Managing Liquidity Risk – The 2007 Crisis¶

After the initial liquidity crisis in 2007 and the ensuing financial collapse, the topic of Liquidity Risk Management has become highly relevant. A query along the lines of “What is the best way to ensure that my bank’s Liquidity Risk Management is on a sound basis?” keeps popping up in my inbox.

This is a rather broad topic. The answers vary based on the specific goals you have in mind. I’d want to take a step or two back – and discuss some of the important ideas and challenges that surround liquidity management – before even attempting to present a broad picture of the key issues to be addressed in assuring solid Liquidity Risk Management.

The first thing to consider when discussing liquidation stores near me is the context in which the term is being used. Let me elaborate. The term “liquidity” refers to an asset’s ability to be quickly and reliably converted into cash. The most liquid asset is cash on hand. In contrast, the term “market liquidity” describes the ease with which an asset can be bought or sold on the market without significantly impacting the asset’s price or value. Liquidity in the context of accounting refers to a company’s capacity to pay its bills as they come due. Current liability coverage ratios and percentages are common ways to convey this concept.

Liquidity, in the context of banking and financial services, refers to an institution’s capacity to pay its bills as they come due. Every day (and in today’s real-time environment, every second counts), bankers must monitor and forecast cash flows to ensure that sufficient liquidity is maintained. Liquidity is essential in the banking industry, as it is used to pay for advances, letters of credit, commitments, and other client-bank activities (such as money transfers and settlements).

Liquidity can also be understood in many more ways. As far as I’m concerned, the above statement is sufficient to both explain the concept and show that there are many other ways to approach this.

A bank’s liquidity can be affected by nearly any financial commitment or transaction. The ability of a bank to meet its cash flow obligations can be ensured with the aid of liquidity risk management. Keep in mind that this capability is highly sensitive to outside factors and the actions of the other parties involved in the transaction. Systemic risk, which can result from a liquidity shortfall at a single bank, highlights the importance of effective liquidity risk management. A financial meltdown could occur if, for example, a single bank were unable to meet its commitments in the end-of-day payment system.

In fact, the central bank has a safety net ready to help out individual banks (or even the wider “system”) in times of need as the lender of last resort. Over the past two years, this has occurred on a global basis, including in the United States, Europe, Asia, and other regions. The problem is that the price of this help is often an unattainable one: one’s reputation. When public, investor, and depositor faith in a bank is shaken, the resulting financial consequences can be devastating. This cost is often too high for the ailing bank to bear.

The market turmoil that started in the middle of 2007 brought home how crucial liquidity is to the smooth operation of the banking and financial sectors. Asset markets were robust and money was easily accessible at low rates of interest prior to the crisis. A lack of liquidity (the proper term is illiquidity) can endure for a very long period of time, as was made abundantly obvious by the dramatic shift in market conditions.

The summer of 2007 has finally here. There was a lot of pressure on the global banking sector beginning in August. The intricacy of liquidity risk and its management has been further compounded by changes in the financial markets over the past decade. As a result, governments intervened on a large scale to restore order to the banking system and the money markets.

At this point, it was abundantly evident that many banks had disregarded several elementary tenets of liquidity risk management. Why? Probably not much in a world where money was easily accessible and inexpensive.

When it came to the liquidity risks necessitated by their specific products and lines of business, many of the banks with the highest exposure lacked even a minimally competent framework. As a result, the company-level incentives did not line up with the banks’ overall risk tolerance.

Despite the high probability of having to fulfill contingent liabilities, many of these banks had not adequately calculated the amount of liquidity they could need to do so.
Similarly, many financial institutions considered the possibility of a major and protracted liquidity disruption to be extremely remote. They also didn’t run stress tests that accounted for the severity and length of the issues, or the likelihood of a market-wide crisis (one that affects the entire sector rather than just one other participant).

Additionally, financial institutions did not connect the outcomes of their stress testing to their backup funding strategies. And to rub salt in the wound, they often expected that their regular sources of funding would continue to be available no matter what transpired.

Banks and bank regulators were still reeling from the events of 2007 and 2008 when the “Basel Committee on Banking Supervision” of the Bank for International Settlements (BIS) released a report titled “Liquidity Risk Management and Supervisory Challenges” in February 2008.

Many of the fundamental concerns, as described above, were exposed by the crisis. As a result, the Basel Committee has revised its 2000 report “Sound Practices for Managing Liquidity in Banking Organizations” to reflect the current state of the industry. Their new document greatly expands their previous recommendations across eight focal points. Some of the fundamentals addressed by these foci are as follows:

It is the responsibility of banks to decide how much risk they are willing to take with regard to liquidity, to maintain a level of liquidity appropriate to their needs, to allocate the costs of liquidity to the bank’s business activities, to identify and measure all liquidity risks, to develop and use stress tests that mimic extreme conditions, to plan for and prepare for liquidity contingencies, to manage intraday liquidity risk, and to encourage open disclosure.
What, then, is the purpose of this fresh advice? In a series of next posts, I’ll go into greater depth on the Basel Committee’s recommendations on these crucial concerns and the ensuing industry response.