Learning Objectives:

  • Define liquidity risk and its key dimensions.

  • Understand liquidity risk metrics: LCR, NSFR, and survival days.

  • Explain the role of the ILAAP and contingency funding plans.

4.1 Defining Liquidity Risk

Liquidity risk is the risk that a bank will not be able to meet its payment obligations as they fall due . Banks must maintain sufficient liquidity to handle daily operational activities such as cash withdrawal from depositors, interbank clearing, repayment of debts, etc. . The University of Leeds module covers “Liquidity Risk Management” as a core topic . The University of Bologna module covers “Liquidity and Interest Rate Risk” .

Two Dimensions of Liquidity Risk:

  • Funding Liquidity Risk: The risk that the bank cannot obtain sufficient funding to meet its obligations.

  • Market Liquidity Risk: The risk that the bank cannot sell assets quickly without significant price discount.

4.2 Key Liquidity Metrics

Liquidity Coverage Ratio (LCR): A minimum standard that requires banks to hold a sufficient stock of high-quality liquid assets (HQLA) to cover net cash outflows under a severe 30-day stress scenario . The LCR must be at least 100% . The underlying stress scenario, the assets to be held, and the cash flows to be taken into account are specified in regulatory frameworks . In the EU, the LCR is implemented through the Capital Requirements Regulation (CRR) and Commission Delegated Regulation (EU) 2015/61 .

Net Stable Funding Ratio (NSFR): A minimum standard for reducing funding risk over a longer horizon . It aims to ensure that institutions have a sustainable funding structure by limiting maturity transformation . Available stable funding must at least equal required stable funding (minimum 100%) . Small and non-complex institutions may be permitted to apply a simplified NSFR .

Local Liquidity Maintenance Ratio (LMR): A liquidity requirement applicable to category 2 institutions, with a minimum requirement of 25% .

Core Funding Ratio (CFR): A requirement applicable to category 2A institutions, with a minimum requirement of 75% .

Intraday Liquidity: Credit institutions need to have intraday liquidity at all times for payment and settlement systems to function smoothly . Intraday liquidity management is a key principle of liquidity risk management .

4.3 Additional Monitoring Metrics (AMM)

Institutions’ liquidity status is too complex to be suitably captured by just two metrics . Therefore, the LCR and NSFR are augmented by monitoring metrics which permit supervisors to appropriately analyse an institution’s liquidity and funding risk . These additional monitoring metrics are specified in EBA implementing technical standards .

4.4 Disclosure Requirements

The disclosure of liquidity ratios has been enshrined in Part Eight of the CRR . LCR disclosure comprises qualitative and quantitative information on liquidity risk management and on components and the fulfilment of the LCR and the NSFR . Implementing Regulation (EU) 2021/637 sets out the detailed disclosure requirements .

4.5 ILAAP and Contingency Funding

The Internal Liquidity Adequacy Assessment Process (ILAAP) is the bank’s own assessment of its liquidity needs.

Key elements of ILAAP:

  • Liquidity Risk Identification: Identifying all material liquidity risks.

  • Liquidity Risk Measurement: Quantifying liquidity needs under normal and stress conditions.

  • Liquidity Buffer: Maintaining appropriate levels of liquid assets.

  • Contingency Funding Plan: A plan for addressing severe liquidity stress.

Stress Testing: Banks must conduct stress testing to assess their resilience to liquidity shocks.

Supervisory Review and Evaluation Process (SREP): The management of intraday liquidity risk is assessed as part of SREP .

 

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