Before the global crisis of 2008, financial institutions of all shapes and sizes took borrowed funds for granted, with virtually no cash outlay. During the deep recession, many institutions unsuccessfully fought to maintain liquidity risk at an adequate level, which led to the bankruptcy of many second-tier banks. Central banks were forced to conduct foreign exchange interventions to keep the economy afloat.
Banking risks
As the dust from the walls of the collapsed banks began to settle, it became clear that banks and capital market companies needed better liquidity management. And the instinct of self-preservation is not the only motive for this. The consequences of inadequate risk management can go far beyond the walls of any financial institution. They can affect the entire financial ecosystem of the country and even the global economy.
Liquidity risk is the inability of a bank to fulfill its obligations to customers and counterparties due to a lack of funds in correspondent accounts. Having spent many years in the shadows, this problem suddenly became a hot topic in risk management, having established itself as a killer during the financial crisis.
Regulators' efforts to control banks
The consequences of most disasters usually include many measures to avoid or minimize the damage from any future similar disasters. When an earthquake destroys entire cities, countries invest in improving early warning systems. Major floods in the Netherlands in 1953 led to the construction of a complex infrastructure in the country to prevent natural disasters. The Enron scandal led the United States to introduce Sarbanes-Oxley legislation.
The global financial crisis of 2008-2009 no different. Regulators have enacted a wide variety of laws, from Dodd-Francs and European Market Infrastructure Regulation (EMIR) to Basel III, with the goal of preventing future financial crises caused by liquidity risks.
Crisis Prevention
As part of the Basel III reforms, regulators have developed new rules for banks to monitor and manage their risks, which can be roughly defined as a threat of running out of cash. The Basel Committee on Banking Supervision has introduced minimum limits for two key parameters used to assess liquidity risk. Financial institutions around the world should maintain these ratios at the required level. Such restrictions can have a significant impact on their customers.
Ratios for controlling the level of risks of financial organizations
The first parameter is the liquidity coverage ratio (LCR), which is designed to improve the coverage of banks' short-term liquidity. LCR is calculated as the sum of the bank’s high-quality liquid assets divided by the expected cash outflow, including unused loan commitments, within 30 days.
Regulators want to calm down that in the event of an unexpected decrease in cash, the bank will have enough assets that it can easily convert into cash to survive a stressful situation and prevent the development of a worse scenario, including bankruptcy.
The second measure is monitoring the Net Stable Financing Ratio (NSFR), which is designed to increase stable long-term balance financing to avoid the risk of a cash shortage for meeting obligations.
This ratio was formulated in order to encourage and stimulate banks to use stable sources to finance their activities and reduce their dependence on short-term refinancing. In this way, the liquidity risks of bank capital are minimized.
The rapid disappearance of this type of borrowed funds during the crisis was the main reason for the failure of several large institutions, including the Leman Brothers Bank. In accordance with these financial institutions, it will be necessary to ensure that their amount of stable financing exceeds the required amount of payments to customers within 12 months.
The impact of regulatory measures on the business community
One of the unintended consequences of the new banking regulation was that future liquidity risks began to spread outside the banks and cause serious damage to the corporate sector. Corporations should begin to seriously think about their own liquidity risk position and how they can survive in the face of a future crisis.
The most obvious connection between banks and corporations is the fact that corporations are heavily dependent on banks for their financial needs. Tighter requirements for managing liquidity risks in the financial sector will undoubtedly affect corporate lending.
The threat of a deeper crisis?
The effect in the future will be much worse, because the new Basel III rules that are introduced for banks will push liquidity risk management issues into the corporate sector. These rules make it difficult for banks to fulfill their traditional role of extending loan repayment periods. Corporations are forced to fight for funding from banks.
Lack of access to bank lending limits the ability of corporations to plan business processes in advance. In these conditions, they are highly dependent on banks that choose to reduce short-term credit lines at the first sign of trouble.
Derivative Trading Changes
Even worse, the new clearing rules, which aim to migrate derivatives transactions towards centrally cleared platforms, will force corporations to place daily margins against their derivatives positions. This will cause massive daily fluctuations in corporate liquidity resources. Taken together, these two effects point to a world where a corporation has much less control over its own cash flow resources, with demand for liquidity growing and a supply decreasing.
Corporate Liquidity Risk Management
Banks that have survived the recent financial crisis have been forced to modernize their practice of managing possible cash shortages in order to better prepare for future liquidity crises. One tactic is to squeeze out most of the potential threats from banking to the corporate sector. As a result, the current crisis raises its head in the corporate sector. Corporations should actively implement risk management systems if they do not want to be the next victim.
Corporate Liquidity Risks
Liquidity risk is the likelihood that an entity will not be able to obtain the necessary funds to meet short-term or medium-term obligations to creditors. In many cases, capital is concentrated in long-term assets that are difficult to convert into cash at fair value if current bills are required to be paid.
A small short-term crisis associated with a shortage of working capital can lead to long-term negative effects on the business. Failure to obtain adequate financing in a realistic time frame may expose a firm to liquidity risk.
For securities, this risk arises when a firm, experiencing immediate cash needs, cannot sell assets at market value due to a lack of buyers or due to an inefficient market.
The crisis of 2008-2009 was caused by defaults on mortgage-backed securities, that is, the classic problem of credit risk, but the speed of the crisis spreading over the entire financial system can only be explained by the close relationship between credit risk and liquidity risk.
A consulting firm with several portfolio deals to support corporate business relies on timely payments by customers to meet cash requirements. Termination of the contract by a large client leads to a sudden decrease in cash flows. The company begins to delay payroll due to liquidity risk. This leads to fines on the part of supervisory authorities, a serious decline in reputation and the dismissal of the most valuable employees who are attracted by competitors.
From a thriving company, the company is rapidly moving to outsiders. A vivid example of how short-term failure to fulfill obligations leads to long-term negative consequences for the business.