definition of liquidity, attention should be paid to the liquidity of each individual asset. The general liquidity squeeze prompted by the Lehman crisis, during which presumed highly liquid assets became completely illiquid for more than six months, calls for fresh contemplation of what constitutes a liquid asset and the definition and application in banks of sound liquidity risk management.
In assessing the liquidity value of liquid assets, the time-to-cash period (the time necessary to convert assets into cash) should be considered. A distinction can be made between assets pledged/deposited at central banks, which can be drawn on immediately, and assets on the balance sheet that may have been pledged as eligible collateral, which may take some time to draw on. The time needed to convert a drawn currency to the currency required should also be considered.
Central banks are an important potential provider of funding through refinancing operations, which are distinct from intraday credit. But institutions do not know in advance how much funding they will receive: they receive only what they are allocated in the auction process. In addition, funds are distributed only once per week. Banks can also draw on central banks' overnight facilities in the course of normal business, but liquidity management should take into account the reputation risk (kind of stigma) potentially associated with the possibility of extraordinary drawings. Thus banks should not rely too heavily on obtaining funding from central banks.
In times of stress, market liquidity may deteriorate. Depending on the type of stress, the deterioration may be specific to certain kinds of assets or it may be more general. The central bank will continue to provide liquidity against eligible assets. When the broader asset market liquidity deteriorates, central bank eligibility may become more important (Figure 1.2 presents the European Central Bank official, lending and borrowing rates from March 2008), as observed during the 2007–08 crisis or the later Greek crisis. Banks may tend to pledge their relatively illiquid assets at central banks, when eligible, in order to use their most liquid/marketable assets to extend their liquidity buffer as much as possible.
Figure 1.2 ECB monetary policy corridor.
Source: ECB.
Figure 1.3 EU gross liquidity shortfall. Each line represents a country.
Source: EBA voluntary LCR monitoring exercise.
Figure 1.4 Banks' volume of high quality liquid assets eligible by introduction of LCR as a percentage of gross liquidity shortfall, single bars referring to an individual country.
Source: EBA voluntary LCR monitoring exercise.
Liquid assets are usually defined as assets that can be quickly and easily converted into cash in the market at a reasonable cost. In this respect, due consideration should be made of the time-to-cash period. In order to analyse the liquidity of an asset, institutions and supervisory authorities need to differentiate between normal and stressed times, taking into account the role of central banks' refinancing policies, particularly in times of stress.
Liquidity risk can also be triggered by credit risk, the bank being exposed to the failure of its counterparties and their obligations due; as a counterparty to other market participants it may fail to meet commitments at a reasonable and timely cost, and as a provider of credit it is exposed to liquidity risk linked to the credit quality of its portfolio.
Reputation risk can affect banks' funding capacity; liquidity problems tend to rapidly become visible to the market, seriously damaging reputation or rating.
Market risk, mainly interest rate volatility, drives liquidity risk management and the market value of securities depends on the number of market participants, their size, the frequency of the transactions and assets' ratings. Critical market conditions lead to uncertainty over the value of assets; margin calls on derivatives in such cases also have implications. Large banks also rely on regular functioning of foreign exchange markets, while interruptions in that functioning can trigger liquidity risk.
Concentration may also generate liquidity risk: funding concentration risk emerges when withdrawal of a few liabilities could be significant to the bank's overall funding and difficult to replace in a timely manner. Operational risk coming from payment system disruptions or delays can be very dangerous during severe and prolonged liquidity crises.
A bank should not undertake imprudent liquidity risk management and hold lower levels of liquidity owing to the expectation that central banks will provide support in the event of a market-wide stress and – for firms whose failure might have systemic consequences – firm-specific stress. Although managers and shareholders have strong incentives, arguably without regulation, to build in some resilience to liquidity stress by holding sufficient amounts of liquidity, these incentives may well prove insufficient. This would not be a problem if the consequences of a firm's insufficient resilience to liquidity stress were confined solely to shareholders and managers. But, as recent events have shown, this is not the case.
A bank will remain liquid as long as creditors have confidence in it, and believe other creditors also have confidence. A sudden loss of confidence, whether rational or irrational, will result in liquidity difficulties. We do not consider that holding a buffer of liquid assets designed to protect against liquidity stress is sufficient. Each firm should know its gross liquidity risk, not just the mechanisms to mitigate the risk when crystallized. At all times, we would expect firms to stress test their balance sheets against the stress test scenarios outlined in Chapter 3 and, where any weaknesses are identified, to limit or restrict the impact of the stress. The key is to ensure that the entire liquidity profile of the firm is such that liquidity risk in the firm does not exceed acceptable levels.
History has demonstrated that during a severe liquidity crisis it is the individual position of the various legal entities within a group that matters most. Supervisors, therefore, have to be satisfied with the liquidity position of the locally incorporated entity or local branch. While some major internationally active groups may strongly disagree with this assertion, recent events have clearly shown that internationally active financial groups can default and that, in such an event, local creditors and customers can be significantly disadvantaged.
The market turbulence of the last decade has also demonstrated that many tend to underestimate the potential extremity of liquidity stresses in their stress testing and CFPs. Regulation has to address this potential shortcoming in firms' liquidity risk management approach. This will be of particular importance in the medium- to long-term future, when the effects of the current crisis have abated and the lessons once learned may have been forgotten.
Contrary to widely held assumptions, extreme liquidity events are not all that rare in the global financial markets. While the length and intensity of the current crisis may be unprecedented, name-specific and even wider liquidity events occur with some frequency. As noted above, any crisis of confidence will invariably have certain liquidity implications. It is therefore necessary for our new regime to prepare for the next crisis and ensure that firms' resilience to liquidity stresses remains high, even during business-as-usual periods.
Models have only a limited role to play in liquidity regulation, as liquidity stresses are heterogeneous events that make it difficult to construct meaningful probability distributions. We agree that internal models can play a useful role in a firm's liquidity risk management, however, they are only one of many tools a firm should apply.
1.2 MANAGING LIQUIDITY RISK
Funding liquidity is closely
