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February 23, 2008
New Directions in Liquidity Risk Management
The market turmoil of 2007 has once again highlighted the crucial importance of market liquidity to the banking sector.What started as weakness in the sub prime markets ( residential mortgage backed securities which were then mopped up by managers of CDOs and asset backed securities)led to Investor's loss of faith arising out of growing arrears in such structured products. This led to tightening of liquidity as banks wanted more liquidity to meet their obligations and a similar necessity for greater liquidity was also seen among asset managers to guard against increased redemption risks. It is now recognised that liquidity risk management is not as easy as earlier and financial institutions need to devise strategies to tackle liquidity shocks such as the one emanating from US sub-prime market.
In other words, the assuring assertions by the best of banks about their management of liquidity has been put to stern tests. The contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks’ balance sheets, led to severe funding liquidity strains for some banks and central bank intervention in some cases.
Emerging lessons for liquidity risk management and supervision
1. It is now becoming clear that banks failed to foresee stresses of such magnitude and the subjective content of the stress led many banks to focus on firm-specific shocks when the combination of idiosyncratic and market-wide shocks was the order of the day. At the end of the day, the challenge of defining an appropriate level of stress remains a formidable one for both banks and supervisors.
2. The Central Bank's Role once again gains prominence and its e in financial stability becomes paramount. Appropriate liquidity facilities can help banks to ease out funding difficulties.
3. It is also clear that banks need to strengthen their Contingency plans. The existence of the plan is not enough, it has to be applied in practice. Many banks floundered when the banks needed to execute their contingency plans .
4. When banks’ contingency plans were based on assumptions of limited cross-border movement of liquidity, the stress on Contingency plans were aggravated.
5. Stress tests also underestimated the off balance sheet effects on banks balance sheet.
6. There was a felt need for banks to take sufficient consideration of reputational risk and its implications for liquidity buffers.
7. ICAAP: Finally, the need for a good ICAAP with business line level risk adjusted measures ( RAROC) and appropriate funds transfer pricing has become important. Recent events highlighted the importance of close coordination between treasury functions and business lines to ensure a full appreciation of potential contingent liquidity risks. In many banks, treasury functions operate in isolation and are unaware of the contingent liquidity risk of new products or how evolving business practices could change the contingent liquidity risk of existing business lines.
( For recent initiatives of Basel Committee read bcbs136.pdf from www.bis.org released on Feb 21,2008)
This once again reaffirms that the journey of Basel 2 will continue as financial markets mature and become more complex. Upgrading skills in supervision is also of paramount importance to contain the adverse consequences of creative destruction that is inherent in market freedom and financial innovation.
Posted by sunandoroy at February 23, 2008 04:00 AM
Sunando:
Looks like you and I are in the same area of business. My interest is the development of risk management in emerging markets banks and the current credibility/role of Basle II in that context. I'd appreciate any comments.
Thanks
Posted by: John at February 25, 2008 06:27 PM
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