Macroeconomic headwinds due to high inflation, rising interest rates, supply chain disruptions, labor shortages, and diminished liquidity are all coming together to create what may feel like a perfect storm in the capital markets. The current volatility comes on the heels of the longest expansion in U.S. economic history. It is a warning to bank leadership that growth, acquisitions, and market share can no longer be their focus unless they effectively manage liquidity and understand how their banks perform under the worst possible scenarios.

Yet, all of us must recognize an important reality: We have been here before, and it is only a temporary situation.

Throughout the last century, history has demonstrated that economies are cyclical. Moreover, when a liquidity crisis has occurred and the economy has faltered, the following years witnessed both structural and regulatory transformation as the economy rebounded. But what history has also taught us is that, while a credit loan portfolio can take months or even years to deteriorate, liquidity can disappear in a matter of hours, resulting in insolvency.

All of which leaves a question: Is your liquidity management framework strong enough to ride out the storm?

What Is Liquidity Management?

Liquidity management is a bank’s ability to fund assets and meet financial obligations without incurring unacceptable financial costs. Given that lending is a bank’s core business, it is the role of the bank’s leadership to ensure sufficient funds are available to meet demands from both depositors and borrowers.

Changes in interest rate can disrupt the delicate balance between a banks’ funding and lending. An interest rate increase by central bankers ultimately means a higher return on a bank’s net interest income (NII) from lending, when that rate is an adjustable rate. Simultaneously, a bank’s depositors will seek a higher return on the money they effectively lend to the bank. Not meeting depositors’ demands can increase a bank’s risk of outflow to Treasury bonds, money market funds, or competitors.

To mitigate liquidity stresses, banks must have a program for the sound management of liquidity. Sound management requires banks to maintain sufficient levels of high-quality liquid assets (HQLA) as well as access to borrowing lines and other sources of funding to meet stress situations. When it comes to intraday liquidity management, the whole point is for banks to have the money when and where they need it, without excess, idle deposits sitting on their balance sheet.

The components of a sound liquidity management framework that should be at the forefront of a bank’s strategy are:

  • Information: That is, clear, transparent, and granular information on trade positions, payment obligations, cash, loans, and deposits when needed to permit bank leadership to make effective decisions. This requires comprehensive, strong governance, policies, procedures, and internal controls as well as risk measurement, liquidity monitoring, and reporting systems. Bank leadership needs to be able to evaluate the cash flow characteristics, structure, and stability of each major asset and liability to determine the impact on both operating and contingent liquidity. A comprehensive view of business lines, products, and services permits a bank to be liquidity-efficient and ensure the proper diversification of funding sources. This allows bank leadership to coordinate treasury, payments, and lending in a timely manner and maintain the proper cushion of high liquid assets at the bank.
  • Management: A focus on liquidity management encompasses well-defined objectives, cash forecasting (segmented by operating, strategic, and reserve), comprehensive contingency funding plans, active limit management, liquidity stress testing, and tools that support bank leadership by providing the correct information to ensure its survival in the event of a liquidity crisis.

A liquidity risk management framework should align to the bank’s organizational or line of business structure and include well-defined roles and responsibilities, process management, oversight committees, technology capabilities, and well-documented policies and procedures.

Oversight and Accountability

Financial institutions have made a considerable effort to strengthen liquidity risk management practices since the last financial crisis. Efforts have included developing internal liquidity stress testing models, improving crisis management and governance, and collecting and reporting the liquidity position both intraday and end of day. The corporate treasury function and asset liability committee now typically establish a bank’s liquidity risk appetite with input and support from the Chief Risk Officer (CRO) and second-line risk team. The treasury function and the bank’s asset liability committee bring a business orientation to the process as well as a risk ownership mindset to managing liquidity, while the CRO and second-line team provide guidance, assumption setting, independent monitoring, analytical support, and continuous, effective challenge.

Measuring Liquidity and Stress Testing

Over the past decade banks have recognized the complex interplay of liquidity with credit, counterparty, and market risk. In practice, large banks have to be concerned about both the business-driven and regulatory requirements for liquidity risk management. Liquidity stress testing provides the critical underpinning of a bank’s liquidity framework by ensuring an institution can meet financial obligations under stressed conditions.

Liquidity stress testing has enabled bank leadership to provide an integrated view for sizing contingent HQLA liquidity reserves, which protect banks against potential adverse markets and secondary effects, such as client and counterparty deposit outflow activity that might threaten the solvency of the institution under stressed conditions. In a bank the program owner should report liquidity risk metrics to executive leaders, the board, and key management so they understand reserve and buffer sizing, such as the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR), as well as short-, medium-, and long-term liquidity stress testing (LST) results.

Even the most sophisticated stress tests are only as good as the scenarios on which they are based. Constructing a good scenario involves the calibration of numerous assumptions, requiring forward-looking forecasts—not just historical experience—since the future could turn out to be entirely different from the past. Moreover, the assumptions must be built on bank events and outcomes relative to the products and services offered, instead of copying another bank or industry benchmarks. Assumptions should cover asset liquidation haircuts, deposit run-offs, potential usage of undrawn facilities, collateral flow, and more.

Liquidity buffers or reserves cost a bank money, since they must be invested in low-yielding, safe assets like U.S. Treasury bonds. The economic cost of holding these reserves must be charged back to the various lines of business and attributed to the business products and services that generate these contingent liquidity needs. Moreover, poorly designed internal transfer pricing frameworks may result in incorrect performance measurement and misaligned business incentives.

Lastly, leadership needs to focus on the system infrastructure required to support the multitude of tools and analytical assumptions. To produce, monitor, and govern liquidity requires a reporting process that is integrated and seamless—not just for regulatory reporting but for buffer/reserve sizing and limit monitoring—and that permits rapid alternative scenario analysis testing as market conditions change. Reporting should be at least daily, weekly, monthly, and in some cases, intraday. The system infrastructure must be supported by strong data governance, including data lakes, data dictionaries, process flow maps, and analytics that help bank leadership ensure that liquidity is deployed to add value and not to destroy value.

Leveraged Portfolios and Challenging Liquidity Markets

Banks now have to comply with multiple capital and liquidity ratios. It is critical that bank leadership look at the impact on their assets and liabilities in a holistic manner and develop a sustainable strategy. Each bank service and product is impacted differently due to its specific mix of assets (e.g., loans, repos, derivatives) and liabilities (e.g., wholesale funding, retail funding).

Leveraged portfolios present unique liquidity management issues, since their associated risk involves the likelihood of forced selling that would reallocate portfolio investments in unintended ways. The stakes can be high, including margins, collateral requirements, continuity of borrowing arrangements, and redemption patterns. The worst-case scenario for leveraged portfolios is forced liquidation of investments to meet cash demands at unfavorable prices.

Bank leadership needs to understand the impact of stressed situations on leveraged positions and portfolios. Types of information required to make timely and effective decisions include the related liquidity and price volatility (ability to exit the position and reduce leverage), the size of liquid portfolio assets available to meet stressed margin and/or collateral calls, and margin/collateral call dispute resolution and cure periods. Leveraged portfolio mitigation techniques for stressed markets include determining and maintaining unencumbered cash or high-quality liquid assets to meet margin/collateral calls, pricing transparency of the leveraged investments, and term bank loan financing.

Finding Solutions in a Challenging Liquidity Environment

Adopting a sound liquidity strategy takes on added importance in the current economic environment and interest rate landscape. An upside to the rising rate environment is that, while borrowing costs are higher, so are rates banks charge on interest-bearing liquidity solutions, like loans and leases. A liquidity management program that understands all the options as well as risk tolerance, can play a significant role in helping a bank’s lines of business manage and deploy cash more effectively. As banks continue to address the challenges of managing liquidity, we offer the following thoughts:

  • Focus on developing an understanding of the big picture and be mindful of the interconnectedness of the liquidity continuum across different types of financial products and services with different funding characteristics. Understanding this interconnectivity permits bank management to effectively design oversight, monitoring, risk assessments, and contingency response programs under both normal and adverse conditions.
  • Recognize that all parts of a bank are impacted by liquidity and that the bank’s framework must span liquidity strategy, liquidity risk appetite, liquidity limit setting, liquidity stress testing, liquidity monitoring with early warning indicators, contingency funding plans, and an overarching information technology infrastructure that can produce reports in a timely manner.

Treliant can work with you to develop strategies to manage issues related to market volatility, leverage positions, and liquidity management.


Frank Morisano

Frank Morisano, Senior Managing Director, is an internationally recognized executive with over 30 years of proven accomplishments: globally growing businesses, steering profitable growth in new markets, guiding product and service development, leading the acquisition, divestment and restructuring of companies, developing companies’ risk and financial crime abilities, and implementing environmental, social,…