Liquidity risk is. Essence, classification, evaluation methods

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Before the 2008 global crisis, financial institutions of all shapes and sizes took debt financing for granted, with little to no cash outlay. During a deep recession, many institutions struggled unsuccessfully to maintain an adequate level of liquidity risk, which led to the failure of many second-tier banks. Central banks have been forced to intervene to keep the economy afloat.

Banking risks

As the dust from the walls of collapsed banks began to settle, it became clear that banks and capital markets companies needed to better manage their liquidity. And the instinct of self-preservation is not the only motive for this. The consequences of inadequate risk management can extend far beyond the walls of any financial institution. They can affect the entire financial ecosystem of the country and even the global economy.

Liquidity risk is the bank's inability to fulfill its obligations to customers and counterparties due to lack of funds in correspondent accounts. After spending many years in the shadows, this issue has suddenly become a hot topic in risk management, proving itself as a hit man during the financial crisis.

Regulatory efforts to control banks

The consequences of most cataclysms usually include many measures to avoid or minimize the damage from any future similar disasters. When an earthquake destroys entire cities, countries invest in better early warning systems. Major floods in the Netherlands in 1953 led to the construction of complex disaster prevention infrastructure in the country. The Enron scandal led the US to introduce the Sarbanes-Oxley legislation.

Global financial crisis 2008-2009 is no different. Regulators have enacted laws ranging from Dodd Francs and European Market Infrastructure Regulation (EMIR) to Basel III to prevent similar financial crises driven by liquidity risks in the future.

Crisis prevention measures

As part of the Basel III reforms, regulators have developed new rules for banks to control and manage their risk, which can be loosely defined as the threat of running out of cash. Basel Committee on BankingSupervisory Authority introduced minimum limits for two key parameters used to assess liquidity risk. Financial institutions around the world must maintain these ratios at the required level. Such restrictions can have a significant impact on their customers.

Financial Institutions Risk Control Ratios

The first parameter is the liquidity coverage ratio (LCR), which is designed to improve the coverage of banks' short-term liquidity. LCR is calculated as the sum of a bank's high-quality liquid assets divided by the expected cash outflow, including undrawn loan commitments, over 30 days.

Regulators want to take comfort in the fact that in the event of an unexpected decline in cash levels, the bank will have enough assets that it can easily convert into cash to survive the stressful situation and prevent the worst-case scenario from developing into bankruptcy.

The second measure is to monitor the Net Stable Funding Ratio (NSFR), which is designed to increase stable long-term balance sheet funding to avoid the threat of cash shortfalls to meet commitments.

This ratio was formulated to encourage and encourage banks to use stable sources to finance their activities and reduce their dependence on short-term refinancing. Thus, the liquidity risks of banks' capital are minimized.

Quickthe disappearance of this type of leverage during the crisis was the main reason for the failure of several large institutions, including Leman Brothers. According to this, financial institutions will need to ensure that the amount of stable funding available to them exceeds the required amount of payments to customers within 12 months.

Impact of regulation measures on the business community

One of the unintended consequences of the new banking regulation is that future liquidity risks have spread beyond banks and are causing serious damage to the corporate sector. Corporations need to start thinking seriously about their own liquidity risk position and how they can survive as a future crisis unfolds.

The most obvious link between banks and corporations is the fact that corporations are heavily dependent on banks for their financial needs. Tighter requirements for asset liquidity risk management in the financial sector will undoubtedly affect corporate lending.

Threat of a deeper crisis?

The effect will be much worse in the future because the new Basel III rules that are imposed on banks will push liquidity risk management problems into the corporate sector. These rules make it difficult for banks to fulfill their traditional role of rolling over loans. Corporations have to fight to get funding from banks.

Lack of access to bank lendinglimits the ability of corporations to plan business processes in advance. Under these conditions, they are heavily dependent on banks, which choose to cut short-term credit lines at the first sign of trouble.

Changes in derivatives trading

Even worse, the new clearing rules, which aim to migrate derivatives trades to centrally cleared platforms, will force corporations to post daily margin against their derivatives positions. This will cause massive daily fluctuations in the liquidity resources of the corporation. Taken together, these two effects point to a world where the corporation has much less control over its own cash flow resources, with the demand for liquidity going up and the supply going down.

Corporate liquidity risk management

Banks that survived the recent financial crisis have been forced to modernize their cash management practices to better prepare for future liquidity crises. One tactic is to push most of the potential threats out of banking and into the corporate sector. As a result, the current crisis is rearing its head in the corporate sector. Corporations must actively implement risk management systems if they do not want to be the next victim.

Corporate Liquidity Risks

Liquidity risk is the possibility that an enterprise will not be able to obtain the necessary funds tosatisfaction of short-term or medium-term obligations to creditors. In many cases, capital is concentrated in long-term assets that are difficult to convert into cash at fair value if current bills need to be paid.

A small short-term crisis due to a lack of working capital could result in a long-term negative impact on the business. Failure to obtain adequate funding in a realistic timeframe could expose the firm to liquidity risk.

For securities, this risk arises when a firm with immediate cash needs is unable to sell assets at market value due to a lack of buyers or an inefficient market.

The 2008-2009 crisis was caused by defaults on mortgage-backed securities, a classic credit risk problem, but the speed of the crisis spreading throughout the financial system can only be explained by the close relationship between credit risk and liquidity risk.

A consulting firm with multiple corporate business deals in its portfolio relies on timely client payments to meet cash needs. Termination of a contract by a major customer results in a sudden drop in cash flows. The firm begins delaying the payment of wages due to liquidity risk. This leads to fines from supervisory authorities, a serious decrease in reputation and the dismissal of the most valuable employees, whompoached by competitors.

From a prosperous company, the company quickly moves to outsiders. A prime example of how short-term failure to meet obligations leads to long-term negative business consequences.