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Liquidity plays a vital role in the daily operations of banks and other financial institutions. Institutions largely rely on deposits and borrowed money, so there’s mounting pressure to ensure that cash and collateral obligations are met without incurring major losses. When a bank or financial institution cannot meet such debt obligations on time, they face a liquidity risk.
One example of liquidity risk is when clients make large withdrawals with a bank, triggering abrupt cash outflows. Other liquidity risks include substantial credit disbursements, unprecedented market activity, and catching up with other related obligations. When liquidity risks turn into a full-blown crisis, there’s a chance that a financial institution will go bankrupt.
Financial institutions must continuously monitor and analyze their financial stability to prevent liquidity risks from snowballing. And to assess financial stability, institutions must conduct liquidity risk management.
In a nutshell, liquidity risk management is what institutions do to determine if their cash and liquid assets can sufficiently meet client demands for deposit withdrawals and loans. More than that, liquidity risk management helps financial institutions gauge and confirm their capacity to pay all necessary expenses.
That said, the importance of liquidity risk management cannot be understated. This article will flesh out the key reasons financial institutions must invest in this practice and how to do it proactively and efficiently.
Helps Analyze Long-Term and Intraday Liquidity Risks
Intraday liquidity risks, or the risks that financial institutions face within a day, must be managed properly to ensure access to cash for daily operations. Failing to be proactive in analyzing these everyday risks leaves institutions unable to meet payment obligations in line with expected schedules, which further impacts liquidity.
Similarly, long-term funding risks result from banks having low liquidity. For example, banks may be unable to offer loans for businesses if the former doesn’t have enough access to cash. It’s also possible that funding for such loans will not be available at an acceptable cost or during a certain term. In this case, banks typically have to sell less liquid assets to the capital markets to get permanent funding.
To properly assess and prevent these risks brought by low liquidity, financial institutions need a comprehensive system for conducting daily analyses and providing estimates of cash inflows and outflows. This can be done more proactively using the right risk management software, preferably one with useful features like data analytics for generating insights that adequately measure short- and long-term liquidity.
In essence, tools that use automated data collection techniques and analytics are highly effective in delivering quantitative and qualitative risk measurements. Such tools are well-equipped to provide early-warning alerts of potential funding vulnerabilities, spikes in business assets, and liability maturation, among others. More than that, risk management tools can provide a balance sheet of assets and liabilities that allows banks to analyze collateral and cash flow needs without disrupting everyday operations. As such, risk management tools have all the functionalities necessary to help financial institutions preemptively correct specific actions that contribute to short- and long-term liquidity risks.
Enables Contingency Planning through Enterprise-Wide Stress Testing
To determine their capacity to withstand a financial or economic crisis, financial institutions must undergo regular stress testing, which helps identify underlying liquidity strains. Should they fail stress tests, institutions must work to build up capital reserves and preserve their finances. Stress testing at an enterprise level allows financial institutions to pinpoint liquidity vulnerabilities in different market-wide and institution-specific scenarios, helping them proactively avoid risks to their financial reserves.
To help institutions gain visibility over liquidity strains and secure their capital, they can use intuitive risk management tools that incorporate analytics-based data and modeling techniques. Through data and modeling, risk management tools can display potential liquidity gaps, projected cash flows, and forward balances under various scenarios.
With this information, institutions become better informed and, in turn, will know what specific contingency strategies they can use to combat liquidity risks. In addition, analytics-driven risk management tools are often able to accurately predict the effectiveness of proposed financial strategies, helping financial institutions prevent worst-case liquidity scenarios rather than react to them.
Ensures Continuous Regulatory Compliance
The Basel Committee on Banking Supervision (BCBS) requires financial institutions to abide by specific rules for calculating financial stability. These include the Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR), which are distinctly different in aspects such as computation.
Compliance can be more challenging for multinational banks since they must adhere to different regulators and measurement guidelines. Nevertheless, regulations such as these provide a standard for banks to gauge their liquidity, which would help prevent further financial risks from snowballing. More than that, compliance is important because there are often hefty fees associated with non-compliance.
Thus, it would be ideal for financial institutions to use risk management solutions that are built for compliance with multiple jurisdictions. Such tools should have pre-built computations, scenarios, and guidelines specific to different jurisdictions.
An efficient risk management system can adjust quickly and accordingly to changes in compliance rules, helping banks assess liquidity through up-to-date standards. All in all, consistently ensuring compliance with the use of integrated systems can help financial institutions ensure full compliance with ever-changing regulatory requirements and prevent risks to their liquidity and finances, including compliance fees.
Supports Risk Disclosure Efforts
Public disclosure on financial stability is another requirement that banks must follow in order to comply with BCBS guidelines.
Essentially, banks must regularly disclose information that can help market participants form their own judgment on the bank’s financial stability. Similar to following ratio computation guidelines, adhering to mandated risk disclosure requirements allows banks to consistently meet standards for regulatory compliance.
To reiterate, these regulations are in place to standardize liquidity assessments and help banks manage their financial posture from the get-go. Non-compliance would only worsen a bank’s financial outlook since they come with expensive sanctions.
With this, it would be a good idea for financial institutions to implement tools that offer full visibility on matters such as financial posture. The ideal solution would use unified data modeling techniques to deliver dashboard reports that visualize liquidity metrics at varying levels of granularity. Again, visualizing these metrics is necessary to keep financial institutions on guard and prepared to keep short- and long-term liquidity crises at bay.
Promoting Financial Foresightedness through Risk Management
Along with other forms of financial risks, banks must adequately handle liquidity risks to ensure long-term business continuity. Through practices such as day-to-day risk analysis and stress testing, financial institutions can properly address the warning signs of instability, come up with solutions, and forecast the effectiveness of such solutions. In addition, a heightened focus on complying with regulations for computations and disclosure will help banks avoid further issues with compliance.
While all financial institutions are exposed to liquidity risks, proactive assessment and planning are the keys to ensuring that these risks do not lead to worst-case scenarios.
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