Liquidity risk: regulatory framework and impact on management

The Basel Banking Supervision Committee defines liquidity as "an entity's capacity to finance increases in its volume of assets and to comply with its payment obligations on maturity, without incurring unacceptable losses”.

In this regard, liquidity risk can be expressed as the probability of incurring losses through insufficient liquid resources to comply with the agreed payment obligations within a certain time horizon, and having considered the possibility of the entity managing to liquidate its assets in reasonable time and price conditions.

Financial entities are particularly exposed to liquidity risk, given the nature of their activities, which include capturing funds. It is an inherent risk in banking. However, liquidity risk has been given less attention than other risks by both entities and regulators. Until 2010, standards basically consisted of a series of non-binding qualitative principles regarding good liquidity management.

In recent years, however, the situation has changed: the financial crisis and liquidity restrictions have prompted regulators and entities to make a far-reaching analysis of liquidity risk management, with the aim of safeguarding financial stability and preventing further stress situations. On the regulators' side, this analysis has led to the development of new binding regulatory standards based on quantitative principles, which are currently being implemented.

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However, these standards imply a series of macroeconomic and financial impacts which are being assessed by the regulators themselves and by the financial entities. One of the main impacts is the increased short term contracting of liquidity in the markets, leading banks and financial institutions to place even more importance on their clientele's deposits as a source of financing, an effect which is partly encouraged by the regulators themselves.

In this context, entities are developing management frameworks which consider liquidity risk from all possible standpoints: governance, organization and functions, policies and principles, methodology, stress tests, contingency plans, tools and reporting.

The object of this document is to provide a global and in depth overview of liquidity risk, to state the key questions in the current situation and the regulatory and management trends concerning this risk. For that purpose, the document has four basic objectives which are addressed in four sections, following a preliminary executive summary:

• Describe the current situation of liquidity standards, with special emphasis on the new regulation issued by the Basel Committee (known as Basel III).
• Characterize the impacts of this standard both on the real economy and on the financial sector, and identify points which could give rise to uncertainty or which the entities and the regulators are yet to agree on.
• Analyze a very important aspect of liquidity management, which is the stability and the macroeconomic dependence on deposits of financial entities, using a quantitative study with real figures and a qualitative analysis of several historical special cases which have happened recently.
• Lastly, describe how financial entities are adapting their management frameworks to this new reality, with emphasis on the most advanced practices in the sector and future points for development.

For more information, click here to access the full document in pdf (also available in Spanish and Portuguêse).