Liquidity Risk Management: How Banks Manage Liquidity Crisis

Two different notions of liquidity risk have evolved in the banking sector. Each has some validity. The first, and the easiest in most regards, is liquidity risk as a need for continued funding.

The counterpart of standard cash management, this liquidity need is forecastable and easily analyzed. Yet, the result is not worth much. Banks of the sort considered here have ample resources for growth and recourse to additional liabilities for unexpectedly high asset growth in today’s capital market.

Accordingly, attempts to analyze liquidity risk as a need for resources to facilitate growth or honor outstanding credit lines are of little relevance to the risk management agenda pursued here.

The liquidity risk that does present a real challenge is the need for funding when and if a crisis arises.

In this case, the issues are very different from those addressed above.

Standard reports on liquid assets and open lines of credit, which are germane to the first type of liquidity need, are substantially less relevant to the second. Rather, what is required is an analysis of funding demands under a series of “worst-case” scenarios.

These include the liquidity needs associated with a bank-specific shock, such as a severe loss and a system-wide crisis.

In each case, the bank examines the extent to which it can be self-supporting in the event of a crisis and tries to estimate the speed with which the shock will result in a funding crisis.

Reports center on both features of the crisis.

Other institutions attempt to measure the speed with which assets can be liquidated to respond to the situation using a report that indicates the speed with which the bank can acquire needed liquidity in a crisis.

Response strategies considered include the extent to which the bank can accomplish substantial balance sheet shrinkage and estimates of the sources of funds that will remain available to the institution in a crisis.

Results of such simulated crises are usually expressed in days of exposure or days to the funding crisis.

Such studies are, by their nature, imprecise but essential to efficient operation in the event of a substantial change in the firm’s financial conditions.

As a result, regulatory authorities have increasingly mandated that industry members develop a liquidity risk plan. Yet, there is a clear distinction among institutions as to the value of this type of exercise.

Some attempt to develop careful funding plans and estimate their vulnerability to the crisis with considerable precision.

They contend that, either from prior experience or attempts at verification, they could and would use the proposed plan in a time of crisis. Others view this planning document as little more than a regulatory hurdle.

While some actually invest in backup lines without “material adverse conditions” clauses, others have little faith in their ability to access them in a time of need.