Liquidity Risk – Algorithmics Highlights Dangers of Proposed Standard Liquidity Ratios in its Response to Basel Committee

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In its recent submission to the Basel Committee on Banking Supervision’s consultative document, ‘International framework for liquidity risk measurement, standards and monitoring’, Algorithmics has cautioned against the danger that is inherent in the proposals to use standard liquidity ratios that do not account for bank size, resulting in a simplistic indication of a bank’s liquidity position.

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Correctly understanding the cost of liquidity associated with the right level of liquidity buffer will be a key factor in optimizing capital management and business growth. Our advice is to ensure that liquidity risk management becomes an integral part in the setting and monitoring of explicit enterprise risk appetite and reward targets at the balance sheet policy level.

In its recent submission to the Basel Committee on Banking Supervision’s consultative document, ‘International framework for liquidity risk measurement, standards and monitoring’, Algorithmics has cautioned against the danger that is inherent in the proposals to use standard liquidity ratios that do not account for bank size, resulting in a simplistic indication of a bank’s liquidity position.

The Basel document proposes two standard ratios that all banks should be obliged to maintain above a defined minimum: Liquidity Coverage Ratio and Net Stable Funding Ratio. Algorithmics warns that applying these ratios without considering bank size might not provide enough protection against the systemic risks of larger banks, while penalizing smaller banks, which do not pose a systemic risk, through unnecessarily high liquidity requirements.

By having standard rather than size-dependant ratios, the regulations fail to recognize that size in itself is a risk, which has been an issue in the recent crisis. The standard ratios only provide a simplistic indication of a bank’s ability to withstand liquidity stresses and, despite being created with severe stress assumptions in mind, they should not be exclusively relied upon by senior management.

Algorithmics has made two recommendations to the Basel Committee with respect to liquidity risk measurement. The first is the use of liquidity buffer and survival horizon measures in conjunction with economic capital as part of a comprehensive framework that reflects the institution’s risk appetite. The second recommends that banks should not only stress and reverse stress risk factors, but also the underlying assumptions of the corporate strategies and business plan, as well as their interdependencies.

Dr Mario Onorato, Senior Director of Balance Sheet & Capital Management Solutions at Algorithmics and Honorary Senior Lecturer, Cass Business School in London, said: “Even if two banks show equal ratios, the potential systemic impact of a liquidity issue can be totally different depending on the absolute amounts of their exposures. Our response to Basel recommends that banks’ size should be taken into account when defining the standard requirement, and that the ratios should be complemented with liquidity VaR for market liquidity risk, liquidity buffer and survival horizon for funding liquidity risk, and the interaction between the two.”

Ratios aren’t the only issue that banks are dealing with. Dividing scarce and expensive resources, such as capital and liquid assets, between competing needs is a pervasive problem facing firms, as Dr Onorato explains, “Correctly understanding the cost of liquidity associated with the right level of liquidity buffer will be a key factor in optimizing capital management and business growth. Our advice is to ensure that liquidity risk management becomes an integral part in the setting and monitoring of explicit enterprise risk appetite and reward targets at the balance sheet policy level.”

To download a copy of Algorithmics’ response to the Basel Committee’s request for comments on the consultative document ‘International framework for liquidity risk measurement, standards and monitoring’: http://www.algorithmics.com/EN/media/pdfs/Algo-GC0410-LtrBaselCom2.pdf

For Algorithmics’ white papers on liquidity risk management see:
http://www.algorithmics.com/EN/publications/whitepapers/

For more information about Algorithmics' liquidity risk solutions, please visit: http://www.algorithmics.com/EN/services/35-prodserv.cfm

For further information please contact:

Heather Smith, Senior Communications Manager, Algorithmics (UK) Ltd
Direct line +44 (0) 20 7392 5820 Mobile +44 (0) 7515 974223
E-mail Heather.smith@algorithmics.com

Notes to Editors:
Algorithmics is the world's leading provider of risk solutions. Financial organizations from around the world use Algorithmics' software, analytics and advisory services to help them make risk-aware business decisions, maximize shareholder value, and meet regulatory requirements. Supported by a global team of risk experts based in all major financial centers, Algorithmics offers proven, award-winning solutions for market, credit and operational risk, as well as collateral and capital management. Algorithmics is a member of the Fitch Group. http://www.algorithmics.com

Liquidity risk management approach
Algorithmics' comprehensive approach to liquidity risk management, described as early as December 2007 in two white papers (see http://www.algorithmics.com/EN/publications/whitepapers/), stresses the need for stress testing in the management of liquidity risk and convergence of local supervisory regimes.

Algo Liquidity Risk offers an integrated, comprehensive, scenario-based framework to help banks gain a more accurate picture of liquidity positions firm wide. Designed with advanced functionality for data management, reporting, compliance, and best practice guidelines, Algo Liquidity Risk enables banks to gain a competitive advantage by more effectively managing and maintaining liquidity.

Algo Liquidity Risk offers extensive product coverage, an advanced framework for a variety of behavioral models and multiple liquidity risk analytics, and stochastic scenario-based simulation of future business to support:
•A wide range of liquidity risk issues including market liquidity risk, funding liquidity risk, liquid assets portfolios, collaterals and contingent liabilities
•Extensive product coverage with accurate modelling of cash flows, optionality and pricing
•Multiple liquidity risk analytics, including gap reports, runoffs, ratios, stochastic analytics, and counterbalancing capacity
•Advanced framework for scenario generation and stress testing
•Behavioural models of core demand deposits, prepayable mortgages, mortgage pipeline and revolving facilities, with twin views of contractual and behaviourally modelled cash flows
•Stochastic scenario-based dynamic simulation of future business
•Organizational effectiveness of risk management framework, including management reporting, limit management, possibility to set up new aggregation criteria and risk reports, dissemination of risk related information across the organization,
•Comprehensive information gathering from all potential risk sources in an institutions

Fitch Group is the parent company of Fitch Ratings, a global ratings agency committed to providing the world's markets with independent, timely and prospective credit opinions. With 49 offices worldwide, Fitch Ratings’ global expertise spans across capital markets in over 150 countries. Fitch Ratings is headquartered in New York and London.

The Fitch Group also includes Fitch Solutions, a distribution channel for Fitch Ratings products and a provider of data, analytics and related services; and Algorithmics, the world's leading provider of enterprise risk solutions.

The Fitch Group is a majority-owned subsidiary of Fimalac, S.A., headquartered in Paris, France.
For additional information, please visit http://www.fitchratings.com http://www.algorithmics.com and http://www.fimalac.com

© 2010 Algorithmics Software LLC. All rights reserved. ALGORITHMICS, Ai Logo, ALGORITHMICS & Ai Logo, ALGO, MARK TO FUTURE, RISKWATCH, KNOW YOUR RISK, ALGO RISK, ALGO MARKET, ALGO CREDIT, ALGO COLLATERAL, ALGO FIRST, ALGO ONE, ALGO FOUNDATION, ALGO ACTUARY, ALGO OPVAR and TH!NK Logo are trademarks of Algorithmics Trademarks LLC. Algorithmics Trademarks LLC & Algorithmics Software LLC, c/o Algorithmics Incorporated, 185 Spadina Avenue, Toronto, Ontario, Canada M5T 2C6

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Algorithmics
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