Non-Bank Financial Institutions Must Prudently Manage Liquidity Risk to Avoid Long-Term Damage

As the global financial landscape continues to evolve, non-bank financial institutions (NBFIs) are facing unprecedented challenges in managing liquidity risk. In a stressed market environment, NBFIs must navigate two options: holding more cash or liquid instruments, which would impact return on equity, or turning to traditional banks for contractually committed funding, which often entails commitment fees.

However, leaving liquidity risk unmanaged can have severe consequences, including reduced access to funding, jeopardizing the viability of the firm and even affecting its reputation. To mitigate this risk, NBFIs must thoughtfully weigh the economic costs of risk scenarios and mitigation tools against their long-term financial objectives.

Measuring Liquidity Risk

Determining appropriate metrics and measurement techniques is a crucial step in liquidity risk management. Firms should consider stress testing financial resources to simulate how specific vulnerabilities would create liquidity strain. Other common techniques include measuring funding concentrations and maturity mismatches that may result in liquidity shortfalls during times of stress. Regular reporting of liquidity risk measurements to the board and senior management is essential.

Mitigating Liquidity Risk

To effectively mitigate liquidity risk, firms must set guardrails and protocols, such as limits on liquidity holdings and contingency funding plans. Robust stress testing, buffers, and contingency planning enable firms to form a pre-planned response to stressed conditions instead of reacting in the moment by reducing business activity or raising new funding on punitive terms.

Data and Systems

Accurate and timely data is critical to effective liquidity risk management. Firms should prioritize building robust risk measurement systems that can quickly identify potential liquidity issues. NBFIs with strong technology talent can leverage their unique strengths to build nimble risk measurement systems.

What Can NBFIs Do Now?

To start managing liquidity risk effectively, NBFIs can take the following steps:

• Build a business case: Avoid waiting for regulatory clarity and focus on protecting financial resources and enabling opportunity.
• Start small: Use unique strengths, such as access to strong technology talent, to build liquidity risk systems.
• Extend practices to other risk stripes: Consider applying the risk management framework described in this paper to other important financial risk areas.

By prioritizing liquidity risk management, NBFIs can protect their financial viability and take advantage of business opportunities in the market.