Liquidityis a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses.Liquidity riskrefers to how a bank’s inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).
During the recent prolonged period of historically low and stable interest rates, financial institutions of all shapes and sizes took liquidity and balance sheet management for granted. But as rates rose and uncertainty increased, many institutions struggled to maintain adequate liquidity and appropriate balance sheet structure due to deposit run-offs and portfolio duration mismatches.
Liquidity risk was exacerbated by asset value deterioration while monetary policy tightened. Inadequate balance sheet management led to highly publicised bank failures and a heightened awareness of liquidity risks.
In the wake of these bank failures, one thing became clear: banks and capital markets firms need to manage their liquidity and balance sheets better. And self-preservation isn’t the only motive for doing so. The consequences of poor asset liability management and liquidity risk management can reach far beyond the walls of any one financial institution. It can create a contagion effect on the entire financial ecosystem and even the global economy.
Regulatory bodies are intent on preventing another financial crisis in the future, and scrutiny of liquidity management is increasing. The onus is now on financial institutions to shore up liquidity risk and balance sheet management – for the good of the firm and the economy.
Liquidity risk management defined
Liquidity risk management and ALM encompass the processes and strategies a bank uses to:
- Ensure a balance sheet earns a desired net interest margin without exposing the institution to undue risks from interest rate volatility, credit risk, prepayment dynamics and deposit run-off.
- Plan and structure a balance sheet with a proper mix of assets and liabilities to optimise the risk/return profile of the institution going forward.
- Assess its ability to meet cash flow and collateral needs (under normal and stressed conditions) without negatively affecting day-to-day operations, overall financial position or public sentiment.
- Mitigate risk by developing strategies and taking appropriate actions to ensure that necessary funds and collateral are available when needed.
The role of balance sheet management
Balance sheet management, through strategic ALM, is the process of managing and optimising assets, liabilities and cash flows to meet current and future obligations. Effective ALM not only protects financial institutions against the risks of falling net interest margins and funding crunches – it's also an opportunity to enhance value by optimising reward versus risk.
Good asset liability management broadly covers portfolio accounting, analytics and optimisation. It relies on a suite of tools for transaction capture, forecasting, interest rate risk measurement, stress testing, liquidity modelling and behavioural analytics.
