Understanding Liquidity and Liquidity Risk

Liquidity refers to an institution's ability to meet its financial obligations when they become due, without incurring unacceptable losses or disrupting normal operations.

Liquidity risk arises when an institution cannot meet those obligations efficiently, whether because expected funding is unavailable, cash flows change unexpectedly or assets cannot be converted into cash at an appropriate time and price.

Funding liquidity risk

Funding liquidity risk concerns the availability of cash and funding to meet current and future obligations. This can include contractual payments, withdrawals, collateral requirements and other cash-flow demands.

Market liquidity risk

Market liquidity risk concerns the ability to buy or sell financial assets without materially affecting their price. An asset may have a quoted market value but still be difficult to sell quickly at that value during a period of market disruption.

These risks can reinforce one another. Market uncertainty may reduce the availability of funding or make assets harder to sell, while funding pressure may force an institution to dispose of assets under unfavourable conditions. For this reason, funding and market liquidity risks should be considered together.

Why Liquidity Management Requires a Forward-Looking Approach

A liquidity position that appears comfortable today may become more constrained as circumstances change. Customer withdrawals, maturing liabilities, delayed receipts, unexpected collateral calls, changes in market confidence or reduced access to funding can all affect an institution's ability to meet its obligations.

Effective liquidity management therefore considers not only the funds available at a particular moment, but also how cash requirements may evolve across different time horizons.

This involves forecasting cash inflows and outflows, assessing the timing of contractual obligations, identifying potential funding gaps and considering how the institution would respond if assumptions proved incorrect.

Supervisory guidance from the Federal Reserve highlights the importance of identifying, measuring, monitoring and controlling liquidity risk through processes proportionate to an institution's activities and complexity.

A forward-looking approach also helps decision-makers understand the relationship between liquidity and wider business objectives. Planned lending, investment activity, expansion or changes in funding arrangements may all influence future cash requirements.

The objective is not to predict every possible event. It is to develop an informed view of potential liquidity needs and establish a framework for responding when conditions change.

Funding Diversification and the Importance of Stability

The availability of funding is only one part of the liquidity equation. Its reliability, cost, maturity and accessibility are also important.

An institution that depends heavily on a limited number of funding sources may be more exposed if one source becomes unavailable or significantly more expensive. Diversification can help reduce this concentration risk, although it does not remove liquidity risk altogether.

Currency, legal and operational considerations may also influence the usefulness of a funding source. Funding needs to be available in the appropriate currency and accessible where required, subject to applicable restrictions.

Supervisory materials from the Federal Deposit Insurance Corporation discuss funding concentration, market access, funding costs and the time required to obtain funds as relevant considerations in assessing funding resilience.

Diversification should nevertheless be considered in context. Different funding sources may be exposed to similar market conditions, meaning that apparent diversity does not always translate into genuine independence. The appropriate approach depends on the institution's size, activities, risk tolerance and funding model.

Liquidity Forecasting, Stress Testing and Contingency Planning

Forecasting provides a baseline for understanding expected liquidity requirements. Stress testing examines how that position might change under less favourable circumstances.

Institutions may consider scenarios involving unusually high withdrawals, reduced wholesale funding availability, higher collateral requirements, market disruption or a combination of events. Assumptions should reflect the institution's particular exposures rather than rely solely on generic scenarios.

A contingency funding plan sets out how an institution would respond if its normal sources of liquidity became insufficient or unavailable.

Elements of a practical framework

• The events or indicators that would trigger escalation.
• The responsibilities of treasury, risk management and senior decision-makers.
• The funding sources available under stressed conditions.
• The eligibility, documentation and collateral requirements associated with those sources.
• The operational steps and time required to access funding.
• The frequency with which assumptions, contacts and arrangements are reviewed.

In July 2023, US banking agencies reiterated the importance of actionable contingency funding plans, a broad range of accessible funding sources and regular assessment of operational readiness.

The institution must understand the conditions under which a funding source can be accessed and whether it would remain available under the circumstances for which it is intended.

The Role of Professional Deposits and Treasury Relationships

Professional deposit arrangements can form part of an institution's broader funding and liquidity considerations. For deposit-taking institutions, deposits may contribute to funding, while professional depositors must consider their own liquidity needs, contractual commitments and counterparty exposure.

The interests of the parties are related, but they are not identical. A receiving institution may assess funding requirements, maturity preferences and the cost of funds. A depositor may focus on access to funds, terms, tenor, counterparty creditworthiness and the suitability of the arrangement.

Looking beyond the headline rate

A disciplined evaluation should consider more than the headline interest rate. Relevant factors may include:

• The agreed maturity and withdrawal provisions.
• Applicable deposit protection arrangements.
• Eligibility requirements and contractual conditions.
• Counterparty creditworthiness and concentration.
• The documentation and due diligence required.
• The depositor's own liquidity requirements.

Deposit terms and protections vary by jurisdiction and product. Professional depositors should establish which arrangements apply to their specific circumstances rather than assume that every deposit receives the same protection.

Where institutions and professional depositors explore potential arrangements, clear communication and appropriate due diligence can help both parties understand the requirements and constraints involved.

Integrating Liquidity into Wider Financial Decision-Making

Liquidity management is most effective when considered alongside an institution's wider risk-management and governance framework.

Decisions about funding, asset allocation, investment, growth and pricing can all affect liquidity. Assessing these decisions in isolation may overlook their impact on cash flows, funding concentration or the availability of liquid assets.

Basel Committee principles emphasise appropriate governance, a clearly articulated liquidity-risk tolerance and the integration of liquidity management into the institution's wider risk-management processes.

Clear responsibilities and informed decisions

For senior management, this means establishing clear responsibilities, maintaining appropriate reporting and ensuring that material liquidity risks are understood by the people responsible for decisions.

For treasury teams, it means maintaining a sufficiently detailed view of expected cash flows, funding requirements, available resources and potential vulnerabilities.

For counterparties and professional depositors, it means evaluating proposed arrangements within the context of their own financial objectives, risk appetite and obligations.

The precise framework will differ between institutions. Regulatory requirements, business models and operational structures must all be taken into account.