Known unknowns: assessing liquidity in the age of COVID-19 - by Don Mumma

known unknowns: assessing liquidity in the age of COVID-19

Pandemic forces financial institutions to get ready for once-in-a-lifetime liquidity reporting challenges

by Don Mumma

Throughout the COVID-19 pandemic, as governments prepared themselves for worst-case scenarios and financial markets whipsawed between record one-day losses and gains, a single variable has been keeping the world’s central bankers awake at night – liquidity.

With memories of the 2008 financial crisis still fresh, monetary authorities are all too familiar with the chaos a credit liquidity crunch could cause, and they responded quickly and aggressively with stimulus and interventions designed specifically to stave off that risk. Along with the focus on maintaining liquidity through central bank actions, the COVID-19 crisis conjured several other spirits of the crisis past. Among them is the host of new liquidity reporting requirements for financial institutions that were put in place after the 2008 crisis. Few thought they would ever be used again.

Many thresholds have already been reached by many institutions – offering a roadmap for what is required and reporting best practices. Others are still looming in the background – providing little indication of how financial firms will comply or whether they will reach the point where safety switches will need to be flipped.

new thresholds trigger new requirements

Throughout the crisis, AxiomSL has been surveilling the situation and monitoring liquidity reporting thresholds globally. Following is a rundown of some of the most prominent liquidity reporting requirements that are either being triggered presently or at risk of being triggered if the crisis continues much longer, along with a brief description of the reporting requirements associated with each.

Basel III Alternative Liquidity Approach: Plunge into the depths of Basel III, and we will find a seemingly obscure provision outlining the eligibility for alternative liquidity approaches. The regulation was designed for financial institutions that have an insufficient supply of high-quality liquid assets (HQLA), also known as Level 1 assets, in their domestic currency to meet the demand of their specific significant currency exposures. In that scenario, banks are allowed certain alternative means of evaluating and recognizing Level 1 assets, such as from other currencies or elevations of Level 2 assets at higher haircut costs, when certain eligibility requirements are met. Originally intended to address situations in developing nations where lining up liquid collateral to support significant holdings or to support fledgling entities can be a challenge, the uncertainties and liquidity shortages caused by the COVID-19 crisis have triggered such treatments for many mature and well-funded financial institutions.

Stress Testing: Daily stress testing has become a fact of life for many financial institutions during the COVID-19 pandemic. While Dodd-Frank mandated biannual stress tests for U.S. banks with $50 billion or more in assets, the new strains presented by COVID-19 have prompted several jurisdictions to issue mandates requiring systemically important financial institutions (SIFIs) to conduct daily stress tests. These include COVID-19-specific stress scenarios – many of which had to be developed on the fly – and, even in cases where daily stress testing is not mandated, many financial institutions are doing it anyway to forecast potential impacts more accurately.

Daily FR 2052a and Liquidity Coverage Ratio (LCR) Reporting: The U.S. Federal Reserve Board’s 2052a report, submitted by 39 of the largest U.S. and foreign banks operating in the U.S., captures certain directed (of interest) significant reporting entities and the consolidated institution’s assets, liabilities, cash and collateral inflows, and outflows for all maturities. It contains granular data on all defined products and provides a detailed snapshot of a firm’s liquidity risk position. The Fed continuously monitors the submissions to gain insight into the strengths and possible weaknesses of each firm’s liquidity position and to judge systemic liquidity risk that could require the Fed to step up support.

Within the 2052a report, the Fed measures LCR, a Basel III liquidity compliance measure that compares a firm’s HQLA to its net cash outflows over a 30-day period. The twelve global systemically important banks (G-SIBs) report 2052a daily, T+2. The rest of the 39 have historically reported monthly, but the severe market stress caused by the COVID-19 pandemic has prompted the Fed to ask them to begin reporting 2052a daily, with some starting out weekly for a month. It can be a huge challenge for the new daily reporters to pipe their source data into regulatory reporting systems daily, as opposed to aggregating and reporting monthly.

getting ready for the known unknowns

The liquidity reporting challenges associated with the COVID-19 crisis manifest themselves across a financial institution. Disparate teams working in different parts of the firm – and doing so remotely from their home offices – need to be able to collaborate to quickly identify thresholds that are at risk of being breached and the source data that will be needed in the reporting process. These teams must be able to pipe the data to the appropriate global authorities on the prescribed timeframe, in many cases daily.

It is no small feat to juggle the operational and technological requirements associated with this global liquidity monitoring and reporting challenge. Fortunately, technology can help automate large swaths of this process for firms that see the ‘known unknowns’ coming and put solutions in place to manage them – before it is too late.

author

Don Mumma

Managing Director, Risk Management, AxiomSL

Don Mumma oversees the risk management practice at AxiomSL. Prior to AxiomSL, Don spent 20 years as a financial services executive, market participant and risk management specialist with JPMorgan Chase, Credit Suisse and Toronto-Dominion Bank, where he spearheaded its entry in the US market.

Don holds a B.Sc. in finance from Miami University and an M.B.A. in finance from Ohio State University. He is an active member of a number of several professional organizations including PRMIA, GARP, and IAFE.