Liquidity risk is the risk that obligations cannot be met when they fall due. An appropriate and robust liquidity risk management framework is therefore needs to be in place to ensure that liquidity risks are understood and, even in a worst case scenario, obligations can be met in full and on time.
Liquidity planning requires looking ahead several days to estimate cash inflows and outflows and ensure available sources of funds if there is a shortfall. This needs to be supplemented by longer-term planning for larger outgoings, such as debt instruments maturing, and stress testing to assess the impact of adverse market conditions and the robustness of contingency plans.
In reality, this type of liquidity planning is not easy for any business – especially for banks. For most nonbank companies, payments are largely known and predictable and credit facilities are generally available if receipts are delayed. But for banks, inflows/outflows are large and unpredictable.
In the lead up to financial crisis, market conditions were favourable. Despite various developments that increased liquidity demands and made banks more vulnerable to liquidity risk, insufficient attention was paid to liquidity risk management by both banks and regulators.
Developments that Led to 2008 Financial
The BCBS in a 2008 communique identified a number of factors that led to 2008 financial crisis and transformed the nature of liquidity risk.
- These factors include:
- Capital Market Funding
- Complex Financial Instruments
Regulatory Response To 2008 Financial Crisis
In response to the crisis, the BCBS introduced new regulatory guideline under Basel III requirement to incorporate the following liquidity measures;
A Liquidity Coverage Ratio (LCR) that requires banks to hold high quality liquid assets to match net outflows during 30 calendar day period of stress.
A Net Stable Funding Ratio (NSFR) that seeks to improve resilience over the long term through providing incentives to banks to develop more stable forms of funding. The time horizon for the NSFR is up one year.
In addition, the BCBS has also introduced Leverage ratio. This is a non-risk based ratio that sits alongside the risk-based capital framework to provide a tool to help regulators control the size of banks’ on and off – balance sheet assets and contingent risks.
These three new ratios are to be introduced in full by January 2018 (NSFR and leverage ratio) and January 2019 (LCR).