Utilising liquidity stress tests as a risk management tool and understanding key drivers and scenario considerations

Utilising liquidity stress tests as a risk management tool and understanding key drivers and scenario considerations

  1. Rocco, can you tell the audience about yourself and how you came to work in risk management?

I am a 42 years old man. I am married and I have two wonderful children. I have been living in Milan since 1993, when I left the South of Italy to get a Degree in Business Administration in Bocconi University. I was hired by UniCredito Italiano at the end of last century, when the bank was still named Credito Italiano and was not the pan-European bank as it is now. I grew up professionally in this banking Group following its own growth steps: as the bank was growing and changing its shape, it offered several professional opportunities to his employees and I enjoyed in getting lots of them.

I started working as a financial analyst in capital markets, assisting to the birth of the Euro corporate bonds market. In November 2006 I moved to the Group Capital Management team, with the task of monitoring and forecasting the Group capitalization ratios and assessing the value generation of different managerial choices. In March 2010 I was assigned the task of leading a team in the Strategic Planning Unit, with the aim to provide the Group Top Management medium-long term forecasts of the Bank’s P&L and Balance Sheet, representing the basis of the budget and the multi-year plan at the Group level.

After these experiences in the Markets division and in the Finance competence line, I decided to enlarge my knowledge background with a period in Risk Management. Since May 2014 I am the Head of the Group Liquidity and Interest Rate Risk Analysis.

2. Can you explain the essential drivers to consider in a stress test and why is it important to evaluate these drivers?

The liquidity of a bank is made of its reserves of cash and liquid assets integrated, through the time horizon, by the expected cash outflows and inflows. The essential drivers to consider in the stress test are those events that might impact these items. In particular:

  • the drop in the value of the securities in the bank’s portfolios or a change in the contractual conditions of the repo market;
  • the ability of the bank to roll over the maturing wholesale debt both in the form of bonds and in the form of interbank deposits;
  • an unexpected withdrawal of deposits by retail or non financial corporation;
  • an extraordinary drawing of committed credit lines.

The above listed events can generate the most severe impacts in a period of crisis, due to their relative size on the total balance sheet of the bank.  In addition to those, other specific outflows to consider when designing a liquidity stress test are the margin calls mostly related with derivatives contracts and the rating trigger clauses included in several funding sources.

The considerations of other balance sheet items (loans run off, uncommitted credit lines, etc.) in the stress test is not straightforward, as the definition of the proper strategy needs to find the right balance between the plausibility of the shock assumption and the need to exclude managerial remedial actions from the stress test.

  1. How can optimizing stress testing internally benefit liquidity risk management and how should managers look to incorporate daily stress testing into liquidity regime?

A well structured liquidity stress test is an effective tool through which the management of a bank can strengthen its liquidity risk framework. The risk manager uses it for different purposes.

The liquidity stress test does not indicate a situation of imminent liquidity crunch. It is instead a powerful attention signal: its result may warn that the liquidity buffer of the bank is not enough to face an idiosyncratic and/or market driven liquidity crunch. As such, it is a powerful early warning indicator and is included in the framework of limits/triggers the Bank has in place for the management of the liquidity risk.

In addition of being itself part of the liquidity risk management limits, the liquidity stress test contributes to define the adequate distance from the point of no viability where to set a limit in other relevant liquidity metrics in order to allow Risk, Treasury and Finance departments to timely address potential and/or actual risks. The liquidity stress test is used to define the right size and composition of the liquidity buffer that the bank must constantly hold in order to survive to a severe stress. Furthermore, the assessment of the financial plans and contingency funding plans takes into account the liquidity absorbed in a period of stress and the performance that the balance sheet clusters display in a period of liquidity turbulence.

In particular, the liquidity stress test is used by the banks in Recovery Plans, with the purpose to test the effectiveness of the contingency liquidity management and the real feasibility of the contingency actions included in the recovery plan.

  1. How do you see the liquidity risk management evolving over the next 6-12 months?

The liquidity risk management changed significantly during last years. Regulators included new metrics (LCR and NSFR) and new risk management practices (ILAAP). This has required important investments in IT infrastructure and people in a period of generalized cost cutting. The extraordinary interventions put in place by the ECB (TLTRO, QE) contributed to increase the liquidity reserves of European Banks. The current abundance of liquidity, spread throughout the banking sector, generates the common belief that liquidity is not a problem at the moment for the banks.

This is true. In spite of this the focus and scrutiny of Central Banks over the liquidity risk management practices has never been so intense. According to my personal view, Central Banks want to ensure that when the extraordinary support to the banking system, created in the recent years, will be withdrawn, all the banks are prepared to survive and prosper in the new normalized environment. In the next 6-12 months, therefore, the situation will not change. Liquidity will continue to be an area of attention of Central Banks in their supervisory review and evaluation process (SREP), with a particular focus on the concentration of funding sources, diversification of the liquidity buffers and the governance framework of the contingency situations.

In this environment, a well structured liquidity stress test program is an efficient tool to spot possible vulnerabilities.