The crisis that has enveloped the world for the last three or so years has resulted in dwindling margins, a lack of alternative investment strategies, and an uncertainty surrounding organisational survival. All of these have resulted in a closer scrutiny of risk management practices, a more comprehensive evaluation of the various risks underpinning a transaction, and the way these need to be managed.

Capital adequacy regulations are supposed to give the average investor and depositor the confidence that the financial institution is immune from risk, particularly systemic risk; but recent events have exposed the flaws in this notion. Eight days before it was nationalised, Northern Rock had a total capital adequacy ratio of 14.4 percent, nearly double the eight percent required by the Financial Services Authority, in line with Basel II guidelines. HBOS, as of December 31 2007 had a total capital adequacy ratio of 7.7 percent.

Why then, did these two organisations not show any immunity to the worsening crisis seen in 2007-8? Simply, capital adequacy directives, and indeed anything that central banks have outlined as positive governance, have not been subject to either robust stress tests, nor tested in crisis situations. This is not a criticism of the capital adequacy framework but an admission that this framework could not withstand the financial pressure when the crisis set in.

The consequences of liquidity risk
It is now clear that sustainable business growth cannot be managed from within, and expansion into unchartered territories is of the essence. This adds to the risk elements that need to be considered, as cross-border considerations, cultural adjustments, and transfer risk need to be managed – in addition to the other financial risks that are inherent in any transaction. This adds to the burden on weakening margins, and has increased pressure on business unit heads and risk managers.

The pressures that caused the demise of most financial institutions did not relate to capital, and in the case of most banks that went under in the UK, not subprime-related lending either. It was a result of liquidity mismanagement. This is what wiped out their positive cashflow structures within a two- to three-month period, resulting in a deterioration of cash operations.

Liquidity, up until 2007, was rarely mentioned in regulatory circles: it was accorded step-motherly treatment by almost all regulatory regimes, it was the ‘forgotten risk,’ an ‘Asian problem,’ a ‘Russian problem,’ or not an issue at all since it is guaranteed by the central banks.

Liquidity risk was regarded by many as inconsequential, since liquidity was always guaranteed by the central bank. However, recent events have clearly demonstrated that most central banks did not step into the role of ‘lender of last resort,’ as evidenced by the spectacular collapses of Northern Rock and Lehman Brothers. It is now certain that the culmination of all risk pressure points is a liquidity shortfall, and while the regulators have tried to shut the proverbial stable door, the horse has long since bolted. It is imperative that the HSBC financial institution leadership understand the inter-relationships between the various risk elements and liquidity and start to understand the dynamics of liquidity risk.

A more complex analysis
It is not possible to use standard liquidity ratios for liquidity management for the following reasons:

• the adequacy of a bank’s liquidity will vary;
• in the same bank, at different times, similar liquidity positions may be adequate or inadequate depending on anticipated or unexpected funding needs;
• likewise, a liquidity position adequate for one bank may be inadequate for another;
• what is liquid in one market may not be liquid in another;
• liquidity is completely governed by an organisation’s risk appetite and therefore cannot be prescriptive.

Determining a bank’s liquidity adequacy requires an analysis of the current liquidity position, present and anticipated asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs, and options for reducing funding needs or obtaining additional funds.

As federal regulators have noted, the treatment of non-maturity deposits will be, for many banks, the single most important assumption in measuring their exposure to interest rate movement. The regulators continue to rely on a bank’s internal modelling systems to determine the value and interest rate sensitivity of such accounts. This presents all bankers with the difficult task of accurately calculating the market value of deposits and credit card loans, as well as developing effective hedging strategies to protect this value against market rate movements.

Similarly, with the continued consolidation trend in the banking industry, accurate valuation of demand deposits, in particular, becomes critical in determining the value of an institution or a single branch. Acquiring and/or target banks will need to measure the deposit franchise value based on the unique characteristics of an institution’s deposit portfolio.

It has now come home to roost with the Northern Rock debacle – which was not a credit risk problem, but a plain liquidity crisis caused by others’ credit risk woes.

Capital adequacy ratios cannot and will not assist a financial institution in a liquidity crisis simply because the amount of capital held has no relevance to an organisation’s cash position and strengths. Capital is an accounting book entry and is no substitute for short-term positive cashflows. It is therefore time for the regulatory regime to take a long, hard look at its cashflow policies, and embark on a healing journey.

More dynamic risk assessment
There exist key dependencies between market risk factors, macro factors, and idiosyncratic counterparty factors. For instance, oil prices are correlated with interest rates, and these influence together the creditworthiness of all organisations in the hotel and tourism industry segments. It is evident that risk factor correlations have to be studied and understood if margins have to improve, and strong pricing decisions can be taken if such inter-connections are analysed and understood. It is manifest that all risk variables are interconnected, and it is futile to embark on an understanding of interest rates without understanding the macro factors that drive interest rates. Not doing so will result in sub-optimal pricing decisions, and in this era of dwindling margins, this may be a killer blow.

In such an environment, an incorrect assessment of risk will be the death knell for organisations, and so, a more dynamic, proactive, and co-ordinated approach must be adopted in risk assessment within an organisation.

Financial institutions must undertake a more searching examination of their balance sheet structures, and decompose their balance sheet into contractual, and more importantly, behavioural, cashflow buckets. Most retail lending and funding organisations have to contend with customer behaviour as a key rationale for the understanding of mortgages and non-determinant maturity cashflows. Without a good understanding of customer behaviour analytics, any structure of liquidity will be inadequate.

Regulators in most regimes have adopted a knee-jerk reaction to the current crises and have tried to formulate regulations that seek to eliminate systemic risk, but such over-the-top regulation has given rise to regulatory arbitrage, or the use of capital to a firm’s advantage while playing the roulette of capital adequacy. Capital and liquidity are not substitutes for one another but need integrated management and measurement.

Today’s risk leadership must understand that risk cannot be managed in isolation but in conjunction with regulatory compliance, even if such compliance flies in the face of management logic where one sees completely contradictory rules adopted by the central banks and the international accounting standards board on the subject of loan losses.

The future of financial institutions is fraught and in these troubled times, the onus on survival cannot be left to the regulatory watchdog. Instead organisations should be bloodhound-like in actively managing key risk areas, of which liquidity is the most prominent. The days of patting oneself on the back because of higher-than-required capital adequacy are not just numbered: they are a thing of the past, and the only way forward is self-regulation.