The collapse of Northern Rock proves that profitability is no defence against liquidity risk: the company made profits in the quarter before it disappeared. Following a significant fall in market liquidity, Northern Rock was unable to meet its payment obligations.
Only a few voices raised liquidity risk issues until now and, even if the regulators did monitor banks’ liquidity management, they rarely raised serious challenges. During this financial crisis, risks tended to repeatedly transform from one type to another and companies face the challenge of placing greater emphasis on developing an integrated view of risk management across all types of risk.
The new economic perspectives bring significant challenges: while funding can still be found, it is only available for short periods and at high costs. Therefore, this is a good time for any company to perform a liquidity stress test such as the following 3 steps approach:
- 1) Identify liquidity risk drivers:
- erosion in value of liquid assets,
- additional collateral requirements,
- evaporation of funding,
- withdrawal of deposits (if the case);
- 2) Design stress scenarios (and probabilities):
- emerging markets crisis,
- systemic shock in main centres of business,
- market risk,
- operational risk,
- ratings downgrade,
- country / industry specific scenarios;
- 3) Model stress tests:
- quantify liquidity outflows in all scenarios for each risk driver,
- identify cash inflows to mitigate liquidity shortfalls identified,
- determine net liquidity position under each scenario.
Times of crisis are perfect opportunities to refocus on fundamentals: you can show that you truly understand your businesses and its potential risks with an integrated risk management perspective.