Gaining a Competitive Advantage Through Advanced Liquidity Risk ...

insight Gaining a Competitive Advantage
Through Advanced Liquidity Risk
Management
“An ounce of prevention is worth a pound of cure.”
– Benjamin Franklin
By Amit Desai and Matthew Peterson
At the time of writing, the S&P Global Financial Sector Index Fund had
declined over 75%, from $94 (£68) per share to under $20 (£14.50) per
share. The market capitalisation losses from declines in the top five
largest investment banks reported by Fitch Ratings Co. amounted to
losses of $290 bil ion or 81%, with entire bankruptcies due to insolvencies.
Financial services firms will spend several years winding down their
risky positions and deleveraging assets to improve their financial health.
Given the prominent role of liquidity management in the events that
have unfolded since 2008, a new day has dawned. As one executive
from a global investment bank told us, “The pendulum has swung the
other way. The U.S. Treasury Department now controls the business,
and liquidity risk management is driving executive decision-making.”

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Regulators are responding to disruptive
Third, organisations lacked the multi-
Executive Summary
economic conditions and financial institutions disciplinary skil s to perform the required
face a reoriented regulatory landscape with
technology and process work.
implications rival ing the Glass-Steagall
Act of 1933, the Sarbanes-Oxley Act of
We also found that complying with
2000, and the Basel II Accord of 2004. The
regulations on a piecemeal basis did
Financial Services Authority (FSA) has made
not save much money. Surprisingly firms
its intentions clear. In its December 2008
that saw Basel II as an opportunity
publication titled, “Strengthening Liquidity
to comprehensively strengthen risk
Standards,” the FSA cal s for action with an
management spent roughly the same on
implementation deadline of October 2009.
compliance, but had a much more robust
The FSA explicitly states: “Our proposals are
risk management and regulatory response
far-reaching and robust; many institutions
mechanism when they were done.
will need to significantly reshape their
We believe that the current liquidity crisis
business model over the next few years as
provides organisational motivation to avoid
a result.” While the deadline may shift, one
the mistakes of the past by creating the
thing is clear: firms wil be further scrutinised
right information platform, organisational
on their systems and controls, stress-testing
responsibilities, and firm-wide capabilities.
methodologies, contingency funding plans,
In this situation, firms can invest money
and the measurement and management of
they have to spend anyway, but in a way
liquidity across legal entities, currencies, and
that creates more lasting value. Our view
business lines.
is that clear advantages will be derived
Because tremendous uncertainty lies ahead,
from focusing on four key operational and
we believe firms wil fal into one of two
technology areas:
groups: those that simply maintain their
• Assign accountability and take control;
footing by implementing the bare minimum
FSA, U.S.Federal Reserve, and SEC liquidity
• Perform insightful stress testing;
risk management requirements, and those
• Develop robust contingency plans; and
more strategic-minded firms that turn
regulatory compliance into an opportunity to
• Become “operational y fit.”
secure a substantial competitive advantage.
The complexity of modern products and
While no financial services firm wants to
financial systems suggests that similar
relive the chal enges of Basel I compliance,
crises are inevitable and preparation is
a look back at the lessons learned can be
essential. While some firms struggle for
instructive in facing this latest situation.
existence in future financial disorder,
When Diamond helped instal Basel II
those that have been proactive will gain
controls at a wide range of global financial
a competitive advantage and benefit
institutions, we typically found three
from wider access to cheaper funding
For more information contact:
key elements missing. First, the firm’s
pools, increases in credit ratings, and
information platform did not al ow for
reputational rewards.
Stephen Warrington
cross-silo risk assessment. Second, no
Managing Partner, U.K. Practice
single individual had firm-wide responsibility
T (44) 20 7959 7700
stephen.warrington@diamondconsultants.com
for risk management.
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Four core technology and operational
(e.g., asset and liability duration) and
Liquidity Risk
improvements are essential to managing
careful y examine a variety of leading
Management Imperatives
liquidity risk effectively. While each
indicators (e.g., liquidity gap). One possibility
initiative offers benefits in its own right,
is to consider managing liquidity risk in a
a comprehensive approach will yield the
manner similar to financial statements,
greatest competitive advantage.
where there is a balance sheet view
of liquidity, a cash flow statement,
Assign Accountability and
and a receivables/future global core
Take Control
excess statement. The first provides
Challenge
a comprehensive view of current cash
Many financial institutions have struggled
positions. The second provides a view of
to deploy an effective governance structure
all cash and security movements. The third
around liquidity risk management. Currently,
provides a forward-looking view of what
banks’ decisions are often based on poor
the global core excess could be based
underlying data fed into liquidity ratios and
on stock settlements or normal patterns
performance indicators that fail to tell the
of client withdrawals.
whole story. The lack of accountability and
Perform Insightful Stress Testing
control has driven many firms to restructure
and others into bankruptcy.
Challenge
Liquidity stress tests provide information on
Resolution
the potential behaviour of a firm’s liquidity
Ownership of a firm’s liquidity risk metrics
position in a crisis and they al ow the firm
should be assigned to a single individual who
to plan and maintain a funding mix that is
is ultimately responsible for the company’s
best suited for its business strategy and
overal liquidity risk position. This liquidity
liquidity needs. Regrettably, many firms suffer
risk officer ensures the firm’s liquidity risk is
from insufficient stress testing. A variety of
transparent throughout the organisation and
factors are to blame. Often, it is the result
that other risk officers (market, credit, and
of using poor-quality data during stress
operational) and business heads are made
testing. Companies avoid stress tests around
aware of potential liquidity threats. Ultimately,
extremes in scope, severity, and duration.
the liquidity officer’s powers should include
Contingent exposures are not properly
authority to set risk limits and instruct the
accounted for. Risk factors are not granular
business to cut positions that expose the firm
enough to undergo worthwhile stress tests.
to unacceptable levels of risk.
And finally, some management teams simply
But while successful liquidity risk management have too much confidence in results of the
starts at the top of an organisation, its roots
stress tests themselves.
are in quality data. If the firm’s leaders are
The FSA’s recent publication around liquidity
required to make business decisions with
standards specifically states that firms must
liquidity impact, the relevant liquidity risk
“improve systems and controls for managing
metrics must be clearly defined, understood,
liquidity risk, making greater use of stress
and agreed upon before the event occurs.
testing and improvements to contingency
Key performance indicators must extend
funding plans.”
beyond commonly used liquidity ratios
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We believe that if firms go beyond the
concurrent impacts are needed to capture
Firms also need to calculate the complete cost
measures required by regulation and ensure
worst-case scenario losses.
of external funding, including the potential risk
a more complete system and understand
to the firm’s reputation. Banks should prioritise
its failures, they wil ultimately outlast
Final y, while stress testing can enable a
options regarding their access to external
competitors that have weaker approaches.
business to better understand firm- and
liquidity, as certain options must only be
industry-specific risks, it can create a false
considered a last resort. As demonstrated by
Resolution
sense of security. First, it is not possible
several premier global banks, public solicitation
Firms lacking proper liquidity testing tools
to cover al eventualities. Second, even
for government capital or intervention can
should first take advantage of their existing
the scenarios covered are only as good as
have negative impacts on a firm’s reputation,
market-risk stress testing capabilities in order the models and data used. The firm should
sparking a fear of col apse that can quickly
to establish initial liquidity risk tests.
stil be prepared for the unexpected and
reduce access to funds.
unidentifiable.
Additionally, variables to be tested should
Access to cash is the ultimate contingency
cover al metrics required by the liquidity
Develop Robust Contingency Plans
plan and its availability must be model ed
risk officer, including but not limited to time
and understood. The prepared firm wil utilise
to cash, global core excess, and maximum
Challenge
funding sources through internal accounts,
liquidity outflow. Furthermore, firms must
Ineffective risk mitigation contingency plans
treasury assets, cross-border liquidity pools,
model daily, monthly, and yearly excess
have added to the poor liquidity management
external lines of diversified credit, asset
liquidity as a means of understanding
at many firms. Amid the financial crisis,
liquidation, and liquidity insurance.
the percentage pick-up or drain to the firms have found it difficult to maintain the
global core excess.
counterparty relationships established prior
to any turbulence, reducing their access
Become “Operationally Fit”
Stress tests should be made more
to expected funding sources. Additional y,
comprehensive by including a larger scope
some financial institutions do not ful y
Challenge
of events, increasing their severity, and
appreciate the repercussions of accessing
When operational processes around liquidity
extending their duration. Tests must also
emergency capital pools. In fact, raising
management do exist, a more fundamental
examine significant changes to variables
extra liquidity through these means can
problem is often seen—information and data
beyond historical observations. After a stress
be counterproductive and damage a firm’s
to assess liquidity risk is limited or simply
test has been designed, try “breaking the
reputation. This exact scenario occurred in
unavailable at senior levels.
model” to disprove quantitative methods
2007 at a prominent U.K. bank. Turning to the
through qualitative reasoning. A review
Bank of England for liquidity put fear into the
In some cases, this problem is caused by the
of the inputs and models and chal enging
bank’s lenders at the time. As the short-term
use of inadequate legacy systems for pricing,
conventional firm wisdom wil increase the
money markets seized up for the bank, the
model ing, and testing; in others, it is a lack
model’s robustness as wel as the degree of
result was a forced nationalisation.
of transparency combined with ineffective
confidence in its accuracy. Each stress test
operational processes. The new FSA liquidity
should be run as frequently as intraday and
Resolution
reporting rules chal enge firms to provide
projected years into the future, focusing on
A firm’s liquidity risk officer should ensure that
transaction-level data containing contractual
the average and the maximum potential loss.
each liquidity stress test is accompanied by a
flows with no behavioural adjustments, “T+0”
robust contingency plan. Where plans exist, a
or potential y “T+1” reporting on a weekly basis
Just as real-life events do not occur in
thorough review is required to evaluate their
(which under Basel I proved to be a chal enge
isolation, firms must examine the effects
effectiveness in resolving funding shortfal s.
even on a monthly basis), by business, legal
of correlation on exposures. The tight
Recent events have demonstrated how
entity, and currency. The latter, in particular,
coupling of financial systems and integrated
rapidly a crisis can develop, making a tested
can compound the operational chal enge, as
dependencies between counterparties
and pre-approved checklist-style approach
currency data is often lost early in the process
increase the probability of a domino effect in
to liquidity risk mitigation a vital asset when as data is aggregated.
impacts. Therefore, simulations that model
chaos takes hold.
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Liquidity Management Framework
Diversified
Funding Pools
Match
Funding
External Funding
Sources
Contingent Funding
Bankruptcy
Programmes
Planned Sale of
Business Units
Government
Proactive,

Support
Fire Sale of
Inexpensive
Assets
Governance
Regulation
Reactive,
Expensive
Stress
Contingency
Testing
Planning
Operations & Technology
Source: Diamond Management & Technology Consultants
It is important to note that the use of outdated
Resolution
• Creating a liquidity data model; and
or ineffective technologies is not only a
Effective liquidity risk managers wil operate
hindrance to risk mitigation—it can often
• Working with the Operations and IT
far differently in the future. They wil rely on
amplify the threats themselves. Consider a
departments to ensure the requisite
granular scenario analysis to thoroughly vet
common scenario on Wal Street in which a
data is available with required
processes and contingency plans against future
firm is assessing its solvency with lagging
frequency and granularity.
crises. They wil hold credit and market risk
or irreconcilable data between two legacy
teams accountable for more transparency in
The model development process should
systems with undetected breaks.
providing information that wil be factored into
include understanding of the diverse
liquidity risk positions.
Not only is there the potential to underestimate
flows for funding vehicles (e.g., repos,
the company’s exposure, but management
OTC derivatives) through documenting the
Furthermore, they wil demand that the
may become overconfident about their model
end-to-end process for each product from
Operations and IT departments deliver al the
and lend when the firm should be borrowing.
origination through to the central funding
data necessary to drive a reliable liquidity
Similarly, ineffective operational processes
desk. Making this information readily
data model. In our experience, making
often force management decisions that are
available will help firms drive “liquidity
liquidity information readily available requires
reactive in nature rather than being proactive,
efficiency” by understanding which product
three core capabilities:
increasing costs and the potential for failure.
flows could potential y cause liquidity drains,
• Mapping each metric required by senior
and then re-engineering those flows.
executives and its relevant data attributes
to their corresponding source system;
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Conclusion
Firms that act early and aggressively to gain
While that effort requires time and
a competitive advantage through advanced
investment, it can be done cost-effectively
liquidity risk management will benefit
and can contribute to both more stable and
substantially through larger and cheaper
higher earnings. Proper preparation will
pools of external liquidity, increased credit
decrease the probability of earnings shocks
ratings, and reputational stature. Each of
through liquidation of positions, portfolios,
these factors will have a positive effect on
or entire business units. Over time, firms that
the long-term profitability of the firm.
take this proactive responsibility wil see
their credit ratings rise, putting downward
A consistent effort to proactively manage
pressure on their overal cost of capital and
liquidity risk requires focusing on four key
increasing their profitability.
operational and technology areas:
Finally, the higher credit ratings, lower
• Accountability and control;
cost of capital, and higher, more stable
• Insightful stress testing;
earnings will increase a firm’s reputation,
attracting clients and investors alike. During
• Robust contingency plans; and
market turmoil there is a flight to safety
• Operational fitness.
and the best-in-class organisation becomes
extremely attractive. Investors and, analysts
will recognise this and, as competitors
struggle, the wel -managed firm will thrive.
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About Diamond
Diamond (NASDAQ: DTPI) is a management and technology consulting firm. Recognising that
information and technology shape market dynamics, Diamond’s smal teams of experts work
across functional and organisational boundaries to improve growth and profitability. Since the
greatest value in a strategy, and its highest risk, resides in its implementation, Diamond also
provides proven execution capabilities. We deliver three critical elements to every project: fact-
based objectivity, spirited col aboration, and sustainable results.
To learn more visit www.diamondconsultants.com
About the Authors
Amit Desai, a Senior Manager in Diamond’s U.K. practice, advises global capital markets clients
on strategy, business-driven regulatory change, and post-merger integration transformation.
His work on various regulatory initiatives, across al areas of risk, has helped commercial and
investment banks understand business impact and realise opportunities for growth.
Matthew Peterson is a Senior Associate in Diamond’s U.K. practice and holds a CFA
designation. He has financial services consulting experience on Wall Street and in London
advising global capital market clients on business strategy, operational analysis, and managing
complex programmes across credit, market, and operational risk management teams.
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