implement the processes, methods and indicators, and to deploy the tools and systems to effectively manage liquidity and its risks.
Financial institutions with a strategy focused on extensive short-term funding or with insufficient high quality liquid assets may face important operating costs when meeting the new liquidity requirements.
To produce the NSFR and LCR ratios, financial institutions would most likely have to adapt their strategy to focus on Basel III requirements. Financial institutions would most likely have to adjust their balance sheets, for instance by:
Holding more high quality liquid assets and measure the encumbrance of the assets in order to reduce the level of structural subordination
Identifying deposits subject to higher outflows via factors such as: volatility, volume, currency, location of deposits and the relationship with customers
Improving additional medium- and long-term wholesale funding
The implementation of Basel III requirements, would likely impact both business model and organizational structure of financial institutions. Indeed, financial institutions will have to create stress and scenario tests, meet new reporting requirements and model cash flows in order to respond to the new liquidity requirements, so financial institutions should expect to face significant operating cost pressures in the short term.As for global banks, they will have to manage both central and local requirements to meet the Basel III requirements with a minimum impact on their ability to move funding and liquidity.
V. Villafranca – Managing Director, Risk Management, responsible for risk management consulting activities for banking and capital markets in France and the Benelux. Based in Paris, she has 20 years of consulting experience, over half in the risk management space. With her broad experience in market, credit, counterparty and operational risk management, and technical experience in areas ranging from modeling work to system implementation and organization review and streamlining, Villafranca is now focused on helping large clients implement Basel 1, 2, 2.5 and 3 requirements.
H. Mohammed – Senior Manager, Risk Management. Based in Paris, and with 13 years of broad-based management consulting experience, and a strong focus on the risk and regulatory agenda in the banking sector, Mohammed is now focused on the liquidity area and helping clients become high-performance businesses.
July 19, 2013
Skip Footer Links