Introduction – Dashboard and Beyond

• One of the critical aspects of a bank’s liquidity risk management (LRM) involves first devising and then monitoring a set of early warning indicators (EWIs) to enable the risk identification process to spot the emergence of new or increasing vulnerabilities.
  • Negative trends serve as early indicators.
• EWIs may be viewed as analogous to warning lights on an automobile dashboard:
  • The turning signals, low oil, and check engine lights alert the driver of driving conditions.
    • Continuing this analogy, a turn signal or “blinker” indicates an intentional risky activity of making a purposeful directional change. In the realm of LRM, this might mean, for example, running a deposit special to raise rate-sensitive liabilities.
    • A low engine oil light indicates to the driver that direct action may be needed in the near future to prevent the engine from seizing up. In an LRM context, this is analogous to noticing that the bank’s Liquidity Coverage Ratio (LCR) has dropped below a specified threshold.
    • A check engine light indicates further investigation is warranted for an as-yet-undetermined reason. This could mean, for example, that a dramatic increase in call center volumes may portend a shift in the bank’s liquidity position.
• EWI triggers are used to initiate management discussions and actions that should be formally documented.
  • This could be as simple as an acknowledgment that the bank’s treasury is aware that a deposit campaign is underway by one of the business lines so it can orchestrate corrective actions to comply with LCR requirements.
• Holding liquid assets to ensure a bank can meet its financial obligations is ultimately a cost-benefit decision.
  • The protection from the catastrophic impacts of not having enough liquidity is offset by a significant drag on earnings if the buffer is too high.
  • A minimum standard for the liquidity buffer is set in accordance with the risk appetite of the bank. However, a basic “set and forget” approach is not effective against a dynamic market.
• Increasing buffers before times of stress can extend the survival horizon in a cost-effective manner, as a bank does not want to be caught short of liquidity when the market freezes.
  • A strong balance sheet position during times of stress opens opportunities for significant gains in market share and acquisitions that may not be otherwise available during normal times.
  • Strongly positioned companies can take advantage of rare market disruptions. The management tool that gives rise to this strategic advantage is the LRM EWI framework.

Regulatory Emphasis In Recent Times

• The global financial crisis of 2007-08 has put the spotlight on Liquidity Risk Management (LRM). The Basel Committee on Banking Supervision (BCBS) issued its “Principles of Sound Liquidity Management and Supervision” (Sound Principles) in September 2008, followed closely by details on standardized metrics such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). This overarching framework includes the use of Early Warning Indicators (EWIs). The list on the right is a non-exhaustive list of EWIs recommended by the BCBS. It includes key indicators that are both qualitative and quantitative in nature.

Key Supervisory Guidelines

• National regulators have started to benchmark financial institutions against these sound principles. The regulatory expectations for banks have gone up as a result. In particular, the data needed to support a modern LRM framework, in terms of quantity, quality, and timeliness, is an expensive investment. The responses from banks span a range from those who aim to minimize the cost of compliance to those who believe it can become a strategic tool to guide future management decisions.

Key Supervisory Guidelines – OCC (2012)

• A bank should have Early Warning Indicators (EWIs) that signal whether embedded triggers in certain products (e.g., callable public debt, OTC derivatives transactions) are about to be breached or whether contingent risks are likely to materialize.
• Early recognition of a potential event allows a bank to enhance its readiness. EWIs may include:
  • A reluctance of traditional fund providers to continue funding at historic levels.
  • Pending regulatory action (both formal and informal) or CAMELS component or composite rating downgrade(s).
  • Widening of spreads on senior and subordinated debts, credit default swaps, and stock price declines.
  • Difficulty in accessing long-term debt markets.
  • Reluctance of trust managers, money managers, public entities, and credit-sensitive funds providers to place funds.
  • Rising funding costs in an otherwise stable market.
  • Counterparty resistance to off-balance-sheet products or increased margin requirements.
  • The elimination of committed credit lines by counterparties.

Key Supervisory Guidelines – BCBS (2008)

• A bank should design a set of indicators to identify the emergence of increased risk or vulnerabilities in its liquidity risk position or potential funding needs.
• Early warning indicators can be qualitative or quantitative in nature and may include, but are not limited to:
  • Rapid asset growth, especially when funded with potentially volatile liabilities.
  • Growing concentrations in assets or liabilities.
  • Increases in currency mismatches.
  • Decrease of the weighted average maturity of liabilities.
  • Repeated incidents of positions approaching or breaching internal or regulatory limits.
  • Negative trends or heightened risk associated with a particular product line.

Key Supervisory Guidelines – BCBS (2012)

• Intraday liquidity monitoring indicators include:
  • Daily maximum liquidity requirement.
  • Available intraday liquidity.
  • Total payments.
  • Time-specific and other critical obligations.
  • Value of customer payments made on behalf of financial institution customers.
  • Intraday credit lines extended to financial institution customers.
  • Timing of intraday payments.
  • Intraday throughput.

Key Supervisory Guidelines – SR (10 – 6)

• Institution management should monitor for potential liquidity stress events by using early-warning indicators and event triggers. The institution should tailor these indicators to its specific liquidity risk profile.
• Early recognition of potential events allows the institution to position itself into progressive states of readiness as the event evolves, while providing a framework to report or communicate within the institution and to outside parties.
• Early-warning signals may include, but are not limited to:
  • Negative publicity concerning an asset class owned by the institution.
  • Increased potential for deterioration in the institution’s financial condition.
  • Widening debt or credit default swap spreads.
  • Increased concerns over the funding of off-balance-sheet items.

Risk Identification And EWIs

• It is important to ensure that Early Warning Indicators (EWIs) align with and are a natural extension of the enterprise Liquidity Risk Management (LRM) framework.
• According to Federal Reserve Board Supervisory Letter (FRB SR) 12-7 requirements, the LRM framework should be end-to-end and ensure that the bank will “sufficiently capture the banking organization’s exposures, activities, and risks.”
• A comprehensive LRM framework begins by identifying liquidity and funding risks inherent in the business activities of the institution. These risks are then documented in the firm’s liquidity risk inventory and subjected to a risk assessment process involving the businesses, corporate treasury, the independent risk management function, and other relevant stakeholders. Once the institution has assessed its liquidity risks, including their sources and drivers, it can then develop a framework for measuring and monitoring these risks, which includes stress tests, EWIs, and a limit and response framework.

Framework Components – M.E.R.I.T.

The EWI framework can be summarized as M.E.R.I.T. (Measures, Escalation, Reporting, Integrated systems, and Thresholds). While an appropriate set of measures is the first essential building block for a robust EWI framework, it will be a mere academic exercise if the framework is eventually not linked to escalation processes. The journey from measures to escalation is facilitated by timely reporting with the support of integrated systems and data as well as relevant and properly calibrated thresholds.

1) Measures

• Principle 5 from the BCBS’ Sound Principles states that –
  To obtain a forward-looking view of liquidity risk exposures, a bank should use metrics that assess:
  (a) the structure of the balance sheet, as well as metrics that
  (b) project cash flows and future liquidity positions, taking into account
  (c) off-balance sheet.
  These measures should span vulnerabilities across business-as-usual and stressed conditions over various time horizons.
• Forward Looking
  A leading indicator is one that will provide information and signal potential stress prior to the occurrence of an actual event. This is particularly important in preparing for systemic scenarios. Rather than using lagging indicators which report on events that have already occurred, such as government-reported GDP figures, a bank can develop proxies for the performance of the general economy from internal loan portfolio metrics.
• Sharpness
  The granularity and specificity of a particular indicator as it pertains to an institution’s profile is known as its sharpness. Sharp indicators are signals that do not go unnoticed within the mass of data. For example, detecting a drop in overall deposit balances is an acceptable EWI; however, detecting drops in deposit balances of more volatile segments, such as high-net-worth customers or rate-sensitive products balances, brings into focus that certain important classes of customers are leaving the bank.
• Balance
  In addition to developing sharp leading indicators, banks should also strike a balance between external and internal measures. Internal measures are customized to the bank’s balance sheet and activities, while external measures signal systemic changes in the economy or market. It is important to recognize that liquidity events can start either within the bank or may be influenced by external elements resulting from the environment within which the bank operates. For example, an idiosyncratic deposit run may result from either the disclosure of poor performance or due to a systemic failure. EWIs should be positioned to capture emerging internally driven stress events before they become public knowledge.
• Environments, Both Normal and Stressed
  EWIs are meant to provide signals or to act as a heads-up for an upcoming potential disaster. Tracking appropriate EWI metrics during a business-as-usual environment is essential as any deterioration in these metrics will alert the bank’s leadership of weaknesses in the bank’s balance sheet or of the emergence of challenging circumstances in the markets that the bank operates within. In addition, institutions should include stressed measures and limits into their EWI lists in order to gauge the adequacy of the firm’s liquidity buffer for a stressed environment. Additionally, stress testing results may also expose previously unidentified or emerging concentrations and risks that could threaten the viability of the institution.
• Spanning Various Time Horizons
  EWI coverage cannot be static and needs to reflect various time horizons in order to match the institution’s unique balance sheet needs as well as the market and economic conditions under which it operates. Typical cycle time horizons that match banking forecasts and business operations tend to be daily, weekly, or monthly. An indicator that is not updated for a period of more than a month is unlikely to satisfy the “early” aspect of the EWI. Certain EWIs may even be monitored on an intraday basis, as warranted by business conditions or required by regulators.

2) Escalation

• An effective escalation policy should ensure that limit breaches are escalated to the appropriate level of management with the authority to undertake corrective actions. An EWI that signals a potentially large cash outflow may require the asset-liability committee (ALCO) to authorize a check on future asset growth. The most extreme cases may require management to initiate the bank’s contingency funding plan (CFP).
• The governance overseeing the escalation of EWI-triggered actions must be formalized and documented as part of the liquidity risk management framework and be included in the institution’s CFP.

3) Reporting

• Timeliness
  EWI reporting needs to be timely in order to provide management with sufficient lead time to make adjustments in response to potential crisis events. It is common practice to have the EWI dashboard reported on a daily basis. Leading institutions are moving toward intraday reporting of certain measures. Firms with a significant trading focus are more likely to use intraday reporting as a result of their increased exposure to external market conditions.
• Balancing Coverage and Specificity
  Reporting also needs to strike a balance between being:
  (a) broad enough to provide wide coverage, and
  (b) specific enough to communicate only key messages.

4) Integrated Systems

• Integrated data and systems within the bank are essential in providing liquidity managers with the capability to ensure that reported metrics are:
  (a) accurate, and
  (b) in sync with each other.
  For example, deposit volumes feeding into liquidity stress tests, and their resulting measures, should be derived from the same source system used to produce non-stressed measures, such as week-over-week declines in deposit funding. This level of automation and integration is particularly important as EWI frameworks supplement traditional market-based metrics with a larger array of internal indicators.

5) Thresholds

• Firms generally use a stoplight system in representing and communicating their performance against the thresholds of their EWIs. A green indicator means that the measure is within normal bounds. A measure that is classified as amber according to the threshold framework should be investigated further, while a red indicator should be a source for significant concern and may warrant an immediate response. The threshold boundaries for which an EWI moves from green to amber should not be so wide that movements go undetected. Institutions should also be careful not to set boundaries that are so narrow as to force constant investigation of its movements, desensitizing management to its impact and creating a “boy who cried wolf” circumstance.
• Historical Data Analysis
  Historical data analysis is commonly used to estimate the volatility of an EWI and to calibrate its thresholds. The length of the calibration time series needs to be sufficiently long in order to be significant, but should also capture recent events to ensure that it represents the current operating environment. If possible, the time series should include a period of stress, such as during 2007-08. When available, a historical time series of at least one year will be used for calibration. The threshold should be subjected to back-testing to determine if recalibration is needed and a management override is warranted.

Industry Practices

• Over the last few years, banking institutions have increased the attention and resources devoted to developing and maintaining EWI dashboards and their overarching governance. The added emphasis in recent years can be largely attributed to supervisory demands in the form of matters requiring attention (MRAs), exams, etc. In certain instances, the credit should also duly be given to self-initiatives from the bank leadership to launch projects to enhance its liquidity management solidifying risk reporting.

Conclusion

• Over the years after the 2007-08 financial crisis, banking institutions have significantly increased their reliance on EWIs to avert any potential liquidity crisis. Nonetheless, supervisors as well as risk managers within the banks are constantly looking to expand and refine their EWIs so that the list stays relevant both to the internal changes that the bank may be undergoing and to the dynamic, ever-changing macro-economic landscape. Regulatory focus is expected to remain elevated, and supervisors are likely to scrutinize idiosyncratic EWIs as these are more tailored to the bank’s specific vulnerabilities. Liquidity risk managers at the bank must ensure that EWIs are governed as a part of the holistic risk management function within the organization. It is critical to ensure that EWIs are updated and aligned with other core aspects of the LRM framework, such as:
  • Risk inventory
  • Liquidity stress testing assumptions
  • Cash flow—actuals and projections
  • Business plans—Short-term/tactical and long-term/strategic
  • Contingency funding plan
  • Stakeholders—business lines/treasury/risk (second line of defense)
• EWIs will likely aid in managing the risk and averting the crisis only if the reporting mechanism is highly efficient. Thus, liquidity risk managers should ensure the quality and timeliness of the data that feeds into the EWIs. A relevant and reliable EWI list will not only alert the leadership during or ahead of a crisis but also will likely complement the overall risk management capabilities of the institution.