Preparing for a rainy day: Managing liquidity risk at non-bank financial institutions (2024)

Establishing a risk appetite is a strategic management decision balancing risk and return. The Board of Directors and management should look to understand the true economic costs of managing (or not managing) risk and then weigh those costs against financial performance to calibrate a desired tolerance. Traditional banks often simulate liquidity stress scenarios to calibrate how much liquidity needs to be held on the balance sheet to cover potential outflows. Therefore, risk appetite is defined as the building up of a liquid assets buffer that prudently responds to stress events without permanently reducing the desired rate of return.

Many NBFIs generally have two options to ensure adequate liquidity in stressed market conditions: 1) hold more cash or liquid instruments, which would create an undesirable drag on return on equity or 2) turn to traditional banks for contractually committed funding, which usually entails commitment fees. Both options impact financial performance. However, leaving liquidity risk unmanaged could result in a scenario where reduced access to funding jeopardizes the viability, or reputation of the firm and could result in customers moving to other providers. Therefore, the board and management need to thoughtfully weigh the economic costs of risk scenarios and mitigation tools (such as liquid assets) against the long-term financial objectives of the firm.

Determining appropriate metrics and measurement techniques should be an iterative process that evolves alongside changes in business activity (e.g., new products) and the financial markets. The most common measurement technique is stress testing financial resources, which is meant to simulate how specific vulnerabilities would create liquidity strain and inform management of the levers available to create liquidity under different scenarios. Other common techniques involve measuring funding concentrations and maturity mismatches that may result in liquidity shortfalls during times of stress. Firms may also want to consider “reverse stress testing,” where the objective is to identify the degree of stress that would “break” the institution. The break-the-institution scenario should drive an open dialogue of the probability of such extreme events and should include operational readiness of executing contingency plans.

Liquidity risk measurements should be provided to the board and senior management regularly. NBFIs should determine which metrics are appropriate to calculate daily such as cash positions, funding capacity and market indicators. Measurements that require more involved analysis, such as liquidity stress testing and “what-if” projections, could happen less frequently (e.g., monthly). However, they should avoid creating reports or dashboards with too much information. A high volume of metrics that do not provide a clear story on the liquidity risk profile can create confusion, or worse, a false sense of confidence that risk is being adequately managed. A concise analysis with an effective story is much more powerful than a “data dump” of metrics.

Banks have learned that complete, accurate and timely data is critical to effective liquidity risk management. Banks recognize that accurate data is fundamental to reliable and efficient risk management. If data is incorrect or incomplete, risk cannot be properly identified and measured, and therefore cannot be adequately managed. Data gaps can also be costly, causing firms to build up too large of a buffer or delaying management decision-making during periods of market stress.

Many firms are broadly investing in their data infrastructure. When doing so, firms should prioritize what is needed for liquidity risk management, particularly the data attributes hidden with credit arrangements, counterparty agreements and other financial contracts that are critical to enable accurate modeling. Models need to be executed on analytical systems that allow for flexible and timely execution.

Strong liquidity risk management is a differentiator in stressed conditions to protect financial resources, and may even enable firms to be opportunistic as their competitors become overly defensive. While it is possible that prescriptive regulation is forthcoming for NBFIs, particularly if the current conditions evolve into a larger crisis, that should not be the driving factor in establishing a stronger liquidity risk management framework. The business case for investing in better liquidity risk management capabilities is equal parts protecting the financial viability of the firm and enabling opportunity.

Creating an inventory of liquidity risk drivers and performing basic scenario modeling doesn't require a substantial investment and it can be a useful step in explaining the importance of liquidity risk management. Investments to secure additional liquidity sources and establish risk measurement systems can then be weighed against the financial impact of liquidity stress. In other words, what is the cost of not managing liquidity risk?