SIMCORP BLOG

THOUGHT LEADERSHIP

Spiraling into control over liquidity risks

Why are we talking about liquidity risks? Why is it a hotter topic than market, credit and operational risks, which traditionally have had more focus? The reason is relatively straightforward, during every financial crisis we find that it is actually liquidity risks that makes things spiral out of control - acting like a virus for firms and the financial industry at large.

Each time a crisis comes around, both big and small, we see that it quickly becomes a question of whether a company (or companies) in distress are liquid enough to honor their contractual obligations and whether market participants can get rid of some of their exposures in time.


Definitions:

  • Market Liquidity Risk: The risk of not being able to unwind or offset exposures
  • Cash (funding) Liquidity Risk: The risk of inadequate cash liquidity when needed 

The problem is that it is not easy to make risk measures that only include liquidity risks while excluding market and credit risks. This frustrates risk managers who typically like to isolate risk, express a risk appetite in absolute or relative terms and surround the risk measures with limits.

The lack of good dedicated liquidity risk measures can also be seen from the fact that regulators are relatively vague on how to tackle liquidity risk. All regulators agree that liquidity risk management is a high priority and all financial institutions must take it into account in their daily risk management. But there is very little information available as to how firms should do it. Having said that, everyone from risk managers to regulators, agree that something needs to be done.

In my view, there are already several actions firms can take to be better prepared for crisis scenarios with liquidity squeezes. There are even ways to turn the focus on liquidity risks to your advantage in your daily operations - saving you money with better cash management.

So what can you do to manage liquidity risks?

The answer is to approach it as you would for any other risks that you are exposed to. You should assess various risk scenarios and make sure that management is aware of the estimated losses incurred if such a scenario occurred. From there it is easier to discuss risk appetites and set limits for the exposures and rules for how to react to excesses. This is business as usual.

However, for liquidity risk, it is also essential to have a game plan for extreme scenarios and that is not business as usual for many companies (fx. Brexit or a terror attack). You should be prepared and ready to take actions when things start to spiral out of control. That is something we often forget – despite it being clear that those financial institutions who know their exposures and risks in real-time are much better at avoiding these situations.

Your IT platform must be capable of creating timely overviews and access to details to quickly make decisions. Thereafter it is business decisions. During a crisis (e.g. the Lehman bankruptcy) the time window of being able to hedge and decrease exposures is always very small. Your game plan could include having investment committees with a mandate to take quick action.

Another approach is to not over-engineer the risk measures, but instead keep it simple. In my opinion, it is better to have several liquidity risk indicators rather than a complex liquidity risk one-number approach.

Over the last couple of years, SimCorp has boosted its offering on market and cash liquidity risks solutions. Our integrated solutions help firms turn a lack of control brought about by extreme scenarios into a spiral of control so that you can quickly take actions with a full overview of your exposures.

To learn more about how you can build a pragmatic approach to market and cash liquidity risk, watch a full recording of the webinar I recently held.

To continue the dialogue, either comment below, or connect with me on LinkedIn.

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