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  • December 9, 2020

Managing liquidity risk during the pandemic stress event

Michael Eichhorn
Professor, Hochschule Harz, University of Applied Sciences / Germany
This is a syndicated post, view the original post here

By Prof. Michael Eichhorn Hochschule Harz, University of Applied Sciences / Germany and Faculty, Bank Treasury Risk Management (BTRM) and Aaron Romano Associate Faculty, BTRM

Liquidity does not matter; until it matters, then it is the only thing that matters! For many banks, the COVID-19 crisis provided a timely reminder of this statement.

Imagine, as an ALCO Blog reader you are invited to speak at an industry conference on liquidity. Specifically, you are asked for your views on the question: How do you manage liquidity risk during a pandemic stress event?

What would your focus be? How do you open and close your speech?

What about the following proposal? In your opening remarks, you contextualize the term pandemic stress event for liquidity risk by asking the audience to recall what happened in March 2020:

  • Short-term funding markets (nearly) closed; in capital markets, spreads spiked, leading to elevated liquidity funding costs.
  • Commitment drawdown rates, from non-investment grade corporates, rose sharply and were frequently higher than in 2008.
  • Initial margin requirements were occasionally several times higher than before the crisis (inducing systemic risk) and vastly different between clearers.
  • Variation margin requirements suffered from pro-cyclicality for banks that chose the historical look back approach for derivatives under the liquidity coverage ratio calculation.
  • Failed transactions caused additional strains due to extensive trade volumes and operational challenges (e.g., the transmission of margins).
  • (thankfully) early interventions by central banks helped to stabilise the markets.

You organise the remainder of your speech around the following themes:

  1. Contingency funding plan: execute processes for crisis governance and communication.
  2. Strategy and concentration: review and, if necessary, adjust the funding plan and mix by-product, currency, tenor, and counterparty.
  3. Risk control framework: monitor utilisation of risk controls and provide a granular, forward-looking view on the impact of potential further shocks on the liquidity position.
  4. Forecasting: warrant cash flow attribution and quality of short-term liquidity projections.
  5. Collateral management: ensure a joined-up, front-to-back approach to managing margin exposures & liquidity.
  6. Management information: ensure timely, granular data to support business-line level decision-making.

These themes are illustrated in more detail in Figure 1. All themes have non-IT elements (e.g., staff, governance) and IT elements (e.g., data granularity, reporting tools).

Figure 1: Six focus themes for managing liquidity in a crisis

You close out by acknowledging that every crisis is different and individual banks are impacted in their own ways, e.g., depending on their business models. Therefore, no general, “one size fits all” statements are possible.

The moderator opens your session for Q&A. Someone asks: How fast can your risk infrastructure reporting system inform your management on changes in a crisis event?

What would be your answer? In our view, most banks require further infrastructure development to inform management of t+0 or even intraday on certain actuals (instead of t+1 and t+2) as part of the regular reporting. It is equally important to provide this information on a granular basis, i.e., by the driver and at the business level (as opposed to aggregation by entity or group-level). Delegates may comment that new technological developments (e.g., data lakes, open, interoperable platforms, big data, AI, agent-based modeling) enable enhanced capabilities.

After this and further questions, the moderator closes your session with his summary: Investments in infrastructure development, coupled with work on the focus as mentioned earlier, enable banks to mitigate a situation where liquidity is the only thing that matters. Would you agree?

For more information, please visit:
Oracle Modern Risk and Finance Solutions: www.oracle.com/risk
Oracle Financial Services: oracle.com/fs

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