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Recent bank failures have demonstrated the importance of effective liquidity risk management to maintaining institutional viability. Many non-bank financial institutions (NBFIs or “nonbanks”) do not have the same liquidity risk drivers as banks – such as the potential for a severe deposit runoff. However, nonbanks face their own inherent liquidity risks and have a high degree of interconnectedness with banks. How should these firms respond to the current environment of elevated financial risk, stress in the banking industry and growing recessionary concerns? The answer lies within the effectiveness of their liquidity risk management practices.
NBFIs comprise a wide array of financial service providers such as private credit funds, consumer financing companies, leveraged loan funds, money market funds, and “fintechs” (to name a few). These firms provide services traditionally performed by banks such as provisioning of credit and financial intermediation. While the specific types of NBFIs differ greatly from one another, some NBFIs will see recent bank turmoil as an opportunity for asset growth. Asset growth requires funding, and bank funding to NBFIs may become constrained (or at least more costly) in a sustained environment of high interest rates and economic uncertainty. More expensive funding may be uneconomical and firms may even be unable to access once reliable funding sources. Such an abrupt loss of funding could create liquidity gaps and, at a minimum, disrupt business activity, or worse - lead to shortfalls wherein a firm cannot meet its cash obligations.
Policy makers have long-debated whether NBFIs need more stringent regulation similar to the regulation applied to banks, and that debate will probably become more pronounced if financial conditions worsen. However, even in the absence of prescriptive requirements, NBFIs should recognize that effective liquidity risk management is a strategic capability that facilitates stability, longevity, and growth. NBFIs should analyze the liquidity risk management practices commonly used by the banking industry and adopt a streamlined version that is tailored for the unique liquidity risk exposures of their business.
Understanding the unique risks of NBFIs
Financial service providers outside the traditional banking system employ a wide range of business models, resulting in a wide range of potential liquidity risks, for example:
Business Model |
Potential Liquidity Risk Drivers |
Private credit funds |
|
Consumer credit financing and “fintechs” |
|
Money market fund |
|
Digital asset exchanges |
|
What liquidity risk management practices could NBFIs adopt?
Most NBFIs have some form of liquidity risk management practices in place today, although the level of maturity of these practices varies. NBFIs should consider the six-point framework described below to test the comprehensiveness of their current practices and identify opportunities to strengthen capabilities for identifying, measuring, monitoring and controlling liquidity risk.
- 1. Liquidity Risk Identification
- 2. Liquidity Risk Appetite
- 3. Liquidity Risk Measurement and Reporting
- 4. Liquidity Risk Mitigation
- 5. Liquidity Risk Data and Systems
- 6. Liquidity Risk Talent and Governance
1. Liquidity Risk Identification
Risk identification is the process of identifying and understanding the distinct risks facing the firm. This process is important because firms that are not aware of the scope and nature of their risks may allow less visible issues to grow unchecked. Incorporating an exhaustive list of liquidity risk drivers is an important first step in establishing processes for risk measurement, monitoring and mitigation. A large confluence of seemingly “small” liquidity risk drivers can lead to a material liquidity risk.
2. Liquidity Risk Appetite
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.
3. Liquidity Risk Measurement and Reporting
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.
4. Liquidity Risk Mitigation
Mitigating or managing liquidity risk requires firms to set guardrails and protocols, such as limits which mandate how much liquidity must be held to withstand stress. Though many nonbanks are not required by regulators to hold a liquidity buffer, they would do well to implement one as well as create a contingency funding plan that outlines how management will identify escalating levels of stress and take the requisite actions to navigate the firm during periods of elevated risk. This set of protocols (and the routine testing of them) will flag circumstances where senior management and the board should raise additional liquidity or, conversely, may enable management to be opportunistic during times of market dislocations. Robust stress testing, buffers and contingency funding planning, coupled with a diversification of funding across short-, medium-, and long-term borrowings and instrument types, enables firms to form a pre-planned response to stressed conditions instead of having to react in the moment by reducing business activity or raising new funding on punitive terms.
5. Liquidity Risk Data and Systems
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.
6. Liquidity Risk Talent and Governance
Talent underpins a firm’s capability to effectively manage liquidity risk both in terms of governance and oversight, as well as execution. Boards and senior management need to have the requisite background and experiences to understand specific risk drivers, risk management methodologies and frameworks and ongoing changes in the risk profile. In particular, firms outside the traditional banking system tend to operate lean financial risk management teams which could translate into a lack of risk management resources. Boards are responsible for overseeing how management acquires and maintains a deep bench of talented risk management professionals. The business case for hiring risk talent, including data and technology professionals responsible for liquidity risk systems, should be directly linked to the financial viability of the firm.
Taking a closer look: how to use an inventory of liquidity risk drivers to design a robust liquidity stress testing process
One of the key reasons to create a comprehensive inventory of unique liquidity risk drivers is to ensure that liquidity stress tests are comprehensive. Each liquidity risk driver may behave differently depending on specific idiosyncratic or marketwide events. Understanding the nuances in how specific drivers will react to events such as negative news or a broader funding market disruption is critical in order to define plausible scenarios. Similarly, “triggers” that are meant to alert management to a particular stress event and resulting mitigating actions available to management should be specific to the scenario. Management’s ability to monetize liquid assets, raise new sources of funds, or curtail business activity will be highly dependent on the specific nature of the liquidity event. The figure below illustrates an example process flow for linking liquidity risk drivers to liquidity stress scenarios, triggers and mitigating actions.
What can NBFIs do now?
- 1. Build a business case and avoid waiting for regulatory clarity
- 2. Start small and use unique strengths
- 3. Extend liquidity risk practices to other risk stripes
1. Build a business case and avoid waiting for regulatory clarity
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?
2. Start small and use unique strengths
Further, NBFIs can use their unique strengths. They often have access to strong technology talent, particularly for model development. NBFIs also do not typically have the technology debt burdens of their bank peers, meaning the architecture is much more streamlined and conducive to building liquidity risk systems. They should use this advantage to build nimble risk measurement systems.
3. Extend liquidity risk practices to other risk stripes
Liquidity risk is just one of the risks faced by NBFIs that may be increasing due to stress in the banking system. Firms should consider applying the risk management framework described in this paper to other important financial risk areas including credit, interest rate, and price volatility risks. While it remains to be seen what lies ahead as central banks continue to fight inflation and the financial system deals with a potential contraction in credit and liquidity, we believe firms need to be critically evaluate and strengthen risk management capabilities to remain viable and take advantage of business opportunities in the market.
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