European Banks Confront a Liquidity Crisis: Success in Europe's Dynamic Liquidity Environment Will Depend on an Approach That Emphasizes Tactical Implementation and Flexible Adaptation

By Sharma, Jitendra; Niolu, Giuseppe | The RMA Journal, September 2012 | Go to article overview

European Banks Confront a Liquidity Crisis: Success in Europe's Dynamic Liquidity Environment Will Depend on an Approach That Emphasizes Tactical Implementation and Flexible Adaptation


Sharma, Jitendra, Niolu, Giuseppe, The RMA Journal


The global financial crisis, increasing regulatory pressure, and shifting marketplace challenges are elevating the importance of liquidity risk management dramatically for European banks. Previously treated as little more than an afterthought before the financial crisis, effective liquidity management is now a central boardroom issue.

In many institutions, liquidity risk was not differentiated in the panoply of risks comprised by the enterprise risk management framework. Governance of liquidity risk had been insufficient, and its analysis, management, and elevation to executive and board levels lagged that of other risk dimensions.

Several factors have changed this attitude. Since the financial crisis reduced confidence (both between banks and from investors), the most significant tactical liquidity challenge for banks has been an inability to roll over short-term wholesale market financing. In addition, reduced confidence in the European banking system is affecting banks' financing capacity, increasing costs and their reliance on financing from the European Central Bank.

The resulting focus on liquidity risk management by European banks provides a need--and an opportunity--to revamp liquidity risk frameworks, policies, business models, operational and analytical procedures, reporting and IT systems, and internal controls and adapt them to the demands of a dynamic liquidity environment.

Moving beyond a stand-alone consideration, liquidity risk is increasingly an integral part of banks' overall risk strategy and governance. European banks are redefining their comfort level with liquidity risk by formalizing risk tolerances and metrics, and improving their capabilities to identify and mitigate liquidity risk more accurately and appropriately.

Under stricter regulatory frameworks, many national supervisors are requiring banks to be locally self-sustainable in terms of liquidity rather than be dependent on intra-group funding to address liquidity shortfalls. These requirements affects banks' branches and subsidiaries.

To mitigate liquidity risk, banks are shifting toward long-term funding sources (most notably from retail clients) in an effort to reduce their reliance on short-term financing. They are also placing increased importance on their overall funding and liquidity risk management processes.

Basel Proposals

Among the major regulatory challenges for European banks is the Basel III package of capital and liquidity standards being implemented across the European Union via the Capital Requirements Directives, which are designed to ensure the financial soundness of credit institutions. The proposed standards would impose two new liquidity requirements on banks: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). (1)

The LCR, designed to strengthen the ability of banks to withstand adverse shocks, would require banks to hold high-quality liquid assets (including cash, government bonds, and other liquid securities) in amounts sufficient to meet a severe cash outflow for at least 30 days.

The NSFR is a more structural measure, intended to ensure that banks hold sufficient stable funding (capital and long-term debt instruments, retail deposits, and wholesale funding with a maturity longer than one year) to match their medium and long-term lending needs.

Banks that rely too heavily on short-term wholesale funding or unstable consumer deposits will likely struggle to meet both ratios. Additional costs may arise for banks seeking to improve (or simply maintain) their liquidity positions because many will likely pursue the same funding sources.

Another challenge for banks is the need to meet tougher requirements for credible and effective recovery plans, including the ability to restore liquidity under stressed conditions. This need is likely to put upward pressure on the cost of contingency liquidity arrangements. …

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