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Liquidity Stress Testing (LST)

Align Liquidity, Capital, Risk, Financial, and Performance Approaches and Methodologies

Historically, the implementation of liquidity, capital, risk, and financial performance frameworks and tools have typically followed different time frames and paths, leading to variations and fragmentation in an institution's approaches, processes, and infrastructure/support systems.

Leading institutions are taking a more integrated approach to the management of liquidity risk by recognizing the complex interplay of liquidity risk with market, credit, operational, and other risks. Operationally, firms are focused on addressing both business-driven and regulatory change imperatives by taking a more holistic approach to the design, development, and implementation of the overall risk management framework and its components. They actively seek to further align such risk management operating models, processes, and platforms over time to address the changing scope and scale of its business activities and leverage emerging technologies to meet evolving regulatory requirements. The results have helped improve business and financial performance management (e.g., risk-adjusted performance analysis, and product pricing), forecasting analytics (e.g., stress testing capabilities to evaluate joint potential capital and liquidity impact under severe adverse scenarios), data quality and reporting, and cost efficiencies stemming from increased system automation.

Apply Rigorous and Effective Challenge in Development of Models and Assumptions

The importance of forecasting and risk models and associated model management practices has risen significantly over the past several years, particularly given their prominence in regulatory guidance pertaining to enhanced liquidity and capital stress testing requirements. In addition to the overall modeling framework and methodologies, there is significant emphasis on both the numeric values produced by models and the governance processes overseeing those values that are derived and/or determined by expert judgment.

In validating these model assumptions, leading institutions not only leverage existing model validation groups, but also follow a formalized governance structure in applying effective challenge to the models by involving senior stakeholders from senior management, business, finance, risk, and other support groups. Assumptions are scrutinized and challenged to evaluate their robustness. The focus on both the quantitative results and qualitative controls, including supporting documentation in the form of technical model descriptions, validation reports, and effective challenge session minutes, illustrates the high bar needed to effectively demonstrate sound risk modeling practices.

Design a Strong LST Framework, Starting with Key Elements, and Enhance Continuously

The scope and complexity of significantly enhancing or building new LST frameworks and tools can be daunting, particularly given the heightened expectations of regulators and the many challenges that come with such an effort. Few institutions are immune to the various constraints of limited time frames, data quality challenges, scarcity of available resources, and cost containment pressures. Adding to those potential obstacles are the complexities associated with intertwining and aligning different liquidity risk and capital-related methodologies for stress testing, business continuity planning, recovery and resolution planning, and overall enterprise risk management.

Leading institutions are developing a more strategic view of these enhancements and continuing to enhance their liquidity risk management capabilities, focusing on “core” or key enhancements needed to address immediate issues and/or pending regulatory mandates. They are implementing changes in a modular or phased manner that enables “quick wins” and allows them to maintain momentum by demonstrating success to internal and external stakeholders. Project plans include short-term goals and demonstrate long-term vision; planning horizons capture additional improvement opportunities with approved budgets for forecasted financial and staff resources needed to support the long-run efforts. Leaders in these institutions also take a more strategic and long-term view of liquidity risk management enhancement initiatives, seeing them as part of the institution's continuous improvement efforts rather than “one-off” regulatory compliance projects.

Intraday Liquidity – Risk Measurement, Management, and Monitoring Tools for Financial Institutions

Prioritize System Enhancements to Communicate Unanticipated Intraday Liquidity Events

The batch processing approach used by many institutions captures the liquidity impact only from activities with more predictable cash flows, including loan events, investment banking activity, and securities that settle at known dates in the future. Other events, such as client cash and securities withdrawals, same-day settlement transactions, collateral calls, and clearinghouse payments, may result in unanticipated liquidity impacts that pose challenges for a batch process. To address these issues and improve the institutional awareness of the intraday liquidity position, firms are improving the flow of communication among the treasury, operations, and cash management functions. Before, these communications tended to be manual in nature, by email or phone, as the systems used by these groups traditionally did not communicate directly with each other during the business day to reflect client or firm activity that could unexpectedly impact liquidity.

By developing linkages between the daily monitoring systems used by treasury, operations, and cash management personnel to account for unexpected activities, leading institutions are now able to have these groups work more efficiently while reducing the potential for intraday liquidity surprises. Firms should continue prioritizing system enhancements for businesses that generate most of the unanticipated liquidity activity, such as prime brokerage, securities clearance, and trading (e.g., fixed-income, exchange traded funds, and commodities). By focusing efforts on these businesses, an institution will capture much of its intraday liquidity pressure points rather than needing to undertake a very costly, extremely time-consuming, large-scale overhaul of its entire transaction processing and risk technology infrastructure.

Establish Linkages between Intraday Credit and Liquidity Monitoring

In the years since the crisis, banks have enhanced their intraday credit risk monitoring to better understand risk concentrations across multiple asset classes, particularly with respect to trading counterparties. These efforts have resulted in the formation of specialized groups that monitor counterparty credit quality throughout the day and alert the businesses to declines in credit worthiness.

Cross-pollinating information between liquidity, operations, and cash management personnel with these credit risk–monitoring functions allows firms to better understand how credit problems can affect projected liquidity and expected cash flows. The credit risk team can alert liquidity managers of a decline in credit worthiness of a counterparty that is expected to settle transactions or make payments previously forecasted as part of the bank's liquidity pool, thereby allowing those managers to respond effectively by altering the liquidity composition and timing of payments of the bank to account for such potential losses. Credit considerations become particularly acute with respect to foreign currency exposure, as late or failed settlements from one counterparty may impact a firm's ability to obtain a currency that it must deliver to another counterparty.

Incorporate Intraday Exposure Analysis to Size the Working Capital Reserve

A common approach to estimating working capital begins with projecting the daily liquidity sources and uses for business operations and then augmenting these projections with stress analysis of historical end-of-day exposures. The analysis includes stressing the liquidity reserve to account for potential disruptions in projected cash flows from events such as the failure of an agent bank or financial market utility, tightening of credit provided to the firm, or an increase in failed trades and delayed settlements.

While this approach highlights scenarios of potential liquidity disruptions during periods of market stress, it may not appropriately estimate the magnitude of these events. A firm's intraday liquidity needs could be significantly higher than its historical end-of-day exposure may indicate. Leading firms have now started to estimate their working capital needs using intraday exposures to account for these large spikes in business activity and the resulting liquidity needs throughout the business day that may not otherwise be reflected in end-of-day metrics.

The Convergence of Collateral and Liquidity

Invest in Collateral Management Infrastructure to Gain Cost and Operational Efficiencies and also to Extract Liquidity Risk Management Benefits

The business case for upgrading collateral management capabilities is bolstered by placing liquidity risk management considerations squarely alongside the imperatives for improved credit risk management, processing efficiency, and cost savings. Collectively, such considerations are starting to drive implementation of unified target operating models, rationalized technology platforms, and greater automation within the world of collateral management.

While focusing on just the credit risk–mitigating aspects of collateral narrows the field of vision considerably, the broader reality is that heightened volatility in fast-moving capital markets activities can trigger unexpected collateral calls which, in turn, can increase an institution's exposure to firm-wide liquidity risk. In such instances, the ability to identify and mobilize eligible collateral effectively, to both meet margin calls and increase access to secured financing, can become the key to economic survival.

Integrate Collateral Management more Closely with Front Office and Treasury Functions

Structural market reforms under the Dodd-Frank Act in the U.S. and the European Market Infrastructure Regulation are giving rise to greater pre- and post-trade transparency. At the same time, such reforms are also making market participation more expensive and operationally complex by requiring increasing quantities of high-quality collateral to be posted for both centrally-cleared and non-cleared swap portfolios. More stringent capital and liquidity regulations under Basel III require banks to hold greater quantities of the same high-grade collateral. The nexus of these different pressure points around collateral increases the business imperative to take a wide-angled lens view of how best to invest in cost-effective technology platforms and capabilities that can meet multiple business and regulatory requirements.

As exchange-traded execution platforms begin covering an ever-broadening swath of the derivatives marketplace, clearinghouse cross-product margining will continue to grow. There will be renewed focus on reaching beyond the cheapest to deliver in order to fully exploit the collateral eligibility of each available asset with greater differentiation. Achieving effective integration and management of both collateral and liquidity requires moving the collateral management function away from being purely a back office function focused on credit risk toward a domain requiring closer collaboration between front office and treasury functions to better facilitate sound trade placement decisions and leverage collateral to its fullest liquidity potential.

Optimizing Collateral Management Helps to Optimize Liquidity Risk Management

Driven by the desire to source, fund, and allocate collateral efficiently, firms are focusing on achieving collateral optimization by putting in place cross-functional teams, rationalized operating models, common technology platforms, and proper collateral management processes. With optimization, leading market participants are starting to realize improved yield from each asset, minimize the cost of financing that asset, reduce capital charges associated with regulatory capital requirements, reduce liquidity risk, and eliminate over-collateralization. This represents the clear prize to be gained from combining capital and liquidity costs while simultaneously viewing collateral and liquidity as two sides of the same coin.

Early Warning Indicators

Select Internal Early Warning Indicators that Complement Market-Derived Measures

Internally-focused early warning indicators (EWIs) provide a perspective on the liquidity profile and health of the institution. These measures are critical in understanding how the firm's liquidity position could be changing over time and what types of vulnerabilities may emerge as a result of business and strategic decisions.

Leading institutions supplement their use of external EWIs with a suite of internally focused indicators. These internal measures should capture trends in specific markets and businesses in which the firm participates as well as those that serve as funding sources. Internal EWIs should be selected in concert with external EWIs to identify emerging risks and evaluate if the nature of these risks is idiosyncratic, systemic, or some combination of the two. Many institutions select broad stock or bond market indices as indicators of overall economic health; however, leading firms will focus on indicators that are specific to their business and funding profile, such as loan portfolio performance, operational loss metrics, or industry-specific bond and swap spreads. Specific indicators may alert management to market trends and warrant further investigation.

Link the EWI Dashboard to a Strong Escalation Process

Leading institutions select and calibrate EWIs and related thresholds to transmit meaningful signals to management about the need for corrective action in light of changes in the broader business environment or impending potential firm-specific distress. Once a EWI registers a change in status, a robust and well-established escalation process will help ensure that management (and potentially the board) reviews the trends to better understand the cause, identify the potential impacts of evolving business dynamics, and take appropriate actions. The firm's selection of EWIs and their calibration should be reviewed to reflect any changes to business mix and activities and the changing nature of the macroeconomic and market environments.

EWIs should be forward-looking, selected so as to provide a mix of business-as-usual (BAU) and stressed environment information, and assessed against limits at predetermined intervals (e.g., daily, weekly, monthly). Continued deterioration in a single or combined set of EWIs should trigger the firm's emergency response tools, such as the contingency funding plan.

Contingency Funding Planning

Bring Contingency Planning to the Forefront and Align to Business and Risk Strategy Development

The contingency funding planning (CFP) should serve as a critical component of the organization's liquidity risk management framework by ensuring that risk measurement and monitoring systems, such as liquidity stress testing, early warning indicators, limits, operating metrics, and regulatory ratios, are operationalized and drive timely management action in times of stress. The goal is accomplished most effectively by fully integrating the firm's risk identification and assessment, scenario development, stress testing, and limit structure into a robust CFP escalation process.

In designing and updating CFPs, institutions typically look to their existing business and risk profiles, risk monitoring capabilities, and external market conditions. While this helps establish a strong CFP at a particular point in time, the relevance and effectiveness of the CFP will likely change given the evolving nature of the institution and changing market conditions; therefore, ensuring the relevance and alignment of the CFP to the institution's business and risk profile and evolving external market conditions is key.

In addition to the periodic updates to the CFP, leading institutions are taking a more proactive stance on the development of the CFP by incorporating it as part of, or in parallel with, their strategic planning exercises, thereby positioning the CFP to be more forward-looking and flexible. As a result, the CFP's key features such as escalation triggers, EWIs, contingent actions, and strategies are more attuned to the institution's current activities as well as its projected areas of growth including new businesses, products, client segments, and geographies.

Further, the collaboration among relevant stakeholders from management, businesses, finance, risk, operations, and other supporting functions enables an improved forum for effective challenge discussions of key business forecasting assumptions and their associated impact on liquidity risk and operational strategies – particularly with respect to crisis response, alternative crisis funding arrangements, and relevant market dynamics – during potential periods of severe stress periods and market disruptions.

Align and Integrate CFP to Business and Risk Continuity Strategies

While the CFP serves as a critical component of the liquidity risk management framework, it should be considered not as a stand-alone instrument but rather as a tool within the suite of capabilities and resources for managing the institution through a liquidity crisis.

For leading institutions, the alignment and integration of related capabilities, such as their business continuity planning (BCP) and recovery and resolution planning (RRP) strategies with the CFP, helps to standardize and streamline governance models, operating processes, and reporting tools and infrastructure, and further enhance management's decision-making capabilities, particularly during critical periods of severe market disruptions. This alignment requires common data taxonomies for defining/classifying the business and functional group segments and associated activities to ensure consistency across the enterprise. Additionally, institutions will need to define a comprehensive list of liquidity risk management applications and related systems, including front office activities, analytics, and reporting support, to ensure continuity of critical services under BAU and stressed operating environments.

Planning, Preparing, and Practicing for the Unexpected

In a liquidity crisis, the importance and robustness of the CFP's design needs to be matched by the institution's ability to execute the playbook. Its people need to understand their roles and responsibilities under the streamlined command structure and its communication protocols so they can implement the steps needed to prepare for and manage the liquidity crisis.

The effectiveness in executing the CFP is further enhanced through periodic testing. While not all components/strategies of the CFP may be tested, leading institutions that perform frequent exercises which best simulate the potential liquidity crisis environment will improve the CFP's operational effectiveness and response times – aspects that are critical during a crisis. Further, the test simulations may also identify potential gaps and/or improvement opportunities that would otherwise be undetected if the CFP were left collecting dust on the bookshelf.

Liquidity Risk Management Information Systems

Enhance Ownership and Accountability of Liquidity Risk Data

As regulatory reporting requirements have increased over the past several years, institutions have been challenged to keep pace with the ever-growing regulatory requirements for additional and more granular information. In stretching to meet pending regulatory deadlines while simultaneously juggling the needs to manage the ever-increasing portfolio of systems and applications, institutions have had little time to develop and implement a holistic approach to the management of liquidity data. Consequently, this has resulted in data quality challenges, including incomplete or duplicated data, variations in reported results due to the use of multiple data sources, and increased manual and time-consuming efforts in reconciling and enriching information needed for reporting across the different parts of the enterprise.

Recognizing such challenges, leading institutions have often designated risk data “czars” to lead and coordinate data management practices across the enterprise, and spanning the risk data management lifecycle – including data capture, enrichment, quality maintenance, analytics, reporting, and archiving.

Manage Liquidity Data Comprehensively: From End-to-End and Top-to-Bottom

Institutions leading the charge to improve their liquidity risk management capabilities have invested significantly in developing a comprehensive view of liquidity information, improved data quality, and “data lineage” as information is captured, enriched, analyzed, and reported.

Leading institutions have undertaken a spectrum of initiatives along the following focus areas:

i. Integration of risk, asset liability management, funds transfer pricing, transaction processing, and forecasting systems to enable more comprehensive data sets and shared common analytic engines/modules (e.g., trade capture systems, collateral management systems, G/L and financial systems)

ii. Standardization of liquidity data definitions and attributes through improved reference and position data collection (e.g., detailed features of product and asset class characteristics, contractual maturities of existing positions, overlay of behavioral assumptions), regulatory reporting classifications, and other segmentations (e.g., holding company, lines of business, legal entities/jurisdictions)

iii. Development of integrated analytics and reporting suites for multiple purposes (e.g., CFP dashboard metrics and thresholds, resolution planning, strategic planning and forecasting)

Develop a Vision and Continue to Build on a Scalable and Flexible Liquidity Risk Architecture

As institutions continue to enhance their liquidity risk architecture and platform(s), they should remain mindful of the interconnections between liquidity risk systems and applications, ensuring that IT initiatives at the enterprise level and at other parts of the organization properly consider potential implications and considerations for liquidity risk as part of their planning and scoping exercises.

In this context, leading institutions demonstrate strong capabilities in several areas. First, they have a strong understanding of the information technology, systems, and data “blueprint” – both the current and the future state design, along with detailed phased implementation and change management strategies and plans. Second, there is an executive owner, such as the chief information officer or a risk data czar, who provides oversight and drives coordination, ensuring a comprehensive view of liquidity risk data and how such information is used across the enterprise. Finally, there is a strong business case and well-defined requirements for IT investments, coupled with the support and buy-in from senior management.

Recovery and Resolution Planning

Embed Liquidity Needs for Resolution Planning into BAU Liquidity Reserves

Resolution planning requires firms to identify and measure the liquidity necessary to resolve the firm in an orderly manner. Leading institutions use the liquidity estimates at the firm-wide and legal entity levels that are produced for resolution planning to assess the size of the liquidity reserves they will maintain to support liquidity risk strategies, both over the course of BAU activities as well as in recovery and resolution circumstances.

These firms model liquidity needs for their resolution strategies on a daily basis and adjust the size of their BAU liquidity base to ensure sufficient liquidity resources needed under recovery and/or resolution. They also set limits by using their resolution liquidity estimates and develop associated response actions, bringing them to the forefront of integrating resolution planning considerations into their liquidity risk management architecture.

Integrate LST and Contingency Funding Planning into the Resolution Plan

In developing a resolution plan and addressing the resulting liquidity impact, institutions should make assumptions concerning sources and uses of funding, including deposit runoffs, drawdowns on outstanding lines of commitment, and additional collateral demands. As part of this exercise, many institutions leverage the assumptions in their liquidity stress testing and/or contingency funding plans to forecast the aggregate amount of net liquidity needed to support their resolution strategies. Leveraging existing liquidity risk management and forecasting tools in this manner is similar to the approach originally prescribed by the regulators of estimating required liquidity under the Liquidity Coverage Ratio (LCR).

Leading institutions are taking additional steps to further embed their own internal liquidity risk management tools into resolution planning by forecasting liquidity at set intervals (e.g., daily, weekly, monthly, and quarterly) throughout the resolution planning horizon. These projections better identify potential liquidity and funding mismatches that might not be readily apparent when strictly analyzing point-in-time, aggregate liquidity requirements.

Understand Liquidity Traps and Frictions to Cash Transfer

U.S. regulators require covered institutions to identify potential liquidity traps in their resolution plans. Traditionally, most firms have provided only commentary with respect to legal entities and national jurisdictions in which liquidity could be trapped but have not fully factored these impacts into their liquidity models and forecasts.

Leading institutions have advanced this analysis by estimating the potential amount of trapped liquidity, along with other potential frictions to the transfer of liquidity among entities, and included this impact in their resolution plan liquidity forecasts. They have also developed liquidity risk triggers and response actions to ensure that entities with national or jurisdictional liquidity requirements will have adequate funding under different stress scenarios and environments.