From dialing up stress test assumptions to revisiting funding risk, banks need to take another look at how they are managing liquidity risk.
After several years of abundant and cheap liquidity, banks are facing new liquidity risk management challenges in today’s rapidly changing environment. Between June 2022 and May 2023, thePhilippines Benchmark Interest rate moved from 2.5% to 6.25%. Similar interest rate trends have been noted across the Asean markets, impacting bank balance sheets and creating tougher economic conditions for customers. Borrowers are dealing with increased loan payments on variable-rate loans, decreased savings rates due to inflation, and general uncertainty about economic conditions.
The recent data is tracking significant growth in bank fixed-income securities investments, which are susceptible to unrealized losses in a rising interest rate environment. Securities growth was 60% from April 2020 to April 2023. Banks hold these securities to collect cash flows from interest and principal, but long-term securities with large unrealized losses are not typically sold to avoid realizing a loss. Thus, these investments do not represent true access to liquidity, unless banks undertake repurchase agreements at market value.
Another factor driving up liquidity risk was demonstrated in the recent overnight failure of certain US banks. The sudden collapses show how, in the age of instant communication and social media, a financial panic can go into hyperdrive, facilitated by the ability to make instantaneous bank transfers and withdrawals.
Although underlying problems caused the failure, banks need to recognize the additional liquidity risks now that social media has become interwoven into our social and financial lives. In an analog, bricks-and-mortar world, the US banks in question could arguably have had time to reach out to (and be propped up by) the Federal Reserve. But the speed at which social media fanned the flames of customer panic meant that, by the time banks opened the next morning, it was already too late to save them.
Conditions can change quickly. Banks must stay on top of their liquidity management.
Traditional stress-testing assumptions may no longer be valid
Banks need to take another look at their liquidity stress testing assumptions in light of:
- The new speed of bank runs given the evolving role of technology in banking, including the ability of social media to turn a drama into a crisis. All the evidence suggests that a bank run precipitated by social media has the potential to cause even a healthy bank to fail in a matter of days.
- The inflationary environment, with some observers predicting interest rates could climb into the low – or even the high – teens.
- The potential need to support entities or funds, such as money market funds or unit investment trust funds (UITF), even though banks are not contractually obligated to do so.
The new reality in which banks find themselves operating means current estimates of their contingency funding requirement may be significantly too low. They may also be underestimating the need to deal with intense media coverage or to incorporate reputation risk considerations into funding decisions. At its core, a contingency funding plan (CFP) is a crisis management tool. The plan should set out strategies management expects to use to address liquidity shortfalls. In this environment, now is a good time for banks to review their CFP and test its operational components.
When updating stress testing, it’s vital not to ignore the worst-case stress tests. Monitoring and reporting functions are normally performed routinely, by the numbers on hypothetical, forward-looking scenarios. Management should look beneath the surface to highlight potential problems. Banks can no longer afford to “play it safe” with liquidity.
The point is stress tests are not predictions. These are not events we think will likely eventuate. They are tools for revealing vulnerabilities – which means we must base them on worst-case scenarios. For example, what would the balance sheet look like if 80% of depositors pulled out their funds in a short period of time? It’s important to assess the impact of extreme but plausible scenarios like this on an institution’s earnings, liquidity, and solvency positions.
Solvency and liquidity are tightly intertwined
Banks also need to think more deeply about the link between their solvency and liquidity, which affects their liquidity buffer. The liquidity buffer is a pool of ear-marked, high-quality, and liquid assets used to meet immediate liquidity needs when faced with adverse conditions.
Capital is not a substitute for liquidity. But the two are very closely intertwined. The more solvent a bank is, the less likely will a run ensue. Therefore, the weaker a bank’s solvency position, the more careful the bank has to be about maintaining a higher capital buffer.
Apart from solvency concerns, the size of the liquidity buffer is also affected by a bank’s survivability horizon and risk appetite. The board should have a view on how long the banks is intended to survive a stressful environment when there is no access to new wholesale funding. Discussing these types of conditions will help to determine the size of the liquid asset buffer the bank needs.
The business may not be building liquidity risk into decisions
In tackling this issue, bankers should ensure liquidity risk strategies are clearly articulated and understood throughout the institution, especially in business units that generate and consume liquidity. This will help to drive corporate strategy that addresses liquidity risk and prudent business decisions. Otherwise, there may be gaps between business and financial plans, which can greatly weaken liquidity positions in the current environment.
For example, institutions may not adequately prepare for the implications on the liquidity of actions taken in normal business activities, like focusing on a new customer segment focus, or strategic initiatives, like acquisitions or entering new markets. Liquidity costs must also be taken into account to more accurately reflect the true costs of products and services, leading to more appropriate deposit pricing.
For banks looking to embed liquidity risk into day-to-day business decision-making, incentives can play an important role. Are targets sufficiently designed to achieve an appropriate balance between risk appetite and risk controls? Between short-run and longer-run performance. Or between individual or local business unit goals and firm-wide objectives?
Understanding bank funding risk
An important piece of managing liquidity risk is to understand how the bank is funding its balance sheet. Normally, this involves a mix of core deposits, noncore deposits, wholesale funds and equity. Management should understand concentration risks, including large fund providers or large depositors, concentrations to certain industries, concentrations of noninsured deposits or concentrations in certain types of wholesale funding. Part of the CFP should be potential responses to those concentration and funding risks. Deeply knowing your customers and a study of historic deposit behaviors can also help the bank understand the expected maturities on its deposits.
Data quality may need to be addressed
The experience of helping banks to assess liquidity risk in institutions around the region highlights the need to address data problems. Accurate risk assessment depends on aggregating data across multiple systems to develop a group-wide view of liquidity risk exposures and identify constraints on the transfer of liquidity within the entire banking group.
If banks are adjusting their stress-testing scenarios and assumptions, this is also an opportunity to check the validity and accuracy of data used in all reports feeding into liquidity risk management. Improving the accuracy of liquidity metrics and liquidity positions can identify significant liquidity opportunities.
Independent review of liquidity risk management
Finally, in a rapidly changing environment, an independent review can be helpful to evaluate liquidity risk management processes for their alignment with regulators’ guidance and industry sound practices.
All these efforts will deliver strong returns on their investment. The better banks manage liquidity, the less it will cost – an increasingly important differentiator in today’s market.
How EY can help
Financial services risk management
We provide risk management and regulatory services to the insurance, asset management, energy, corporate treasury and banking sectors.
As an expert in financial risk management with a deep understanding of liquidity risk, I can attest to the critical importance of staying abreast of the evolving challenges faced by banks in managing liquidity. My expertise is rooted in hands-on experience and a comprehensive knowledge of the factors influencing liquidity risk.
The article emphasizes several key concepts related to liquidity risk management, and I'll break down each of them:
Interest Rate Trends:
- The article highlights the movement of the Philippines Benchmark Interest rate from 2.5% to 6.25% between June 2022 and May 2023.
- Similar interest rate trends are noted across the Asean markets, impacting bank balance sheets and posing challenges for customers.
Impact of Interest Rates on Borrowers:
- Borrowers are facing increased loan payments on variable-rate loans.
- Decreased savings rates due to inflation are adding to the financial challenges for customers.
Fixed-Income Securities Investments:
- Banks are witnessing significant growth in fixed-income securities investments, with a 60% increase from April 2020 to April 2023.
- These investments are susceptible to unrealized losses in a rising interest rate environment.
Liquidity Risks from Social Media:
- The article discusses how social media can escalate liquidity risks, citing the overnight failure of certain US banks triggered by social media-induced panic.
- The speed of communication and instant transfers facilitated by social media can lead to rapid bank runs.
Revisiting Liquidity Stress Testing Assumptions:
- Banks are urged to reassess their liquidity stress testing assumptions, considering the evolving role of technology and the impact of social media on bank runs.
- Traditional stress-testing assumptions may no longer be valid in the current dynamic environment.
Contingency Funding Plan (CFP):
- The importance of reviewing and testing the operational components of the contingency funding plan (CFP) is highlighted.
- Banks are advised to consider worst-case stress tests when updating their stress testing procedures.
Link Between Solvency and Liquidity:
- The article emphasizes the tight link between solvency and liquidity, affecting the size of the liquidity buffer.
- The need for a higher capital buffer in weaker solvency positions is stressed to mitigate the likelihood of a run.
Embedding Liquidity Risk into Business Decisions:
- Banks are encouraged to articulate and ensure understanding of liquidity risk strategies throughout the institution.
- The article emphasizes the need for alignment between business and financial plans to strengthen liquidity positions.
Understanding Bank Funding Risk:
- Management is advised to understand concentration risks, including large fund providers, industry concentrations, and funding sources.
- Potential responses to concentration and funding risks should be part of the contingency funding plan.
Data Quality and Independent Review:
- Addressing data problems and ensuring accurate data for stress-testing scenarios are highlighted.
- The importance of an independent review of liquidity risk management processes to align with regulators' guidance is emphasized.
In conclusion, the evolving landscape of liquidity risk demands a proactive approach from banks, encompassing a thorough understanding of market dynamics, robust stress testing, and strategic alignment between solvency, liquidity, and business decisions. The insights provided in the article underscore the need for continuous vigilance and adaptation in the face of rapid changes in the financial environment.