Prior to the crash that threatened the solvency of banks in Europe and the United States, many financial models lacked this focus on liquidity risk. Today, as firms continue toward economic recovery in the face of continued uncertainty, one fact remains clear - an economy can suffer sustained harm when credit dries up. Better Liquidity Risk Management (LRM) is essential, and a functioning LRM framework is the foundation of every prosperous treasury and finance department.
Severe disruption to capital and a liquidity crunch were dominant features of the 2007 banking crisis, but hindsight is of course a wonderful thing. Prior to the global financial crisis, liquidity risk was not top of the business agenda, but in the aftermath of the downturn, the importance of liquidity as a critical business issue for both individual banks and capital market firms, as well as for the entire global financial system, was accentuated.
In today’s unpredictable business climate, economic conditions can change in an instant due to global fiscal issues or more industry-specific speed bumps, and these fluctuations can have an immediate impact on a firm’s financial health. To survive, banks and businesses alike need to have a robust plan in place to protect the interests of investors, preserve the strength of collective investment schemes and markets and cut systemic risk. At long last, liquidity has taken centre stage in many business protocols.
Tom Ranger, Treasurer, Santander UK states: “Liquidity depends on confidence. It is therefore vital that the understanding and management of liquidity risk is ingrained into every decision we make. We continually assess the adequacy of our liquidity resources, to not only ensure compliance with any regulatory liquidity requirements, but also to ensure that we maintain sufficient liquidity resource to meet our own liquidity risk appetite across a number of different and extreme stressed scenarios.”
Prior to the crash that threatened the solvency of banks in Europe and the United States, many financial models lacked this focus on liquidity risk. Today, as firms continue toward economic recovery in the face of continued uncertainty, one fact remains clear – an economy can suffer sustained harm when credit dries up. Better Liquidity Risk Management (LRM) is essential, and a functioning LRM framework is the foundation of every prosperous treasury and finance department.
Timothy Ko, Director of Hyperbridge Technology, a software development company explains, ‘For us planning is key to our liquidity management. Our liquidity management processes are forward looking, hence we can project future cash flows from assets and liabilities on our balance sheet. A robust framework must include (1) the ability to conduct risk analysis on extreme, hypothetical situations and (2) the maintenance of liquid assets to guard against any potential shortfalls.’
It’s a middle-market bank’s worst nightmare to have insufficient liquid assets readily available to meet its day-to-day debts and commitments, and though banks are more vulnerable to liquidity risk than other financial institutions, all businesses must acknowledge the important changes within the European and indeed global financial landscape, as the non-bank financial sector can also harbour leverage and liquidity risks. So what is the best way to manage liquidity risk? Timothy Ko believes businesses need to up the ante and ‘conduct regular financial stress tests to anticipate liquidity shortfalls. Using the results of your stress tests, adjust your liquidity risk management strategies accordingly, and utilise these new policies and positions to develop a formal contingency funding plan.’ Stress tests can expose the fragility of a company’s funding, including, for example, a weakness to previously liquid markets becoming suddenly illiquid.
LRM is crucial to the overall workings of the financial system and the Bank of England’s Stress Test is a clear indicator of the health of the UK banking sector. The test assesses the banks’ resilience, making sure they have enough capital to withstand shocks and to support the economy if a stress does materialise. The results from the BoE’s 2018 Stress Test, which included a scenario modelled on a hypothetical synchronised global downturn, showing growth in Hong Kong and China and other emerging market economies being particularly adversely affected, are in. The scenario also incorporated a rise in the UK bank rate to 4% and a sharp depreciation of sterling. The BoE concluded that all seven banks and building societies passed the 2018 Stress Test to withstand a ‘disorderly’ Brexit without having to reduce lending, and HSBC plans ‘to maintain a conservative and prudent stance on capital management.’
Like stress tests for any financial organisation, the BoE needs to constantly review their assessment, and are planning to include the impact of climate change in its UK bank stress tests as early as next year. The BoE has also reportedly decided to delay work on the first cyber stress test for banks to focus on Brexit preparations, due on the 29th March. Furthermore, the PRA expects firms to consider the impact of a range of severe but plausible stress scenarios on their cash flows, liquidity resources, profitability, solvency, asset encumbrance and survival horizon in their stress testing.
LRM is finally getting its time in the limelight, but it must be flexible and subject to change, and companies should intermittently review their structures to make sure they continue to meet the needs of the organisation. The analysis should include questions around whether a different approach would work better or whether funds should be swept to a header account more or less frequently than they currently are. Additionally, as rates begin to rise and the value and importance of LRM to businesses can be altered by anything from M&A activity to regulatory change, treasurers’ need to regularly assess their framework to ensure that the company is fully protected.
LRM has also become more complex than ever before, so it is vital that businesses identify and implement the driving principles behind a robust strategy to guarantee stability and success. The root cause of the majority of business failures commonly stems from poor management of available cash, an absence of finance or a lack of access to appropriate funding services. Subsequently, the three main areas to consider are financing facilities, liquidity buffers and cash flow forecasting.
Financing facilities:
With numerous forms of financing available, both short and long term, each with various costs and conditions, it is important to find the optimal mix of external funding. Therefore, an in-depth analysis of what is on offer is vital. Questions like how much does the business depend on external financing and how reliant is it on one lender are significant, as liquidity will be affected where several financing facilities are being employed and maturity dates fall on the same period.
Liquidity Buffers:
Businesses cannot control the economic climate, but they can prepare for rough seas. Businesses that experience regular or large cash flow fluctuations should consider a policy of maintaining a liquidity buffer to see them through difficult times. These buffers, made up of cash and other highly liquid unencumbered assets, should be adequate to allow an institution to weather liquidity stress during its defined ‘survival period’ without needing alterations to its business model. Early identification and the availability of liquid assets to serve as a cushion in case of a shortfall is essential.
Cash Flow Forecasting:
Cash flow forecasting is a vital piece of overall treasury management, and is key to the success of all businesses. No matter how lucrative a company is, if it doesn’t have the working capital on hand to meet its immediate financial obligations, it could either spell serious trouble or potentially even lead to a business closure.
Regulators have become increasingly uneasy about LRM issues in recent years For example, insurance cycles, where companies sell assets in a downturn and search for yield in an upturn or the inability to service debt due to trapped liquidity are garnering more attention. Due to the numerous sources of liquidity risk, there are several ways of measuring this risk, including cash flow forecasting and financial ratio analysis, and in the current business landscape it is crucial to learn how to manage liquidity correctly. The following four basic principles of a robust LRM system could help make your business stronger and more resilient to change:
Regulators have found most organisations risk-management practices to be at best mediocre in meeting the demands of tighter liquidity constraints and decreased funding access. This is not entirely surprising as liquidity risk has been given less attention than other risks by both entities and regulators up until recently. Before 2010, for example, standards basically consisted of a series of non-binding qualitative principles regarding good liquidity management. However, cash management as we know it today is set for a major digital upheaval, and banks need to be ready to leverage the opportunities arising from this.
Risk managers in 2019 must have a solid understanding of governing ethics, alongside an awareness of the approaches and procedures for stress testing their organisation’s liquidity profile to provide an adequate response to watchdog practises. As a whole, the industry is facing continual change and there is not only pressure to implement all of these requirements, but also to align them to ensure they all run smoothly and interact efficiently. Timothy Ko understands the importance of meeting regulatory requirements, stating ‘We would ensure that all liquidity monitoring would include global liquidity indicators, business-specific liquidity indicators, advanced cash flow forecasting and all relevant regulatory ratio.’ A thorough liquidity risk management policy alongside continued scrutiny of balance sheet dynamics is an absolute must to navigate through the highs and lows of contemporary LRM.
Banks and financial firms face some give and take between the security of more liquidity and the overhead of gaining it. Liquidity undoubtedly comes at a cost, but no business, irrespective of size or sector, wants to find itself begging the bankers when a cash flow emergency take place.
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