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A decade after the crisis, we are still learning key lessons about liquidity risk

“Wow, I can’t believe I can say that the financial crisis was a decade ago,” said Chris Mills, Managing Director of Model Validation Services for MountainView, a Situs company, during Wednesday’s liquidity risk webinar. “It doesn’t feel like a decade.”

Time flies when you are trying to emerge from a global financial crisis. Post-crisis, regulators identified ineffective liquidity risk management as a key contributor to the crisis.  Now, 10 years later, financial industry executives are assessing whether their financial risk management strategies are effective enough to enable them to meet ongoing cash and collateral obligations if another crisis, or liquidity event, occurs.

Mills, a seasoned executive banker and balance sheet strategist, made it clear in the webinar that predicting the next downturn is not nearly as important as preparing your institution for the next downturn. “The industry was ill-prepared for an extreme systemic crisis,” said Mills. “We just didn’t have the proper plans in place, and stress testing was not a mainstream.”

Reflecting on the crisis, Mills further explained that many institutions had a siloed approach to risk management. Key risk red flags from one area of the institution were managed separately from other areas, without knowing how interdependent these risks were. Now, said Mills, we’ve spent a full decade trying to fix these problems.

With that in mind, Mills discussed the industry’s migration to enterprise risk management and the key components necessary for an effective liquidity risk management framework. That said, Mills noted some of the deficiencies that still linger, possibly limiting the effectiveness of liquidity risk management and stress testing. Financial institutions need to keep an eye on the following key areas:

(1) Are Holdings of Liquid Assets Sufficient?

Financial institutions need to determine the amount of on-balance sheet liquidity that is appropriate to cover the day-to-day funding needs as well as short-term fluctuations of unexpected behaviors.

(2) Have You Defined Appropriate Measures and Metrics?

Liquidity measures should be a combination of current position static measures and dynamic forward-looking measures such as Basic Surplus, LCR type coverage ratios and liquidity gap forecasts.

(3) Are Your Modeling Assumptions Dynamic? Do They Consider Economic Factors?

Stress tests should include assumptions that are reasonable based on the economic environment of the scenario, including regulatory constraints.  For example, institutions should consider asset growth assumptions as well as loss of funding.  Institutions need to periodically review scenarios to encompass both escalating liquidity threat and specific events such as market disruption or economic recovery.

(4) Are Your Policies and Governance Comprehensive?

The institution needs both a comprehensive liquidity policy that establishes a sufficient liquidity risk management framework, including intra-day processes, and a full-scope contingency funding plan (CFP).

(5) Do You Have Adequate Early Warning Systems?

Create dashboards that are monitored and reported frequently, and include both idiosyncratic and systemic measures that will alert the institution to potential funding issues or possible liquidity events.

What strategies, processes, systems, measurements and tools should institutions have in place today?

Watch the webinar on-demand, download the slides, or contact MountainView to find out whether your institution has put in place appropriate liquidity risk management strategies.

This webinar is now available for on-demand viewing.