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  • Liquidity Risk - It Affects All of Us

    Liquidity Risk – It Affects All of Us

    “The crisis drove home the importance of liquidity to the … financial markets and banking sector”

    (Bank of International Settlements, Dec 2010)

    If nothing else, the current financial crisis has taught us that the “wholesale” end of the financial markets (e.g. investment banking) and the “retail” end (e.g. personal account banking, retail investments), are not separate. They are all part of a continuum, at least for now, and phrases such as “spilling over into the real economy” can give a false sense of security to either group.

    Many of the trading operations performed in the major financial centres of the world such as the City of London, are umbilically tied to the bank’s balance sheet, and that includes the straightforward deposit made by a regular consumer / member of the public.


    This means that the risks are, also, tied together.

    Hence, the new rules being imposed on the banking sector known as “Basel 3″ and relating to Liquidity Risk, affect us all in one way or another. From investment finance and corporate banking; to retail account customers; to pension and ISA investors; an understanding of Liquidity Risk can lead to improved returns and / or lowered exposure.


    Liquidity Risk – What is it?

    It may come as a surprise to many of us but according to the Bank of International Settlements (BIS), many banks actually had “adequate capital levels” when the financial crisis struck in 2007 as they met the international standards required of them. The real problem was in the deployment of that capital i.e. they suffered “lapses in basic principles of liquidity risk management”.(Source: Basel III International Framework for Liquidity Risk Measurement, Dec 2010)

    Leading up to the crisis, banks had not checked in sufficient detail the quality of the assets they had under management, so that in the event of extreme conditions they could “unwind the positions” they were holding without significant loss to themselves, their investors or depositors i.e. maximum of 10% loss. Also, the banks were so focused on the asset side of the balance sheet that they overlooked the demands of the liability side. Now, Basel 3 has the FSA and other regulators around the world asking a raft of detailed questions that include :

    • What are the banks using to fund their activities including the complex derivatives trades written between themselves i.e. over-the-counter (OTC)?
    • Are they relying on money from depositors?
    • Are they dependent on short-term finance from the money markets to fund their trading activities, the place where banks lend to each other?
    • Are they leveraging, or borrowing against, corporate client assets, UK government bonds or foreign sovereign bonds?

    Fundamentally, liquidity risk is where the bank can comfortably answer questions such as the ones above with the end result being minimal, or ideally zero, loss to the bank itself or to its investors. And because investors include retail deposit account holders and the monies they place with banks, it becomes self-evident that liquidity risk has an impact on everyone whether they are aware of it or not.

    This whole checking process is known as “Stress Testing” and is where a wide range of real-world scenarios are run that span normal market conditions, to stressed market conditions, to highly-stressed market conditions. The Basel Committee for Banking Supervision (BCBS) has been putting together a framework for the banking system, globally, since 1974. This latest version (i.e. Basel 3) aims to reduce the likelihood of a similar crisis in the future. Clearly, it cannot eliminate such crises totally; however, when the new Liquidity Risk framework of Basel 3 and the Capital Adequacy framework of Basel 2 are combined, the banking system is potentially safer at a structural level for us all.

    There are two key components to Liquidity Risk that aim to protect us. These are:

    i) Liquidity Coverage Ratio

    ii) Net Stable Funding Ratio

    This article will continue with an overview of the Liquidity Coverage Ratio and how it potentially benefits us all as stakeholders in the financial system. The Net Stable Funding Ratio will be dealt with in a subsequent article.


    Liquidity Coverage Ratio : The New, First Safety Net

    It stands to reason that if something can be sold quickly and is able to maintain all, or most, of its price, it is often because the item is essential, in high demand or of high-quality (or all of these things).

    And that is why the Liquidity Coverage Ratio (LCR) is a positive first step for banks, banking and the financial system as a whole.

    LCR aims to secure the bank’s ability to survive in the short-term (30 days) on its own merits and without central bank assistance in conditions of extreme market stress. It does this with the rule that banks must hold two groups of high quality assets known as “Level 1″ and “Level 2″. Level 1 assets are deemed to present no-to-low risk to the bank in severe market conditions and, as such, at least 60% of all assets in the LCR must be readily classified as Level 1. (Similarly, Level 2 assets can be no more than 40% of the bank’s short-term liquidity position.)

    Liquidity risk then compares the money that can be raised quickly and without much fuss (as above), with the payments that have to be met in the same time period. This is income versus expenditure in extreme conditions. Hence, the calculation is as follows:

     

    High Quality Liquid Assets that can be sold quickly in extreme market conditions

    ________________________________________________________________

    Total Net Cash Outflows (i.e. expenditure) that are expected over the same period

     

    If the income (i.e. high quality liquid assets) exceeds the expenditure (net cash outflows), then the bank can report to the regulator that it is in a liquid position for the market conditions that it has tested itself against (hopefully highly-stressed scenarios).

    This is good news for all investors, of all shapes and monetary sizes. Why? Because they will be with an institution where they should not have to be unduly worried, at least not in the short-term. Assuming the bank successfully implements the Net Stable Funding Ratio (NSFR) too, then the long-term position should be equally secure.

    Although Basel 3 is a mandatory ruling standard, it does not have to be fully implemented until 2015 for the LCR and 2018 for NSFR. There is still quite some work to do as studies by the European Banking Authority (EBA) and BIS show that LCRs are anything between 71% and 90%. The banks have a significant challenge set before them because the data required spans multiple sources including databases, spreadsheets and legacy systems.


    Nevertheless, is the LCR a marketing opportunity for the banking sector?

    It could well be.

    The banks that successfully, and consistently, exceed a 100% liquid position could use the LCR to rebuild the trust in the banking sector but especially in their own brand. All stakeholders in the banking sector, regardless of size or capacity, want to know that banking is systemically sound. Therefore, should the markets experience another period of nervousness and volatility close to that faced since 2007/8, then institutional, corporate and retail investors can all be positively affected if their monies face low levels of liquidity risk. This can be, but, a good thing for us all.

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    Opening Doors Finance is an Appointed Representative of Intrinsic Financial Planning Limited and Intrinsic Mortgage Planning Limited which is authorised and regulated by the Financial Services Authority. Intrinsic Financial Limited and Intrinsic Mortgage Planning Limited is entered on the FSA register (http://www.fsa.gov.uk/register/) under reference 440703 and 440718
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