Open the tap and get liquidity
“Liquidity risk and portfolio management: Lessons from the crisis”: This is the title of a presentation by Giampaolo Gabbi, Professor of Financial Markets and Investments at University of Siena in Italy, invited by the Luxembourg CFA (Chartered Financial Analyst) society. In an interview with LFF, he spoke about restoring the liquidity pipeline, high frequency trading and the lessons from the crisis.
What is liquidity risk?
It can be defined in two different ways. The first one is the funding liquidity risk. It has increased more dramatically since the Lehman crisis, but it existed since before then with the subprime crisis in 2007 in the United States. It is when a company, in most cases a bank, is having difficulty finding liquidity and matching cash flows. Before the crisis, liquidity was considered marginal compared with market, credit or operational risk; it was only an issue of academics, less so of practitioners.
If you are wondering why we need liquidity, think about water. The price of water is very cheap in some countries, because it is easily accessible. We can open the tap and get liquidity. That’s why we generally don’t store water in our houses. The crisis was like a drought where liquidity evaporated very quickly.
What is the second definition of liquidity?
This one is closer to the asset management industry; it is the market liquidity risk. Take, for instance, government bonds: Before the Greek crisis, they were considered risk-free; there was no real spread between German and Italian bonds for instance. The first definition, the funding, affects the second one, which is the market. When I sell, I have two risks: the price could collapse and there is a potential lack of liquidity in the market.
Is liquidity risk a continuous one?
It started because there was lack of trust. Some banks didn’t know exactly what the quality of their portfolio was. Secondly, if you have to sell parts of your portfolio, this creates market liquidity risks. Third, you have the European Central Bank, which, technically speaking has the power to provide banks with liquidity infinitely. From the political point of view, we mustn’t forget that some member countries of the Eurozone are afraid of inflation, which is not so dramatic for others because of their historic background. Now, the goal is to restore this liquidity pipeline that has collapsed.
How does regulation fit in here?
The Basel Committee, within the framework that we call Basel III, decided to introduce two new ratios for banks. The first one is called liquidity coverage ratio. This is a constraint for banks because they are required to create a buffer for at least 30 days of liquidity needs in stress. If we get back to the water example, it is like estimating how much water you need to drink every day under stress for the next 30 days. So you have to stock enough water in your house to last at least a month, which makes you independent for that period of time. This has also an effect in terms of your profitability: the higher your liquidity, the lower your expected return.
The second ratio is the net stable funding ratio, which is a more long-term view. This means that banks have to avoid a mismatch risk within one year. Borrowing in the short term and lending in the long term could create an interest rate risk because you have to refinance your liabilities with a new rate while your assets are fixed.
Is high frequency trading an efficient way of diminishing liquidity risk?
One of the problems in calculating the impact of the phenomenon of liquidity is trying to evaluate whether it is continuous over time. The actions of the traders are not continuous; they are concentrated during periods of time when information is expected to come. If you look at the daily news, you notice that the moments before the news begin is affected by higher trading levels than during other periods.
I don’t have an empirical answer, but it would be interesting to analyse if there are volatility peaks of trades, because this obviously affects both volatility and liquidity. The problem when analysing these new kinds of issues is the lack of data. It is not easy to find databases for intraday prices.
What is the main reason that forces financial institutions to improve on their liquidity risk management skills?
Financial institutions were not prepared for this financial crisis that is not over yet. The first reaction was to increase the liquidity assets and second was to reduce the number of cross-border trades. This was the case especially during 2007, 2008 and 2009 because of the national bailout interventions scare. Before the beginning of the financial crisis, more than 60% of trades between banks in Europe were cross-border; with the Lehman Brothers’ crisis in 2008, the cross border deposits collapsed to 15-20%, and only among highly rated banks. The first reaction was to increase the skills within treasures and to manage portfolios to become more liquid.
In general, I would say that risk management is mainly affected by regulation. Though regulation for liquidity is now much tougher for liquidity than before the crisis, Basel Committee decided to give a lot of time for these new processes to be implemented, basically to avoid a shock for financial institutions. This means that the Basel III Directive should be implemented by 2019. This could be a problem because the long grandfathering period does not restore trust instantly, among players.
What are the lessons from this crisis?
Today, liquidity and counterparty risk are really worrying if we look at the portfolios of banks. If a bank gets a loan by the central bank, it helps in the short term, but behind that there is the need to restructure assets and liabilities. We are waiting for new strategies from banks in which they increase their liquid assets and reduce credit risks.
Government bonds are another issue. From a regulatory point of view, they are highly liquid assets. However, financially speaking, we have to consider that even though we are creating a buffer of liquidity, we should look inside every day to see if something has evaporated in terms of leverage. If credit spreads rise, the value goes down. So you don’t have the amount of liquidity you thought you had. CW