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Liquidity risk
The liquidity gap

The liquidity gap

Regulators are increasing their focus on liquidity risk in response to the financial crisis, but there
are questions about whether capital is an effective mitigant for liquidity risks and the nature of
the relationship between liquidity risk and bank solvency. Roy Choudhury, Peter Marshall and
Hovik Tumasyan look at the interdependencies between solvency and liquidity risk within a
bank’s risk management framework

Solvency and liquidity are the two core pillars of banking. Solvency
risks arise from the credit creation and
investment function in banking, as some obligors may default and some investments may
lose their value, resulting in unexpected losses. Liquidity risks arise from the maturity
transformation function in banking – specifically, banks borrow at a short duration from
depositors or markets, and lend at a long duration to borrowers or invest in illiquid securities.
In most banks, solvency and liquidity are managed as separate functions with minimal
consideration for interdependencies. Risk management is usually responsible for solvency,
mostly expressed in the language of the Basel framework, whereas treasury and asset-and-
liability management departments are responsible for funding and liquidity.
The banking industry has put considerable effort into shaping and implementing the new
capital adequacy rules for bank solvency over the past decade. The main goal has been to
determine a capital amount that would cover potential losses from all types of risk-taking to
ensure the solvency of individual banks and protect the financial system as a whole.
Underlying the solvency models that have been adopted internally by banks and regulators
is a well-established structural model of default, where the event of default is described as
the value of a bank’s assets falling below the book value of its liabilities.1 Insolvency, then,
can emerge from poor asset-purchase (lending) decisions made over a period of time that
cause earnings deterioration and erosion of capital, leading ultimately to default.
However, the financial crisis has highlighted the limitations of such a view of bank
solvency, and emphasised the inherent interdependencies between solvency and liquidity.
What started as a localised concern regarding credit quality in US subprime and non-
standard real estate asset classes rapidly escalated into a total loss of confidence in banking
sector assets, followed by a near-total collapse in liquidity in the interbank and asset-
backed securities markets. This loss of liquidity had a knock-on effect on the real economy
and rapidly gave way to a wider solvency crisis.
The problems began with increasing defaults in US subprime mortgages portfolios,
which resulted in uncertainties in the valuations of structured credit generally. Banks
reported significant mark-to-market losses for such exposures, which accelerated as it
became clear concerns over the quality of mortgage-backed assets were not limited to the
US subprime sector. Investors in turn became increasingly concerned about the structured
credit and residential mortgage assets underlying bank conduits or special-purpose
vehicles, making it difficult for these entities to raise funding by issuing asset-backed
commercial paper or asset-backed securities.
Against this backdrop, banks were forced to de-leverage by selling other assets to raise
liquidity, triggering a general decline in market prices and liquidity across most asset
classes. The slump in prices and uncertainty in valuations began to erode the capital bases
of banks, endangering their solvency – and the confidence required to restore liquidity to
key funding markets was rocked by weekly revelations of further bad news.
Many banks cut back on lending to preserve liquidity, starving credit to the real
economy and leading to increased defaults in the banking book. This led to more capital
It should be noted that not every default event forces insolvency. Equity holders have the option to distribute the assets of the bank to debt holders,
or to inject more capital and restructure the bank

Market risk is explicitly included in an institution’s risk

1 Integrated view for balance-sheet management appetite statement, so the funding mechanism needs to be
t=0 t=1 t=2 t=3 Risk integrated into the process of setting risk appetite for the bank as
Forward-looking balance sheet (3YR)
a whole. The institution also needs to define tolerance levels for
Interest rates, FX Unemployment


deposit ratio exposures originating from the funding mechanisms that are

Core Capital Banking Book Cash capital
(Including Retained

ratio commensurate with the risk appetite of the firm.

Credit risk
Liquidity risk
_ Survival time
horizon There are three basic channels through which liquidity risk
Long -Term IRRBB percolates into the risk appetite framework of a bank: liquidity
Equity markets

_ Core capital funding, market/asset price illiquidity, and the choice of funding

_ Tier 1 ratio mechanism and funding instruments.
Liquidity risk ICGR
Trading Book
Factors that generate the tolerance levels for the first two types
of liquidity risk are different in their nature, operational impact
Credit risk Earnings at
and the mitigation techniques used to keep exposures under
House prices

Short-term Liquidity risk risk (EaR)

Funding Cost-to- limits. For funding liquidity risk, tolerance levels can be set

Market risks _

Liquidity risk income ratio

Market risks _ Funding costs within the realm of contingency funding plans and the stress-
_ Impairments/
provisions test scenarios in place. These can then be used as mitigating tools
against situations when business-as-usual funding is disrupted.
The bank needs to estimate to what extent a loss of each type
erosion, with trillions of dollars wiped off banks’ capital bases. of funding can be absorbed before the lack of funding starts
Liquidity has started to flow only due to huge injections of threatening business strategy or pushes expected losses on
capital and cheap funding by central banks around the globe. earnings beyond tolerable limits. Accordingly, it must define
Clearly, capital and liquidity management together have failed. limits for each funding liquidity type in such a way that the loss
One of the main reasons for this failure is the silo-based of any single source of funding does not create an unacceptable
approach to balance-sheet management. Before the crisis – and risk to expected earnings.
even, in most cases, today – banks carved their balance sheet Two important dimensions should be considered when setting
into management silos and did not have an organically consist- tolerance levels for funding liquidity risks: the amount of time
ent and robust view of a forward-looking balance sheet in its the bank can afford to be in a contingency or stress mode with
entirety at board and senior management levels. Based on the respect to each particular type of funding source; and correla-
lessons of the recent crisis, this article analyses the interdepend- tion and contagion between conditions in which the different
encies between solvency and liquidity, and makes recommenda- funding sources will behave in the same undesirable ways.
tions for better management of such interdependencies in the One could argue that difficulties with funding sources can be
future. The interdependences are discussed within the context of mitigated by carrying an appropriate portfolio of liquid,
two management functions: the setting of risk appetite and unencumbered assets at all times. Unfortunately, the opportu-
integrated balance-sheet management and stress testing. nity costs of carrying such a portfolio are fairly high, which
limits the size of these portfolios. Moreover, the question of the
Integration of liquidity risk into the risk appetite quality of the assets in setting the liquidity value for unencum-
Banks with more advanced risk and capital management bered assets creates the tolerance levels for various types of assets
frameworks define a risk appetite for their operations as a whole, that can be included in the portfolio. Banks need to consider the
and are careful to include all the risks assumed in the course of risk factors specific to particular securities and the markets they
conducting their businesses. This risk appetite consequently are traded in, including the depth of the market (the size of a
provides guidance for setting up a limit framework for various transaction that would move price levels) and its liquidity (the
types of risks, such as credit, market and operational risk. size and volatility of the bid/offer spreads). These considerations
Inclusion of liquidity risk in the definition of risk appetite takes are usually overlaid with time-to-monetisation estimates for each
an intermediated form through its effect on profit and loss (by of the security classes in the portfolio of liquidity reserves.
identifying the highest acceptable costs for funding), and its impact Meanwhile, the third channel through which liquidity risk
on balance-sheet structure (by defining the size and composition of filters through into the risk appetite – the choice of the
the liquidity buffer a bank can afford to hold given the high funding mechanism and funding instruments – exposes banks
opportunity cost and negative carrying cost associated with liquid to various types of market risks. These should be consolidated
assets). The two together affect both tactical and strategic views on with the rest of the market risk exposures included in the risk
the acceptable methods of funding business growth. appetite of the bank.
For example, expected returns on new business can dictate the These three channels are the main routes via which liquidity
amount of low-earning liquid assets to be carried, which in turn risk tolerance enters a bank’s risk appetite framework. It seems
limits the maximum size of a negative liquidity gap the bank can obvious, then, that liquidity risk should be an endogenous and
afford to have in any of its short-term time buckets. The actual integral part of the balance-sheet and business management
mechanism chosen for funding the balance sheet will contribute strategy of a bank.
to market risk exposures (interest rates, foreign exchange rates and
so on) and may increase risk capital consumption, since capital is Integrated balance-sheet management and stress testing
allocated to these exposures regardless of how they are acquired. The financial crisis has highlighted shortcomings in governance
Hence, a dynamic process of assessing the types of assets being frameworks and organisational structures that can prevent the
originated and the size of the required liquidity buffer to support formation of a holistic view of the entire balance sheet. Due to
them is necessary. the exceptional nature of recent events, stress-testing approaches

Reprinted from Risk February 2010

to bank solvency have gained unprecedented popularity. When
performed correctly, stress tests can help reveal breakpoints in a 2 Stress-testing governance
bank’s business management and strategy. Unfortunately, these
stress tests are often designed as exercises in creating the highest Risk management Asset-liability
possible loss number. Stress tests also sometimes fail to capture committee (RMC) committee (ALCO)
interdependencies between structural elements of the balance
sheet and contagion across risk categories. Stress-testing steering committee
An integrated view of the multifaceted nature of a bank’s
solvency seems to be the missing ingredient. A deliberately built, Group economist
fit-for-purpose integrated stress-testing framework is necessary to
assess the vulnerability of the balance sheet and resilience of Group Group
Group risk
financial plans. The framework should be dynamic and forward- finance treasury
looking, with business growth plans, structural shifts in funding
profile and capital strategy factored in.
In an integrated stress-testing framework, the financial and
Credit risk Market risk ALM risks
business-planning assumptions are aligned to baseline macroeco-
nomic scenarios (the expected or forecast outlook) across
different entities, the hypothetical scenario definitions and a Business unit (BU) representative(s)
selection of macroeconomic factors based on the balance-sheet
structure and risk profile of the bank.
This kind of framework allows the assessment of stress
BU RMC BU finance BU risk
scenarios on the structure of the bank’s balance sheet, earnings
(profitability), capital base (solvency) and liquidity position.
Integrated stress-testing frameworks are built on two funda-
mental elements (in addition to the plethora of analytical and
business models): a data repository, and a meaningfully inte- terms of relevant risk drivers, macroeconomic modelling and
grated stress-testing governance framework. recommendations for ad hoc stress tests.
The data repository holds transaction and/or portfolio level The results of the integrated stress tests are presented to a
data by business unit, legal entity and currency, and contractual committee of the board with oversight on balance sheet, risk and
and behavioural cashflow data for all assets, liabilities and off- asset-and-liability management for the bank. Potential or observed
balance-sheet exposures. It has functional, fast interfaces with breaches of risk appetite are dealt with through a management
the risk parameter repositories (for example, probability of action plan (proactive) and contingency plan (reactive).
default, loss given default, exposure at default, term structures of
interest rates) and management accounting systems. Conclusion
The more advanced banks are in the process of enriching their The financial crisis has highlighted the importance of a
Basel II data models with cashflow, profitability, cost allocation, comprehensive risk management framework that integrates all
collateral and other relevant data dimensions to build an significant risk factors, including market, credit, liquidity and
integrated multi-dimensional online analytical processing cube operational risks. Part of this enhanced framework is the need
for stress testing and management information. for the stress-testing function to be robust enough to consider
The second fundamental element is a meaningfully aligned the dynamic interrelationship between liquidity and solvency,
governance framework for the stress-testing process. It usually earnings, balance-sheet structure and capital. It is imperative the
starts from the board-of-directors committee level. The group governance processes within the stress-testing function be
risk management committee is typically the main group adequately structured and maintain the capacity to address
responsible for managing all financial and non-financial risks, multifaceted decision-making.
including stress testing and scenario analysis. Alternatively, stress An integrated risk framework is needed for the board and senior
testing could be part of the agenda for a separate balance-sheet management to assess optimal levels of capital and liquidity
management committee. required to support the business plan, while adequately consider-
A steering committee should exist that is responsible for running ing the carrying cost of liquidity buffers and the high opportunity
the stress-testing function. Its membership should include cross- cost of liquid asset portfolios. As capital cannot mitigate liquidity
functional specialists from group risk, group finance, group asset- risk, the latter needs to be explicitly reflected in the bank’s risk
liability management, the chief economist and business units, and appetite statement, including its impact on other risk types.
should be responsible for presenting an annual stress-testing plan Such an analytical and comprehensive framework would also
and ad hoc stress-test assessments. It should engage with central help bank management better understand the options it has for
banks, regulators and peer groups to understand latest develop- responding to market stress, while simultaneously managing risk
ments, emerging new methodologies, and provide guidance in and return for the long-term benefit of shareholders. ■
planning and execution of the stress tests, including influencing
the choice of plausible scenarios by the front-line management, Roy Choudhury is a director, Peter Marshall is a principal and Hovik Tumasyan
interpretation of results and development of action plans. is a senior manager in the financial services office of Ernst & Young. The views
While sometimes overlooked, it is important the firm’s chief expressed herein are those of the authors and do not necessarily reflect the
economist actively participates in this steering committee and views of Ernst & Young. Email:, peter.marshall04@
helps co-ordinate scenario definitions and interpretations in,