Outline of the Book
This book is organized into three sections. The first section, “Measuring and Managing Liquidity Risk,” lays out the building blocks of a liquidity risk program in a series of chapters dedicated to key topics. We begin with Chapter 2, “A New Era of Liquidity Risk Management,” by outlining a set of leading practices that can be garnered from each of the chapters in this book. Our chapters – addressing stress testing, intraday liquidity risk management, collateral management, early warning indicators, contingency funding planning, liquidity risk information systems, and the liquidity implications of recovery and resolution planning – are designed to assist practitioners in honing their knowledge of these areas and creating a forward-looking improvement agenda.
The second section, “The Regulatory Environment of Liquidity Risk Supervision,” describes recent and upcoming developments on the all-important regulatory front. This landscape includes a focus not only on recent standards in liquidity proposed by the Basel Committee of Banking Supervisors (referred to as Basel III) but other developments in the areas of stress testing and reporting.
The third and final section, “Optimizing Business Practices,” considers how this transformation of liquidity risk management practices will impact business activities and how banks should respond. Clearly, with liquidity risk receiving more attention than ever before, sticky money will be more valuable than hot money. The question is: How will banks meet the challenges of aligning their business activities – through product design, funds transfer pricing, management incentives, and other mechanisms – to reflect this new priority?
Core Themes
Before we delve into the details, we highlight three core themes that you will see throughout the chapters in this book. These themes represent the fundamental characteristics of today's liquidity risk environment and where we see the future direction. As you read these chapters, please keep an eye out for:
• The intertwining of the regulatory and management agendas. The importance of the regulatory agenda in driving liquidity risk transformation is, and will continue to be, a key feature of liquidity risk management. While this agenda is driving banks to improve their practices, practitioners should remain mindful of the importance of an internal management-driven agenda aimed at continuous improvement of the firm's capabilities.
• The challenge of automation. In many respects, the challenge of raising the liquidity risk management bar will be less about measurement frameworks and policies and more about implementing a robust set of capabilities that will be underpinned both by effective governance and technology-enabled solutions. Building an infrastructure that captures, stores, and transforms data in an automated and controlled fashion may be the most daunting challenge.
• The drive to integration. Despite all of the advances in risk management since the financial crisis, banks' risk management frameworks remain largely fragmented, with the management of various risks often being addressed in siloed fashion, and with risk management processes themselves often being delinked from other business activities such as strategic planning, incentives, and profitability measurement. Integrating liquidity considerations into how the bank is run will be a key priority.
Acknowledgments
As this book is a practitioner's guide, we thought it useful to have our team of practitioners that specialize in the risk management arena share their perspectives and insights. We would like to acknowledge not only these contributors, but many dedicated current and former PwC professionals that worked behind the scenes to make this publication happen. They include: Vishal Arora, Lee Bachouros, Michelle Berman, Jon Borer, Rahul Dawra, Amiya Dharmadhikari, Jaime Garza, William Gibbons, Alison Gilmore, Mayur Java, Shahbaz Junani, Emily Lam, Fleur Meijs, Agatha Pontiki, Manan Shah, Dan Weiss, Jon Paul Wynne, Scott Yocum, and Yuanyuan (Tania) Yue.
Our special thanks go to Chi Lai and Richard Tuosto, who not only served as contributing authors but also helped us extensively with reviewing and developing content in other areas of this book. Finally, we are deeply indebted to Tina Sutorius without whom this book would not have been possible – she kept us focused on the mission at hand and helped stitch the different pieces together, both large and small.
Part One
Measuring and Managing Liquidity Risk
Chapter 2
A New Era of Liquidity Risk Management
Shyam Venkat2
Introduction
Liquidity risk management is a core competency for all types of financial institutions, from “sell-side” firms, like banks, to “buy-side” institutions such as insurance companies. Banks typically engage in maturity transformation by funding themselves with deposits and other short-term liabilities and investing in assets with longer-dated maturities, while continuing to meet liability obligations as they come due. Capital markets trading businesses provide market liquidity in various asset classes by facilitating order flow between buyers and sellers of financial assets and maintaining inventory through positions using their firms' own capital.
The period from the mid-1990s to the mid-2000s saw relatively few advancements in the discipline of liquidity risk management, even as approaches for measuring and managing credit, market, and operational risks were gaining in sophistication and infrastructure. The Asian currency contagion of the late 1990s, dotcom bust in early 2000, terrorist attacks of 9/11, and subsequent commencement of two major wars in Iraq and Afghanistan did little to heighten concerns outside of regulatory circles around liquidity risk management or spur significant advances in the risk management discipline. Robust global economic growth, fueled by easy credit, looked poised to remain the new normal as industry insiders, pundits, and regulators touted the benefits of the “great moderation,” pushing concerns for liquidity risk into the background.
The global financial crisis began in mid-2007, spurred on by the onset of several liquidity events, and brought on dramatic and rapid change. The dramatic increase in systemic risk made almost all financial institutions – even those few leading firms that had upgraded their liquidity risk management practices and infrastructure over the preceding decade and made some astute market calls – unprepared for the crisis. Company treasurers and their treasury functions, tasked with managing enterprise funding and liquidity, were now immediately center stage under the spotlight, and worked feverishly to help keep their institutions afloat even as financial markets and peer institutions faltered around them. Suddenly, client cash and secured financing, long considered safe sources of funding, were evaporating; deposits, even those guaranteed by the Federal Deposit Insurance Corporation (FDIC), were being withdrawn, giving rise to concerns of runs on banks. Previously liquid asset markets with readily transactable quotes experienced significant disruptions as market makers and buy-side customers were unsure how far the contagion would spread and became risk adverse. Consequently, the ensuing erosion of balance sheet strength and earnings power among financial services firms brought forth a renewed focus on the importance of liquidity risk management. The raft of new rules and regulations that shortly followed the financial crisis also prompted financial firms, particularly banks and capital markets institutions, to significantly enhance their capital and liquidity positions and related risk management capabilities. Much of the market scrutiny in the United States, United Kingdom, and Europe directed banks and other financial services firms to concentrate on de-risking balance sheets and enhancing capital management capabilities with respect to risk governance, stress testing, capital planning, and capital actions.
In the aftermath of the crisis, liquidity risk management practices have continued to evolve and the pace of that change has quickened as regulatory guidance continues to raise the standards on what are considered “strong” capabilities. Given the relatively early stage and continuing evolution of capabilities in this area, some of these practices may even be viewed as “leading”