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Liquidity risk management in financial institutions

While there were many diverse problems that led to the recent financial crisis, one of the key tipping points was the implosion of Lehman Brothers due to liquidity issues. Liquidity risk is a fluid, dynamic area of risk with great impact on financial institutions. It has just as much potential to bring down a bank as credit risk or market risk, and deserves a measurement and management regime that is just as rigorous..

Industry regulators have distributed a preliminary notice of how they expect large global institutions to manage liquidity risk. From our experience with financial institutions, we have seen that regional and community banks should also increase their focus on liquidity risk management. This is especially true of banks under regulatory orders because of the limitations typically placed on the bank’s flexibility to raise funds.

Liquidity is, first, the bank’s ability to meet its cash-flow obligations and, second, its ability to fund asset growth. This definition means managing liquidity risk requires analysis of forwarding-looking projections of both cash in-flows and cash out-flows. This is not static, point-in-time analysis; rather it is dynamic and subject to the affects of actions (or inactions) by and among other parties spread across the economy. Complicating the dynamics, changes in liquidity are primarily driven by events associated with other types of risk, particularly interest rate, market, and credit risk.

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