Monday, August 17, 2009

Closer look at liquidity risk is crucial

Liquidity Risk is the risk that a financial institution does not have sufficient liquid funds to enable it to meet its obligations when they fall due, or that they can secure them only at an excessive cost.

Thus, the effective management of liquidity risk allows a financial institution to meet its cash flow obligations – in all circumstances. Important to assessing liquidity risk and deriving the right management measures are robust cash flow models as well as sophisticated stress scenarios. Regulators are more and more emphasizing stress testing as a critical component of the risk management tool set of a financial organization because it enables a better understanding of the liquidity risk profile and it also helps to model the liquidity risk appetite.

The financial services authorities (FSA) in the UK proposed recently new rules that are based on recently agreed international liquidity standards, in particular the Basel Committee on Banking Supervision’s (BCBS) Principles for Sound Liquidity Risk Management and Supervision, published last June, and also take into account difficulties faced in the market over the past 18 months.

The FSA’s proposals emphasize the responsibility of firms’ senior management to adopt a sound approach to liquidity risk management, and present the following changes:

  • All regulated entities must have adequate liquidity and must not depend on other parts of their group to survive liquidity stresses, unless permitted to do so by the FSA.
  • A new systems and controls framework based on the recent work of the BCBS and the Committee of European Banking Supervisors (CEBS).
  • Individual liquidity adequacy standards for firms based on firms their being able to survive liquidity stresses of varying magnitude and duration.
  • A new framework for group-wide and cross-border management of liquidity allowing firms, through waivers and modifications, to deviate from self sufficiency where this is appropriate and would not result in undue risk to clients.
  • A new reporting framework for liquidity, with the FSA collecting granular, standardized liquidity data at an appropriate frequency so the FSA can see firm-specific, sector- and market-wide views on liquidity risk exposures.

The FSA hopes to introduce the new rules in October 2009. These rules will come along with new reporting requirements. I believe that these new rules are important, not just in the UK but for financial institutions as a whole to manage liquidity risk more efficiently. Therefore I would be surprised if these new regulations are not adopted quickly by the other (European) countries.

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