Liquidity is defined as the debtor’s ability to meet their maturing obligations or the ability of an asset to be converted into cash at market price. Liquidity risk consists of a lack of liquidity to meet maturing obligations (the reverse situation, i.e. when liquid assets are in disproportionate surplus, is not discussed below). In the case of a bank, the lack of liquidity can lead to panic, run on the bank, and even its collapse, as it did in March 2023 for Silicon Valley Bank or Signature Bank. According to the Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank, one of the main causes of the bank's collapse was a failure in the management of the bank's liquidity risk and interest rate risk in the banking book (IRRBB).
According to regulatory requirements, banks must calculate and report Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). LCR measures short-term liquidity (stock of high-quality liquid assets / net cash outflow over the next 30 days), while NSFR provides a view liquidity in 1 year horizon (available amount of stable funding / required amount of stable funding). Both ratios must be higher than 100 %.
In December 2023, the EBA issued a Risk Assessment Report. Based on the submitted data the EBA has reached the following conclusions:
At this point, it should be stressed that the regulatory LCR and NSFR should be seen more as minimum requirements that a bank must meet. However, compliance with them does not automatically mean that the bank manages its liquidity well and that it will always be able to meet its maturing obligations. Other methods should be used to assess whether the bank has sufficient liquidity, in particular the projection of expected cash flow and, for example, balance sheet liquidity analysis.
Balance sheet liquidity analysis is based on the rule that long-term assets should be financed by stable liabilities. It is carried out by classifying assets and liabilities according to liquidity (i.e. time it takes to change the assets into cash) into, for example, highly liquid, moderately liquid, and illiquid, and then comparing the different categories against each other. For example, the following ratios are used:
To manage liquidity risk effectively, it is advisable to set limits for each ratio.
This analysis should also be supplemented by an estimate of the net cash outflow and the value of liquid assets within a specified time horizon or future scenario. Both deterministic and stochastic cash flow modeling should be included to better understand and predict liquidity under different scenarios.
In the context of liquidity risk management, ARM can offer you: