Principles of Bank Liquidity Risk Management

Why is Liquidity Risk Management Important?

The central tenet of the principles of banking is that of liquidity risk management; therefore by definition it should be part of the strategy of every bank to be able to survive a liquidity crisis. Liquidity management is the most important risk management function in banking, at the individual bank level and at the aggregate industry level.

What is Bank Liquidity Risk?

In banking, liquidity is the ability to meet obligations when they become due. In other words, maintenance of liquidity at all times is the paramount order of banking. Banks need to set in place an infrastructure and management ability to ensure that liquidity is always available, to cover for all times when market conditions deteriorate. Because banks are so important to the economy’s health, central banks operate as “lenders of last resort” to come to the aid of a bank that finds itself in liquidity difficulties.

What are the Elements of Liquidity Risk Management?

The importance of liquidity risk management is such that it must be addressed at the highest level of a bank’s management, which is the Board of Directors. Liquidity management is devised and dictated from the highest level, and influences every aspect of the bank’s business strategy and operating model.

Liquidity crises are endemic in banking and finance. That is why it is essential to maintain liquidity principles throughout the economic cycle, a discipline that may break down during a bull market or a period of cheap and plentiful cash availability. The majority of banks do adhere to sound principles of liquidity management during a bull market, when funds are readily available, but some do not. Sound liquidity management is to the benefit of the bank’s shareholders and all its stakeholders.

What are the Principles of Liquidity Risk Management?

The following represent basic essential management standards of banking. We consider these to be the most important principles of what should be taken to be the cornerstone of banking and liquidity risk management.

1. Fund illiquid assets with core customer deposits
2. Where core customer deposits are not available, use long-term wholesale funding sources
3. No over-reliance on wholesale funding. Run a sensible term structure wherever wholesale funding is used
4. Maintain “liquidity buffers” of instantly liquid assets, to cater for both firm-specific and market-wide stresses
5. Establish a liquidity contingency plan
6. Know what central bank facilities the bank can access and test access to them
7. Be aware of all the bank’s exposures (here we are referring to the liability side, not the credit side)
8. Liquidity risk is not a single metric. It is an array of metrics, and a bank must calculate them all in order to obtain the most accurate picture of liquidity. This is especially true for multinational banks and/or banks with multiple business lines
9. The liquidity risk management framework is “owned” by the Board, i.e. the policy is centralised.