Politicians and central bankers have been working overtime to overhaul the banking system in an effort to prevent another crisis. Graham Buck looks at the impact of the new international liquidity standards, dubbed Basel III, that are coming in and assesses how best to deal with the issue of liquidity risk on a global basis

Liquidity risk has always been a vital issue for financial institutions. After all, if you don't have sufficient money then you're in no position either to lend or to take positions in the financial markets. Since the credit crunch of 2007, the issue has been given added urgency after the fall of Lehman Brothers precipitated a full-scale liquidity crisis that went on to nearly topple other high-profile names, such as RBS, and cripple the world economy.

The meltdown sparked a multitude of books and papers about the crisis and its effect on the 'real' economy. One of the most recent was a white paper entitled Managing liquidity risk in a changed and global world, issued in April by the Society for Worldwide Interbank Financial Telecommunication. Written by Wim Raymaekers, SWIFT's head of the banking market, the paper notes how liquidity in the international transaction system evaporated during the crisis. The cause? A combination of complex interconnected systems, difficulty in alignments of operational practices, and trust issues between banks.

Definition
But how does the financial sector actually define liquidity risk? The basic description is the risk of loss incurred by a bank when it lacks sufficient liquid funds to enable it to meet its obligations as and when they fall due - or the bank can secure them only at excessive cost. Liquidity risk applies to all financial transactions, ranging from cash to securities, custody and derivatives.

There are two basic kinds of liquidity risk suggests Gerhard Lohmann, product manager for risk and compliance at the vendor, Fernbach. "In the first instance is the risk of illiquidity; it's caused by sudden, unexpected and unbearable net outflows and is reflected by the inability to respond to a sudden liquidity squeeze that could lead to the failure of a firm," he says. "Secondly, it covers the risk to earnings. Impaired liquidity means that funding costs are unusually high, with a direct impact on earnings." It is the first of these two that has been the focus of global regulation across the world's supervisory bodies, and it is usually not covered by asset and liability management.

SWIFT's Raymaekers' suggests the best way to handle it is to tackle liquidity risk top down and calculate it bottom up. "We believe there are two dimensions that underpin everything else and that you can address now [even before the final international rules come in]," he says. "Improve your intra-day liquidity visibility and improve your liquidity forecasting capability." Do these two things - and support it with the appropriate technology and procedures - and you'll have a head start on other firms seeking to comply with the global standards coming in post-crunch.

Effective management of liquidity risk involves a projection of all of an organisation's future cash flows, while competitive cash flow generation requires different kinds of cash flows to be considered and treated individually. To this must be added additional requirements such as Counter Balancing Capacity (CBC) - basically the ability to manage detrimental liquidity situations - and meeting situations for which dedicated software is needed.

The SWIFT Managing liquidity risk in a changed and global world white paper warns that many facets are involved. Proper liquidity risk oversight requires decisions at multiple levels of aggregation (transaction, product business lines, and bank-wide). Funding must be in place for all transactions, both current and future, as a failure to provide it can trigger ripples throughout the entire bank and banking system.

So a liquidity risk capability comprises a multi-tier segment and is an area in which many major banks, particularly those that are more leveraged, need to be highly proficient, says Tony Freeman, head of industry relations for Omgeo, a post-trade services and automation specialist. "This means having strong technology and operational capabilities, ensuring that the requirements of granularity and real-time information are met," he says. "If legacy software is unable to meet these reporting and risk assessment standards, it will need to be either supplemented or replaced."

For other, perhaps smaller financial institutions with niche operations, formalised liquidity management is not a core skill and has traditionally been conducted on an ad hoc basis. "Increasing this capability, especially the requirement to report detailed information on a daily basis, will mean a significant investment in technology and staff," says Freeman. "Buy-side firms will be directly affected."

While the technology to increase oversight and monitoring is available, doubts are being expressed as to whether there are enough individuals able to fully understand the complexity and depth of liquidity risk. It was an issue much to the fore at last December's annual Ri$k Minds conference in Geneva, reports Steve Wilcockson, financial services marketing manager at software vendor, The MathWorks. "Fears were expressed that there just weren't enough people who had the necessary expertise. It's a complex picture and demands intellectual curiosity and capability, so we could see a hiring crisis in the risk department," he predicts. "While many people are going through the training they haven't yet gained the experience needed, and it will be a hard task attracting the right individuals."

International liquidity risk framework: Basel III
A changing, interconnected and global world has created the need for a new approach to managing liquidity risk. At the height of the crisis, in September 2008, the Bank for International Settlement (BIS) Committee on Banking Supervision (BCBS) issued Principles for Sound Liquidity Risk Management and Supervision guidance. This outlined the key elements for a robust liquidity risk management framework at major banks, covering: board and senior management oversight; establishing policies and risk tolerance; using liquidity risk management tools, such as comprehensive cash flow forecasting, limits and liquidity scenario stress testing; developing robust and multifaceted contingency funding plans; and maintaining an adequate cushion of high quality liquid assets to meet contingent liquidity needs.

More recently, the BCBS has put forward two major reform packages post-crunch, entitled Strengthening the resilience of the banking sector and International framework for liquidity risk measurement, standards and monitoring respectively (known collectively as Basel III by most in the industry). The proposals aim to further reinforce the resilience of banks that are active around the world and subject to liquidity stresses across the globe, by improving the quantity and quality of the capital held by banks. The reform package also aims for greater international harmonisation of liquidity risk supervision, reporting and monitoring.

The Basel II approach has developed two internationally consistent regulatory metrics for liquidity risk supervision, as a cornerstone of a future global framework, due to come into effect in 2012. The first of these, the Liquidity Coverage Ratio, aims to meet the objective of ensuring that the liquidity risk profile of financial institutions includes enough "high quality liquidity resources" to survive an acute stress scenario lasting up to one month. The second, the Net Stable Funding Ratio, aims to improve financial institutions longer-term resiliency by creating further "incentives" for banks to fund their activities through more stable funding sources on an ongoing structural basis.

The BIS report notes that the new proposals are in line with those agreed last September at a summit of finance ministers and central bank governors from the G20 economies, who called on the BCBS to "...enhance tools, metrics and benchmarks that supervisors can use to assess the resilience of banks' liquidity cushions and constrain any weakening in liquidity maturity profile, diversity of funding sources, and stress testing practices."

The measures also acknowledge the G20's call for the Committee and national authorities to "develop and agree by 2010 a global framework for promoting stronger liquidity buffers at financial institutions, including cross-border institutions."

The consultation period for both initiatives ended in mid-April but BIS says it is too early to comment on the industry feedback yet, which it is still analysing. Omgeo's Freeman expects a positive response though. "The market doesn't generally respond in a knee-jerk way to BIS statements because they are normally very well argued and backed-up by a strong understanding of its technicalities," he says. "I think most in the market realise that new regulations are inevitable, and constructive engagement is more productive than opposition."

According to Simon Hills, executive director, prudential capital & risk, at the British Bankers' Association (BBA), banks are fully committed to reform. Based on the lessons learned during the crisis, they are already playing their part as economies recover by seeking to ensure that future crises are less likely to happen and less damaging. "The reform of the regulatory requirements for liquidity are central to this drive," he says. "The industry and authorities must work together, however, to ensure that they are implemented over a suitable period of time, to ensure that their imposition does not impair expectations of growth."

Fernbach's Lohmann adds that BIS will set up a regulatory catalogue as part of the post-crisis response, which will provide for a wide range of liquidity regulation and then give this to national legislative bodies. The opportunity exists therefore for regulatory arbitrage but hopefully this won't come to pass. "Most current liquidity rules in the UK are derived from the Financial Services Authority's (FSA) papers in this area [after the watchdog struck out on its own last year, pre-empting the international BIS protocols that are now coming together]. The FSA rules cover calculating future liquidity gaps, devising the counterbalancing capacity and stress testing your liquidity," explains Lohmann. "Against this background European banks are tentative, but generally expect less restrictive liquidity regulation than we have in the UK." A harmonisation process will now hopefully begin. (For more on the specific UK liquidity requirements please refer to FST's article in the Jan-Feb10 edition or see it online HERE).

Although the new international liquidity standards are meant to be introduced in 2012, adherence to deadlines is expected to be locally enforced, just as introduction of the Basel II capital framework in 2007 showed wide variation between national jurisdictions in their timing priorities. As the BIS is unable to implement its proposals through law the timing is in the hands of local regulators and supervisors, who agree to implement the decisions reached in Basel in their local jurisdictions. In Europe, the Basel III changes to up capital and liquidity requirements will be introduced via a fourth round of changes to the Capital Requirements Directive, known as CRD4.

Managing the risk
While we wait to see if and how the industry feedback changes the Basel III proposals, SWIFT's white paper suggests institutions can address two vital aspects immediately. The first, as touched on earlier, is improving intra-day liquidity through better communication flows. This not only involves connecting up and gathering position and liquidity information from each of a bank's internal systems, business lines and divisions, but reaching beyond its various branches and subsidiaries to the level of account holding institutions and agents, systems and market infrastructures.

The second measure recommended by SWIFT is improving your bank's liquidity forecasting capability and mastering your data will be an essential element of this. Building a data warehouse that can look at detailed and timed transactions, events and positions across your bank would be a help. This data can then be used to generate models and produce reports for the board and others to ensure better informed decision making.

"There is evidence from our clients that they want better visibility - as close as possible to real-time - across their cash and liquidity positions, which is driving new solutions and investment," reports Les Gosling, head of the European, Middle-Eastern & African (EMEA) region for the vendor, Two Four. He adds that the BIS proposals require both a macro and a micro view from pan-global organisations, as well as financial institutions. "The central message is that to meet new requirements, you need better granularity of information to go into a centralised view as close to real- time as possible."

A further vital ingredient will be the ability to 'slice and dice' information. Risk managers will face greater pressure and be judged on their ability to aggregate data in real-time and to create multidimensional views. There will also be a need for greater flexibility, as risk managers question whether analytics and risk models are still valid and ask how they can be improved upon. Value at Risk models (VaR) was discredited during the crunch so new risk calculations and methodologies are needed, even if capital ratios are so strong in future that 'dynamic' thin money bases should be a thing of the past.

"In any event, financial institutions will need to revise their risk management models as the crisis deeply challenged the relevance of the existing models," comments Christian Ball, financial services director at the Capgemini consultancy. The group's recently-released Small Business Banking and the Crisis: Managing Development and Risk report, produced jointly with UniCredit and the European Financial Marketing Association (EFMA), noted that the notion of payment defaults, although still crucial, may have different meanings in today's world. The report says that the traditional way of assessing creditworthiness is questioned in times of crisis, because the analysis of most SME borrowers' financial statements or liquidity behaviours can deteriorate significantly after the date at which the financial snapshot was taken.

Larger banks are working to address these issues and have the budgets necessary to deliver results, believes George Ravich, European vice president of the transaction vendor, Fundtech. "Indeed, some banks began work before the credit crunch took hold," he says. "The smaller banks have more limited research and development budgets, so will, in my opinion, have to outsource these cash management, settlement and liquidity management activities if they are to remain competitive." Among the tools being adopted, he cites two in particular:

• Electronic invoice presentment - which not only processes the transaction but also the attaching data. Banks managing invoices for a customer can see what money is coming in and going out, enabling them to better predict the client's liquidity needs.
• Remittance data - or data attaching to the transaction, provides a better understanding on what payment an amount of money is going towards and enables payments to go through more quickly and easily.

Race against time
A number of questions still remain unanswered, such as how risk managers will manage and report the liquidity risks they are running to regulators - sometimes on an intraday basis. Much will depend on the complexity of the firm; if it's a multi-national, an investment or a retail bank.

"For large, geographically diverse firms that operate in multiple business segments, the primary challenge is to integrate the data, which can be very siloed in vastly different formats," says Omgeo's Freeman. "For a lot of firms end-of-day batch processing is still the norm, so converting to a real-time process isn't easy." And can the new requirements be integrated into existing systems in time? Many analysts are doubtful, suggesting that the proposed 2012 timeline is too short for more complex firms as true integration could take from three to five years.

While the new rules also carry the potential problem of data overload, this probably shouldn't concern the banks. As one analyst observes "nobody can be sanctioned for reporting too much information", and the real issue is more likely to be with the ability of regulators to process the data they receive.

The BBA's Hills disagrees though. "A big problem for banks operating across international borders is that they are currently required to complete different reports for the authorities of the different countries in which they operate - all based on the same underlying information," he comments. "What is needed is agreement by regulators on an internationally harmonised liquidity reporting framework. From this 'menu', recognising that there is no 'one size fits all' approach, they would collectively choose and agree the range of metrics on which an individual bank should report, depending on its business model." This would avoid any potential confusion between the FSA's UK liquidity rules and the global Basel III standards now coming in. It would also enable synergies to be found.

All these changes are producing a number of positive developments, suggests The MathWorks' Wilcockson. One is the increasing readiness of risk managers to challenge front office departments and their assumptions. As a result, there is already evidence that departments are more ready to collaborate, with traders exchanging ideas on how to build best practice. Quicker reporting, research and monitoring tools can be used to spot market opportunities more quickly than rivals can. "There is a conflation of research and development," he explains. "Banks need to be more agile and to be able to apply the right research, right away. This makes optimal risk management and cutting edge trading strategies possible." There may therefore be a silver lining to this raft of new international liquidity risk requirements.

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