Liquidity risk has been at the epicenter of the evolving subprime crisis, and management of this previously underappreciated risk has suddenly moved to the top of executive, practitioner, and regulatory agendas, according to a new report, “The New Liquidity Risk Management Paradigm: Restructuring Foundations for Best Practices” from Celent, a Boston-based financial research and consulting firm.
Key findings of the report include:
* The main lesson to be learned from the subprime crisis is the need to return to the fundamentals so that liquidity risk management practices can be updated to accord with the paradigm shift in financial intermediation. Although many institutions’ balance sheets shifted away from the basic premise of “deposits funding loans,” liquidity risk management practices have not evolved in tandem. Recognition of the new realities and building appropriate risk management practices will ensure convergence to new market standards in the coming years.
* Unlike most risk management improvements, developing new methodologies is not the main issue concerning liquidity risk. Most players will find that they need to focus on three core issues: 1) Clarifying risk tolerance articulation and oversight at the most senior level, 2) Aligning the underlying components of risk measurement with business specifics, risk tolerance, and market realities, and 3) Integrating contingency plans with risk tolerance and stress testing to ensure that they are in place prior to any liquidity event.
* Lack of a thorough understanding of the cash flow profile together with behavioral adjustments, off-balance sheet instruments, other remote vehicles and contingencies is a key deficiency in the marketplace. Developing this view is a prerequisite to prudent liquidity risk management since managing cash flow risks can be effective only with accurate cash flows.
* Updating stress testing practices to reflect relevant, significant and plausible scenarios will be key going forward as many institutions either used overly simplistic scenarios or made unrealistic assumptions. In particular, the crisis revealed that: 1) Liquidity problems can last much longer than envisioned, 2) The interrelationships of liquidity events should be taken into account, and 3) Funding availability can exhibit erratic patterns, and even sources regarded as extremely safe can disappear.
* Ultimately, the winners will be the financial institutions that move quickly to build up their defenses and signal to the market that they have a robust framework in place that keeps their risks under control.
A pdf version of the full report is available on Celent’s website.