What are the best ways to manage liquidity risk in a financial institution?

Imagine you have a piggy bank where you keep your allowance. Managing liquidity risk is like making sure you always have enough money in your piggy bank for things you need. -First, you need to know where you get your money (like allowance or birthday gifts) and what you spend it on (like toys or snacks). -Next, think about what could make you need more money suddenly. Maybe there's a cool new toy you'll want to buy, or maybe you won’t get as much allowance next week. - Then, think about ways to get more money if you need it. Maybe you could do extra chores or sell some old toys you don’t play with anymore. It’s like making sure your piggy bank is always ready for anything, whether you want to buy something or need extra money.

Other ways to measure and monitor liquidity risk: 1. Diversify Funding Sources: Avoid reliance on a single source. Diversify funding with a mix of short-term and long-term instruments to mitigate vulnerabilities. 2. Maintain Adequate Liquid Assets: Hold sufficient high-quality, easily marketable assets to cover short-term obligations, providing a buffer for liquidity needs. 3. Stress Testing: Regularly conduct stress tests to assess the institution's ability to withstand adverse scenarios, identifying potential vulnerabilities and gaps. 4. Contingency Planning: Develop clear contingency plans for unexpected liquidity events, outlining procedures for accessing emergency funding and central bank facilities.

Using a Lemonade Stand to Understand Liquidity Imagine you’re running a lemonade stand. You need to keep track of how much money you make from selling lemonade (cash in) and how much you spend on lemons and sugar (cash out). You also have to make sure you have enough money for days when fewer people buy lemonade (slow days) and enough supplies for days when lots of people want lemonade (busy days). This is like the 'liquidity gap' Liquidity Coverage Ratio (LCR): This is like making sure you have enough savings from your lemonade sales to keep your stand running for a month. Net Stable Funding Ratio (NSFR): This is planning for bigger things, like buying a new table for your stand, ensuring you save a bit of your lemonade money over time.

Avoiding asset liability duration mismatch is key, as we saw with the now infamous collapse of SVB. They decided to invest in long maturity bonds, so were vulnerable to interest rate rises and, on the point of diversification, their customer base was concentrated on one industry. Take interest rate rises, long-term investments intended to be HTM, a customer base hit hard after the end of the pandemic and you had a recipe for disaster. Individuals took out their money in the search of better yield whilst SVB were experiencing prices falling in their long-term investments, and the outflows pressured them to sell more and more at a loss. It’s why ALM is hugely important!

Key part of stress tests is you need to prepare, test and model the unexpected (which I get can be hard because, well, it’s unexpected.) Of course, you can’t accurately model completely unexpected black swan events, but take the example of interest rates. During the low interest rate environment, you might’ve done a stress test with an upper limit of a 200bps increase. Now with the rate hike cycle we just had, hindsight would probably tell you that 200bps wasn’t enough. From there, then you can identify liquidity gaps and evaluate your LCR and take steps to protect yourself and ensure you’re falling in line with regulatory requirements.