What it is and why it matters
Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses. Liquidity risk refers to how a bank’s inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).
During the recent prolonged period of historically low and stable interest rates, financial institutions of all shapes and sizes took liquidity and balance sheet management for granted. But as rates rose and uncertainty increased, many institutions struggled to maintain adequate liquidity and appropriate balance sheet structure due to deposit run-offs and portfolio duration mismatches.
Liquidity risk was exacerbated by asset value deterioration while monetary policy tightened. Inadequate balance sheet management led to highly publicized bank failures and a heightened awareness of liquidity risks.
In the wake of these bank failures, one thing became clear: banks and capital markets firms need to manage their liquidity and balance sheets better. And self-preservation isn’t the only motive for doing so. The consequences of poor asset liability management and liquidity risk management can reach far beyond the walls of any one financial institution. It can create a contagion effect on the entire financial ecosystem and even the global economy.
Regulatory bodies are intent on preventing another financial crisis in the future, and scrutiny of liquidity management is increasing. The onus is now on financial institutions to shore up liquidity risk and balance sheet management – for the good of the firm and the economy.
Liquidity risk management defined
Liquidity risk management and ALM encompass the processes and strategies a bank uses to:
- Ensure a balance sheet earns a desired net interest margin without exposing the institution to undue risks from interest rate volatility, credit risk, prepayment dynamics and deposit run-off.
- Plan and structure a balance sheet with a proper mix of assets and liabilities to optimize the risk/return profile of the institution going forward.
- Assess its ability to meet cash flow and collateral needs (under normal and stressed conditions) without negatively affecting day-to-day operations, overall financial position or public sentiment.
- Mitigate risk by developing strategies and taking appropriate actions to ensure that necessary funds and collateral are available when needed.
The role of balance sheet management
Balance sheet management, through strategic ALM, is the process of managing and optimizing assets, liabilities and cash flows to meet current and future obligations. Effective ALM not only protects financial institutions against the risks of falling net interest margins and funding crunches – it's also an opportunity to enhance value by optimizing reward versus risk.
Good asset liability management broadly covers portfolio accounting, analytics and optimization. It relies on a suite of tools for transaction capture, forecasting, interest rate risk measurement, stress testing, liquidity modeling and behavioral analytics.
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Challenges to successful balance sheet management
- No centralized view of balance sheet management. Siloed departments and business units limit a firm’s ability to understand its balance sheet positions (especially those involving optionality and customer behavior). Silos also make it challenging to assess the impact of illiquid assets across geographies, business units and asset classes.
- Limited analytics capabilities. Without sufficient analytics, firms have extreme difficulty projecting cash flows and net interest margins for underlying transactions, particularly when those transactions number in the millions. Overly simplified term structure and behavioral models lead to limited balance sheet risk management.
- Insufficient stress testing. Because too many firms have commonly ignored trading and funding liquidity considerations in stress testing, they are unprepared for the impacts of market shocks, making it hard for them to get out of positions easily or to attract new funding.
- Overcoming the compliance mindset. Firms that focus too much on the compliance requirements surrounding balance sheet management may overlook potential business benefits.
3 steps to successful liquidity risk management and ALM
To institute an effective liquidity risk management and ALM system at your organization, follow these three steps.
1. Establish an analytic framework for calculating risk, optimizing capital and measuring market events and liquidity.
- Minimize the effects of market shocks and look for better risk management opportunities by analyzing the consequences of changes in cost and liquidity in near-real time. Then you can act with precision.
- Analyze cash flow and market value dynamics comprehensively and granularly. Proactively manage your assets and liabilities with on-demand scenario analysis incorporating forward-looking market condition and balance sheet evolution assumptions.
2. Manage your data.
- Gain a centralized view of firmwide interest rate and liquidity risks by integrating the latest market information, portfolio updates, capital returns and a market view of liquidity on an intraday scenario basis.
3. Integrate your risk management processes.
- Value complex portfolios and asset classes using an efficient platform to integrate portfolio valuation and scenario analyses with consistent market, credit and behavioral models. Process orchestration and governance can further reduce operational risk.