Liquidity risk governance

Liquidity risk governance

Steve Turner, Managing Director, Novantas provides insights in to why liquidity risk governance is an important topic for discussion and how this can improve efficiency and effectiveness, how incorporating liquidity into funds transfer pricing assist key decision metrics as part of the balance sheet optimization process and more. Steve will be attending the upcoming 6th Annual Risk Americas 2017 Convention, May 23-24.

  1. Steve, can you please tell the Center for Financial Professionals about yourself and your experience in the industry?

I have been in the financial services industry for over 25 years as both a bank treasurer and as a consultant to the industry. Much of my work has involved measuring and managing capital, interest rate, and liquidity risks for banks in the US, Canada, UK, EU and Australia. I started my career in regional banking treasury and was responsible for asset/liability management, funding, hedging, liquidity risk management, and money market investments.  I have managed through liquidity stress events while in banking and have guided clients through a range liquidity preparedness and liquidity stress situation responses.

2. Why is liquidity risk governance an important topic for discussion and how can this improve efficiency and effectiveness?

Liquidity often is the final event which causes a financial institution to fail, not insufficient capital, making it a critical area of management focus. Additionally, setting liquidity limits has challenges which are not mirrored in capital management. That is, in capital management the risks are baked into the balance sheet and there is little management can do to change the outcome once a credit or other capita-impacting event occurs.  Conversely, liquidity events evolve and often are influenced by management actions after the event begins.  Regarding efficiency and effectiveness, the range of information and analytics that banks must have in place today requires thoughtful development and common usage of data, analytics, and applications.  Liquidity measurements require large amounts of use-specific data that are shared with ALM, financial planning and analysis, capital stress testing, and other applications.  Efficiency and effectiveness come from liquidity measurements using the same source data and baseline analytics (e.g., behavioral decay functions for deposits) as other applications while avoiding conflicts that often occur when this discipline is not part of the development process.

3. Can you provide some examples of liquidity measurement challenges, and why is triangulation needed to project liquidity in stable and stressed environments?

Liquidity, unlike other risks, does not lend itself to direct measurement. For example, when measuring credit risk it is possible to develop correlations of credit risk to changes in macroeconomic factors, like unemployment, housing prices, and CRE vacancy rates.  Liquidity stress, on the other hand, does have some contractual components which can be aligned with external factors, but it is largely a function of loss of confidence in an institution.  This tipping point of confidence can occur for a multitude of reasons, including something as simple as a comment in social media, making it difficult to draw direct connections between a set of factors and a level of liquidity stress.  This combined with the fact that no institution has experienced all of the possible sources of liquidity stress makes triangulation a critical component to stressed liquidity measurement, much more so than for credit and other risks.

4. How does incorporating liquidity into funds transfer pricing feed key decision metrics as part of the balance sheet optimization process?

Funds transfer pricing (FTP) without liquidity components would grossly understate the value of liquidity sources, like deposits, and grossly understate the cost of funding term loans.  The issue is not whether liquidity values should be in FTP, but what is the nature of these values and how should they be calculated.  The value incorporated into FTP is impacted by things like the behavioral life of deposits, the size of potential draws on contingent lines, cost of funding HQLAs, how the market cost of liquidity is determined, etc. etc. etc.  With liquidity metrics in place, decisions on what to pay for deposits, how to structure the overall liability book, and what to charge for variable rate term loans can be made in alignment with their true values and costs to the bank.

5. How do you see the role of the liquidity professional evolving over the next 6-12 months?

We believe that there is an unprecedented buildup of idle monies in transaction and other non-maturity deposit accounts which will be impacted by changes in interest rates, macroeconomic activity, trade patterns, and tax policy. Changes that occur in these factors are likely to dislodge these idling monies in ways that liquidity managers need to understand and be prepared to act on. This should cause liquidity managers to be investing in forward-looking measurement and management capabilities.