This article was first published by The Risk Management Association Journal (RMA) in 2022. For more than 100 years, RMA has been laser focused on one thing: helping its members in the world's financial institutions better understand and address enterprise-wide risk through education, products, and community.

Key highlights from Oliver Wyman’s Global Survey

It’s no secret that banks have spent the last decade considerably strengthening risk management practices and infrastructure as a necessary response to the 2008 financial crisis. During this time, market leaders have made tremendous progress in enhancing methodologies, models and stress tests aimed at making their institutions more resilient and less prone to liquidity shocks. In response to significant industry interest and demand for greater insight into the range of practices prevalent in the industry, Oliver Wyman conducted a survey of Treasury functions across 40 large banking institutions globally, focused exclusively on liquidity risk management and charging practices.

The rapid onset of the Covid-19 pandemic, and the performance of the financial sector through it, illustrated the strength of the financial system and the improved risk management practices. At the same time, the Covid-19 shock reinforced concerns about the speed at which liquidity can deteriorate without government intervention and also highlighted weaknesses in the backward-looking nature of many risk management practices. Assumptions related to the behavior of some key risk drivers were challenged, while in other cases assumptions proved to be quite sound and served banks well. Perhaps most importantly, as conditions began to rapidly deteriorate prior to government intervention, there was a recognition and a need for more comprehensive real-time liquidity risk measurement, monitoring, and management capabilities.

The pandemic illustrated how differing practices, assumptions and risk appetites across firms could result in materially different outcomes on firms’ liquidity positions. In response to Board-level and senior management inquiries, as well as in response to post-mortems, leading firms have been attempting to assess how their capabilities and responses compared to their peers. Common questions being asked ranged from: “Are we aligned with our peers, or are they managing liquidity in a more sophisticated manner?” to “How conservative do our liquidity buffers need to be?” and “What will the next shock look like and have we appropriately identified and calibrated our risk drivers.”

Business-level attribution and charging for liquidity buffers has also come into sharper focus as liquidity buffers have become commonplace and grown significantly in size. Liquidity buffers are a drag on income as they are required to be invested in low yielding, high quality assets. Accordingly, the cost of maintaining contingent liquidity reserves should be charged to businesses driving the need for reserves and ultimately should factor into product pricing and comparison of fully- loaded returns across businesses. Our observation is that internal transfer pricing frameworks are in varying stages of development across the industry, with widely varying practices across firms, and many still relying on legacy approaches.

Revising charging mechanisms to reflect new economic realities can be a politically challenging undertaking at financial institutions, nevertheless, bank Treasurers and CFOs have a responsibility to their institutions and key role to play in advancing the state of art in this space.  

The Oliver Wyman 2021 Liquidity Risk Management Practices Survey

Oliver Wyman conducted a survey of Treasury functions across 40 large banking institutions globally focused on liquidity risk management and charging practices, one of the broadest and deepest surveys of its kind. The breadth of coverage included a wide range of banks of different sizes (ranging from $100 billion to $3 trillion in assets), geographies (including institutions headquartered in the Americas, Europe, Asia, Australia, and Africa), and business models (including both G-SIBs and domestic banking institutions). Survey responses generated a wealth of granular data against which participants were able to benchmark their practices on an anonymous basis against their peer group.

Oliver Wyman’s Liquidity Risk Management Practices survey provided comprehensive coverage across the following topics:

• Liquidity risk management. Top-of-house liquidity risk management practices including target setting and limits (~25 questions)
• Stress testing methodology and parameters. Specific methodologies, assumptions, and range of parameters used within internal liquidity stress testing (~30 questions)
• Funding and liquidity charging. Methodology and approaches used to calculate Funds Transfer Pricing (FTP) contingent liquidity charges (~15 questions)
• Markets business-specific FTP considerations. Specific methodology considerations for capital markets or trading businesses (~10 questions)
  
• Data/processes/governance. Incorporation of internal liquidity stress testing results in bank-wide processes, e.g., FTP, capital planning. As well as supplemental processes, e.g., reporting (~10 questions)

What follows are key highlights from our survey. We take a look at some of today’s key challenges faced by liquidity managers, identify key Treasury and Liquidity themes that strongly resonated across the response pool, and highlight the range of practices observed across the survey participant groups. Below is an excerpt, and the full RMA Journal article can be found here.

Today's liquidity challenges

Financial institutions have spent more than a decade strengthening liquidity risk management practices. Efforts have spanned the development of internal liquidity stress testing models, improving crisis governance, and the collection and reporting of liquidity data, amongst other activities. Stress testing exercises, in particular, have increased the rigor around the sizing of contingent liquidity reserves, which serve as protection against potential adverse markets, client and counterparty activity that might otherwise threaten the solvency of the institution under stressed conditions. Liquidity risk at individual institutions as well as systemic risk as a result of these efforts have been considerably lowered.  

Where are we now

After more than a decade spent implementing crisis era liquidity risk management regulation, banks have made progress and put significant effort into building up models and methodologies. Infrastructure is now largely in place with mature practices at the vast majority of institutions surveyed. However, mature practices have been built up organically over years, through rounds of iteration. As a result, we observe mature practices to be highly functional, but not necessarily the most efficient nor necessarily robust to change.

Based on responses from our survey, firms utilize a wide variety of approaches in both overall liquidity risk management and liquidity charging. As there is no one perfect approach for liquidity management and charging, the banks that have an advantage are the ones who have defined an approach tailored to their specific needs. The approaches selected should appropriately balance:

• Accuracy in reflection of economic costs
• Alignment with regulatory requirements
• Transparency/ease of communication
• Granularity
• Data availability and automation potential
• Operational impact
• Alignment with business incentives
• Organizational culture

Our survey highlights a number of key design decisions that each bank must make around liquidity risk management (see PDF page 4). For each design element, banks should comprehensively evaluate the pros and cons of the available options and select the one(s) that best align with the firm’s strategic goals. In concert with designing the bank’s liquidity risk framework and determining the appropriate buffers to hold, our survey also highlights a set of key design decisions around attribution and charging of the buffer (See Table 2 in the PDF).

How are peer institutions managing liquidity?

Our survey provided participants with granular detail and observations into peer activities. What follows is a high-level summary of our peer findings. We found that peer institutions continue to revise and review both their stress testing methodologies and funds transfer pricing (FTP) liquidity charging methodologies, particularly in response to recent stresses from Covid-19 (see Chart 1 below).

Our survey also highlights that firms have developed a range of approaches to calibrate liquidity needs, fit for each bank’s business mix and risk profile (see Chart 2 in the PDF).

As with liquidity framework decisions, our survey also highlights that firms employ a range of practices for liquidity charging, which is an important mechanism for creating appropriate mechanisms for incentivizing appropriate liquidity risk management within the business units and for being able to assess the liquidity-risk adjusted returns across businesses (See Chart 3 below).

With limited attractive lending opportunities and increases in corporate and retail cash reserves driven by fiscal stimulus, many banks have found themselves with excess deposits, which creates a unique challenge for FTP methodologies, which typically credit businesses for deposit gathering. We observed that many institutions are assessing the behavioral characteristics of the deposit base, and are re-examining their FTP methodologies to try to create incentives that are better aligned with the current post-COVID reality. We found that Finance and Treasury teams continue to take on more active roles in managing and ensuring the optimal usage of liquidity buffers and reserves (See Chart 4 below).

Where do we need to go?

Areas of focus and opportunities for Treasury leaders

There is a real economic cost to the enterprise if liquidity buffers are not optimized effectively. It’s a delicate balancing act, and many firms are struggling with how to create a methodology that is both transparent to the businesses (and therefore creates incentives that can be actioned upon) and also sufficiently nuanced and granular to take into account drivers of contingent liquidity needs. Some liquidity stress test assumptions may be too conservative, especially if there is a lack of data or difficulty in analyzing data. Firms need to set up a framework that optimizes the economics across the organization. Getting the allocation right and creating the links back to business activities is important to incentivize profitable activity that generates the least amount of liquidity risk to the organization. With infrastructure in place and mostly stable, now is a good time for leaders to re-examine liquidity risk management practices, with a more critical and business-oriented lens.

There are three areas we believe Treasury leaders need focus on going forward:

First, re-assessing liquidity stress testing model assumptions needs to be a priority, in light of recent market stresses (e.g., Covid-19 shocks) and in light of greater consensus around the appropriate conservativeness of assumptions that go into stress testing models. Many banks have incorporated Covid-19 stress information into their liquidity stress testing calibrations — but for those that have not, now is a good time to re-examine how assumptions fared and whether any recalibration is warranted.

Second, many banks need to upgrade their Funds Transfer Pricing frameworks to incorporate appropriate fully loaded charges for liquidity usage and provide granularity to business units on the drivers of such charges. Banks that must comply with NSFR should also incorporate this measure into their frameworks, where it is binding. Greater transparency would help provide the appropriate incentives for businesses to better self-manage activities that drive liquidity usage and charges they incur.

And third, firms need to reassess the overall efficiency, speed and nimbleness of their analytical and reporting capabilities to produce, monitor and govern results. This includes examining the extent to which data feeds and calculations are automated to the extent practical and ensuring that liquidity risk MIS can be appropriately produced in a timely manner for use, not only for regulatory reporting, buffer sizing, and limit monitoring — but also to more rapidly analyze and assess liquidity risks and alternative scenarios in a fast-moving crisis. Firms should also examine more real-time monitoring tools, including capabilities for intraday liquidity risk monitoring and management — beyond many of the capabilities which exist today which are largely backward looking and rigid in their construction.

Conclusion

Liquidity risk management practices have come a very long way since the 2008 financial crisis and the financial system is substantially safer as a result of the considerable investments the industry has made to improve practices.

Nevertheless, there are still several areas of improvement that Treasurers and CFOs can make to further refine and evolve their practices — and importantly do so in a manner that improves enterprise economics while remaining aligned with peer practices and regulatory expectations.