In the context of banking institutions, liquidity pertains to a bank’s ability to meet its regular financial obligations without suffering huge losses as a consequence. The bank must have enough of its assets liquid in order to meet these obligations. The task of identifying and protecting a bank from risks to its liquidity is called liquidity risk management. Though bank executives know that they have to oversee sound liquidity risk management, like many things about doing business, this is easier said than done.
It’s no secret that liquidity risk management is a challenge for banks, and will remain so in the coming years. For one, there are so many different types of risk to liquidity and so many risk variables for banks to keep their eyes on. For another, regulators have become more aggressive about monitoring both liquidity and capital from their constituent banks. Lastly, banks suffer extra stress in times of great socioeconomic upheaval, like the financial crisis of 2008 and, more recently, COVID-19. In events like these, they can anticipate to feel the pressure on several areas of their balance sheet at the same time.
Given those circumstances, what should banks do to stay liquid and to protect themselves sufficiently from internal and external liquidity risks? Here’s a briefer on five strategies to maintain liquidity, which may prove helpful if you’re a decision-maker in a banking company:
Better Balance Sheet Management
Good balance sheet management is one of the best ways for a bank to mitigate liquidity risks. Nowadays, more banks are paying attention to this and are thus investing in more updated solutions for balance sheet management. This enables them to use software with greater analytics and budget planning capabilities in order to maintain positive balance sheets from period to period.
There are several advantages to investing in better balance sheet management. Doing so helps banks consolidate a wide pool of data from multiple sources, from their core banking services to their payment systems and treasury. Banks thus get the widest real-time view of their assets, liabilities, and shareholders’ equity and can determine the following:
- Which assets are liquid and which are not
- Where in the balance sheet potential sources of risk lie
- What exactly these risks are and what causes them
- What the bank’s time horizon is like for properly managing its debts
Thanks to their heightened control and breadth of insight from their balance sheets, banks are empowered to safeguard their financial health. They can respond immediately to any potential risks and stay on top of both their long-term and short-term obligations. This can surely preserve any bank’s reputation among its stakeholders, including its investors.
Better Management of the Company Cash Flow
Another important strategy for dealing with liquidity risks, especially those that are internal in nature, is proper management of the bank’s cash flow. The bank should aim for the most accurate cash flow projections and timely action to improve spending and stay faithful to its obligations.
For the most part, this involves ensuring operational efficiency within the bank with regard to payroll, collecting customer payments, and paying debts. But it also includes sound planning for investments, like new equipment and systems, so that neither end up being a long-term cash drain. Put simply, the better a bank is at cash flow management and cash flow projections, the more protected it is against internal liquidity risks.
Improved Risk Reporting Abilities
Yet another strategy a bank can deploy to protect itself from liquidity risk is the improvement of its current risk reporting abilities. Risk reporting no longer has to be a matter of reconciling individual spreadsheets and tallying separate insights from them. Banks can invest in software that streamlines their financial data and helps them zero in on liquidity risks from a whole-of-enterprise standpoint.
Upgrading to better software will make the task of reporting risk easier, faster, and more consistent. It will also help decision-makers present customized risk reports to whoever will access the information, whether they’re internal stakeholders or outside regulators. It’s also a means of showing how committed the bank is to transparency in handling its assets, liabilities, equities, and processes.
Usage of Comprehensive Liquidity Risk Metrics and Monitoring Processes
Some banks have to revisit their liquidity risk metrics, or their common agreement on what counts as risk and in what context. But this step shouldn’t be skipped, as banks will need to identify their own ideas of liquidity risk and when exactly to implement their contingency plans.
It’s also wise for banks to roll out formal monitoring mechanisms for the liquidity of their assets. Such monitoring should be done regularly and not only from time to time. Banks should also align on which assets count as liquid according to indicators of global liquidity and according to business-specific situations. Monitoring liquidity conscientiously is the key to responding in a timely fashion to risk.
Greater Preparedness for Imminent Periods of Stress
The last strategy that banks should have in their liquidity risk management plans is greater preparedness for stress. Stakeholders must be honest about the possibility of extreme situations unfolding, especially given today’s volatile financial climate. Will the bank be ready to face these scenarios—or multiple adverse scenarios at the same time—and how?
It’s recommended that banks undergo regular financial stress tests so that they can envision how to deal with both short-term and long-term liquidity shortfalls. These stress tests can simulate institution-related problems as well as market-wide problems to the bank’s liquidity. From thereon, banks can assess their current levels of risk tolerance and craft a proper contingency plan based on the results.
Those who work in banking must remember that their strategies for managing liquidity risk are subject to evolution. The same methods for dealing with liquidity risk decades ago may no longer work now, when the market and the company culture are so different. Hopefully, banks can leverage good liquidity risk management practices and quell excessive risk appetite, while still pursuing new opportunities for their future growth.
May your own institution be governed by transparent, accountable, and responsive liquidity risk management, in times of both economic stress and economic prosperity!
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