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

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.

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.

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.

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.