As recent events have shown, even large, sophisticated banks can fail. These failures have been the result of risks which generally are managed within bank treasury groups: market and liquidity risks. For these banks, decreased market values of high-quality assets, paired with excessive levels of uninsured deposits, was a fatal combination.
There are a number of proactive tangible steps that boards and management teams can take to evaluate and enhance their institutions’ current market and liquidity risk management practices, beyond first-tier risk management.
Let’s start with measurement. Virtually all banks calculate base case balance sheet interest rate and liquidity risks. They need to measure the short-term effects on net interest income, along with the effect on market values in both rising and falling rate scenarios. They should particularly scrutinize portfolios that require behavioral assumptions for cash flows: non-maturity deposits, loan commitment facilities and mortgage-based assets.
This is where banks frequently fall short in not creating sufficiently stressed scenarios. They view extremely stressed scenarios as implausible — but implausible scenarios do occur, as demonstrated by the pandemic-driven economic shutdown. And yet, considering every possible extreme scenario will lead to scenario exhaustion and balance sheet immobilization.
What to do? One approach is to reverse the process and ask, “Where are potential exposures that could hurt us in an adverse scenario?” Use large, rapid movements up and down in interest rates, changes in yield curve shape like inversion or bowing, customer actions that drain liquidity, and market situations which affect hedge market liquidity and valuations. These scenarios create stresses based on known relationships between market events and balance sheet responses along with the effects of uncertain customer behavioral responses in these environments.
From these scenarios, the bank would know the market value and net interest income effects on investments, loans and known maturity liabilities. On non-maturity deposits and undrawn amounts in committed loan facilities, the bank must rely on assumptions of how these items would behave in various scenarios. One starting place for setting these assumptions is the outflow rates provided in the liquidity coverage ratio rules, which can be used for base assumptions, followed by scenarios with variations around these starting levels of outflow.
Measurement may be the most straightforward element of managing balance sheet risks. Once the bank puts measurements in place, they must communicate, acknowledge and act on them. Each of these elements present an opportunity for breakdown that executives should evaluate.
Effective communication is the responsibility of both treasury and risk management teams. In normal operating times, treasury develops information and risk management challenges this information. Risk management must then interpret the results for executives and the board. This interpretation role is useful in normal operating environments, but critical in stressed environments; risk management amplifies treasury’s message to ensure timely and appropriate actions.
Effective balance sheet risk communication must be accurate and timely. These communications include two critical components:
- They are layered. The first layer shows the status of compliance with policy limits. The second layer provides a narrative of the current balance sheet situation, operating environment, projected earnings and range of potential risks. Unfortunately, the second layer often is presented as a compendium of everything that has been calculated and analyzed — but this compendium of information should occur in a third reference layer.
- They are designed for the intended audience. Asset/liability committee, executive management and the board each should be receiving a different form of communication that aligns with their decision-making role.
Acknowledgement and action both must occur outside of the treasury group. Executive management and the board must absorb the risk situation and act accordingly. There is one word that captures the likelihood that a bank will effectively acknowledge and act on a risk situation: culture. An effective risk culture is one where all parties strive to optimize returns within agreed risk parameters while looking to eliminate or mitigate risks where possible.
There are signposts of effective risk management that a bank can evaluate and act on now. Management teams and the board should be looking at their current risk management practices and determine:
- Are the measurements correct?
- Is the information on risks communicated in ways that are digestible by each intended audience?
- Are policy limits comprehensive and aligned with risk levels required to support business activities?
- Do risk management groups have unfettered access to all information, as well as regular interactions with key board members?
- Is everyone working collaboratively towards optimizing long-term risk adjusted returns?
If the answers to all these questions are “yes”, then the risk management function seems to be effective. If not “yes,” use the markers described above as starting guidance on moving toward effective risk management.