Incorporating a level of liquidity risk in stress testing and reviewing CLAR requirements

Incorporating a level of liquidity risk in stress testing and reviewing CLAR requirements

Ahead of the Liquidity Risk Management Summit, October 17-18 New York, Sunil Gangwani discusses why it is important for financial institutions to combine CCAR and liquidity stress tests, the challenges faced during implementation of liquidity stress testing and more.

  1. Sunil, can you provide some background information about yourself and how you landed in the financial risk industry?

I started my career with PwC consulting and spent significant amount of time reviewing underwriting process & policies; identifying potential risks in the consumer and commercial businesses for a financial institution in India.

I joined GE Asset Management business at the height of the financial crisis. The industry experienced high levels of dry powder aka unfunded commitments and endowments, pension funds and other limited partners were struggling to meet their legal commitments to fund capital calls from general partners as there were no cash inflows from portfolio sale. I learned the importance of liquidity from Private Equity portfolio perspective during this phase. I sometimes joked that the best time to really learn is during a crisis if we are able to keep our jobs.

In 2011, I joined GE Capital and took Capital Allocation responsibilities and was later given the opportunity to set up the Risk Appetite framework for the Company. Financial Stability Oversight Council designated GE Capital as SIFI (Systemically Important Financial Institution) on July 8, 2013, and the Company was subject to oversight by the Federal Reserve Board. This resulted in a significant change in the Risk organization and risk framework.

GE’s Risk Committee and Senior Leadership played a crucial role in enhancing the company’s ERM capabilities by defining the risk appetite and linking the business processes & decisions to the governance mechanisms. My team was responsible for ensuring that the company has an ERM framework that was optimized for various risk categories and the business units had a structure to identify, report & mitigate risks.

I left GE Capital and joined ING to assist them in creating liquidity stress testing and risk appetite frameworks apart from other responsibilities.

  1. What has been your experience with a bank designated as SIFI (Systematically Important Financial Institution) and regulatory requirements that come with meeting those expectations?

In hindsight, it was a great learning experience. But at the time when we were in thick of things, it felt that somebody opened the flood gates on us. Our extensive portfolio that ranged from aircraft leasing to consumer loans, made it challenging to comprehend the requirements and develop plans to meet the expectations laid down by the Federal Reserve. Even the regulators observed that our product offerings & portfolio added complexities, as we were trying to execute our responsibilities under the new regime of regulation.

We went two step forward one step backward and spent a disproportionate amount of time and resources to gear the company to meet the regulatory expectations. The regulators identified deficiencies in our processes and significant efforts were put in by the business teams and external consultants to lay down plans, frameworks and new policies and procedures to remediate the deficiencies. The onslaught of being designated as SIFI changed the GE Capital future for forever. Despite being very profitable and significant cash flow generator for GE, the regulatory cost was so high that after going through the process for few years, GE decided to scale back and sell most of the portfolio and significantly reduce the business footprints. GE Capital applied for de-designation and the plan got approved in mid-2016.

  1. With the political and regulatory trends evolving, how do you see the liquidity risk landscape evolving over the next 6-12 months?

The new administration plans to significantly change the Dodd-Frank Act. Currently, the US and Basel requirements are somewhat similar although differences exist in terms of implementation timing.
US House of Representatives Financial Services Committee has proposed Financial CHOICE Act which will provide relief from the current requirements for banking organization that are considered well capitalized.
The relief is loosely termed as “off ramp” approach. A well-capitalized banking organization means the one that maintains a leverage ratio of at least 10 percent and (2) the insured depository institution has a composite CAMELS rating of a 1 or a 2 at the time the banking organization makes the election.
There is still a long way to go to change Dodd-Frank and depending on how the bill finally shapes up and approved by the Senate and House. If the new bill is enacted as proposed, there will be noteworthy differences in US & Basel rules that may be beneficial for some and not others depending on their footprints and applicability to domestic vs. foreign banks operating in the US. No doubt change in the course of action will result in deployment of additional resources and costs to meet different regulatory regime expectations and is a big concern for global banks. At the same time, there is a potential for regulatory arbitrage as the gap between US and Basel rules widens.

4. Why is it important that financial institutions combine CCAR and liquidity stress tests?

Currently, the CCAR and CLAR requirements are not aligned with each other and the rules have been established somewhat independently without considering the impact of one on the other. From a financial institution perspective, it’s a big challenge. The team has to unscramble the requirement under both regulation and at the same time have to make a sense of the results as a whole. The bigger question in my mind is the “use test” of different regulatory requirements. Could the banks use the results produced for meeting CCAR and CLAR requirements and use it as a tool to foresee in future, correct the course and steer the ship away from potential risks in the business?

In order to make regulatory requirements have a real impact on the financial system & banking organizations, it’s not only important to consider the interconnectedness but also simplify the process for banking organizations. The end goal of these regulations should be to proactively identify risks in the portfolio and assist banks to inform their strategy and build safeguards where there are vulnerabilities.

5. What are some of the challenges faced during implementation of liquidity stress testing especially the one you didn’t anticipate at the beginning of liquidity stress testing process?

As we were trying to lay down the Liquidity stress testing framework for a foreign branch of a European bank, we realized that we had not anticipated difference in the Balance Sheet of a local entity vs. the consolidated view of the parent company. We recognized that the funding model as a whole and portfolio view at top of house is very different from the local Balance Sheet. As we dug deeper and tried to understand how the local balance sheet was viewed from the top of the house, the sheer scope and size of total Balance Sheet made the local portfolio seemed immaterial and hence less of a concern and focus. However on the flip side, to meet local requirements we still had to have the rigor and detailed stress testing assumptions and framework. The experience sounds almost like the tail wagging the dog instead of another way around. We still have not completely solved the problem but have come up with few options to address it.