With the introduction of tighter regulation, and closer scrutiny from shareholders and investors, liquidity risk is one of the most pressing business concerns facing organisations today. As the upheaval in the financial landscape prompts a grassroots reassessment of liquidity risk within large institutions, Anya Davis of Baringa Partners and James Nicholls (PICTURED) of Cornhill explores how banks should manage liquidity risk.
The list of credit crunch casualties is now a familiar sight in the press. Northern Rock, Bear Stearns and Lehman Brothers are just a few names to have fallen by the wayside in the last eighteen months. It's a popular misconception that credit risk was to blame for the death of organisations like Lehman. But credit risk wasn't the culprit: the real killer was lack of liquidity. With institutions now working to recover their reputations and the trust of the market, liquidity risk has shifted from being a largely invisible risk for many institutions to a serious business issue.
If your business is perceived - rightly or wrongly - to be weak in terms of liquidity, public and corporate confidence drains away. Confidence has also played a significant part when it comes to cash. During these rocky times for the financial markets, many believe that having cash in the bank makes your organisation comfortable. When banks begin to find themselves in trouble, a common knee-jerk reaction is to rush to fill the coffers with cash. In actual fact, this approach can stir up suspicions that the scale of the problem is far worse than it really is, creating a huge reputational risk and further damaging investor and market confidence.
Don't lose sight of the bigger picture
Think of a bank as a boat sailing along in the ocean. Sometimes conditions at sea will be favourable; sometimes rough weather can temporarily throw your boat off course. If you focus too closely on the waves that are all around you, you can miss the tsunami approaching in the distance. Keeping an eye firmly on the horizon makes it easier to chart a safe course through stormy waters and buys you time to react to any short-term obstacles along the way.
Managing liquidity risk is just the same. Without proper visibility on liquidity within your organisation, short-termism can creep in to scupper your long-term goals. In recent times, many banks have been so tied up with day-to-day fire-fighting that they have missed the bigger picture and failed to make liquidity risk management a core part of their strategy.
Capitalising on the liquidity opportunity
The downfall of banks like Lehman shows that failure to take liquidity risk management seriously can damage - and even ruin - your business. But in fact there is an element of real opportunity here. Now is the perfect time to refocus on fundamentals and take a closer look at the way you handle liquidity risk management. Rather than viewing liquidity risk management as a daunting prospect, getting it right gives banks crystal clear visibility on their future cash commitments, allowing them to identify spare capacity and therefore develop shareholder value.
As the FSA moves towards more principles-based regulation: assessing the business model of banks rather than simply specifying reporting requirements, institutions will need to have a far better grasp of liquidity risk management i.e. modelling scenario analysis rather than simply reporting to standard formats. But institutions that get in on the act early by tightening up their own processes can find themselves well positioned to take advantage when the markets start turning up. It's important to ask yourself whether you have timely and accurate data, and the right tools and strategic business model to manage the liquidity risk in your business effectively - unlocking huge amount of value without having to take extra risk.
Charting a safe course through stormy waters
So what's the best way for organisations to navigate these choppy waters? In uncertain times, the quality and reliability of management data equips banks to make sound decisions. CEOs need to establish the best way to structure their organisation to ensure that they have accurate and timely management information at their fingertips to give them clear visibility on liquidity at all times. Many organisations employ highly intelligent analysts who are mathematical geniuses to build state-of-the-art liquidity risk management solution. But having a good grasp of the theory behind the solution is only half the battle. If it's not relevant to your particular business, it won't do the job it has been designed to do.
Proper contingency planning is vital. Cases like the collapse of the Icelandic banks highlighted the need to strengthen stress-testing processes: after all, there's no point in taking a stress test only as far as you still feel comfortable with the results. When the banks failed, it became apparent that their disaster management had been modelled on ‘nice-day' scenarios, rather than on the absolute worst-case scenario of what the financial world has experienced in the past 18 months ago.
Taking a holistic look at liquidity
Many international banks still split their liquidity risk management into local or functional silos, giving them very fragmented visibility on their overall position. It is now imperative that they take a holistic view of risk across different regions and business functions. What's more, they need to think about creating a liquidity strategy across different time horizons - from the immediate to medium to longer term - allowing them to plan effectively for any future calls on their liquidity. At the same time, this strategy also needs to be aligned with their strategic business model as well as dealing with the day-to-day management of cash in and cash out of the business.
Banks need to look beyond what's going on right on their own doorstep, forming a strong view of how the wider economy is affecting their liquidity. They also need to build up a clear understanding of where cash is in the wider economy. For example, large pension funds are currently sitting on stockpiles of cash rather than diving into investments. At the same time, institutions need to appreciate the micro factors that might affect their organisation's day-to-day views on liquidity. One of these external factors is customer behaviour: in order to manage their liquidity risk as tightly as possible, banks need to understand know their customers, their needs and why they bank with your organisation.
The past 18 months have been tough for all institutions, and those that have survived have done well. But the pressure is now on these same institutions to demonstrate that not only have they learned lessons from the credit crunch, they are putting these lessons into practice into their business. And by proving to the outside world that they can run their businesses prudently with a strong focus on liquidity risk, financial institutions will be making huge strides towards rebuilding confidence in themselves and in the financial system as a whole.
