One sure sign of notoriety is having a form of risk management named in your honour. For market and credit, this has long been the case but in the last year we have seen liquidity risk come into its own. As many people have pointed out, it is not so much a credit crisis that the world is facing but a liquidity crisis. Similarly, for all of the banks that have been bailed out, and regardless of the different catalysts involved, a shortage of liquidity has been the end result.

So it is no surprise that regulators have highlighted liquidity risk and the failure of many banks to model or stress-test this risk as a major factor in the current crisis. Back in February, Andrew Haldane, Bank of England executive and author of the Bank's Financial Stability Report, in a speech entitled Why Banks Failed the Stress Test, spoke of the "misaligned incentives" at many banks which rendered stress testing a fruitless exercise.

"There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management," said Haldane. "Stress testing was not being meaningfully used to manage risk. Rather it was being used to manage regulation," said Haldane.

He also outlined a new agenda in risk management that addresses the isolated role of the risk manager and the disjointed relationship between banks and regulators. "These measures involve a greater degree of engagement between risk managers and senior management within firms, and between financial firms and the authorities." Quoting the Keynes adage that it is better to be roughly right than precisely wrong, Haldane concluded that these measures - the greater emphasis on stress-testing, greater communication between risk managers and the boardroom and an end to regulatory camouflage - might help make risk management "roughly right".

The UK's regulator, the Financial Services Authority, has since targeted liquidity stress-testing as its priority. Back in December 2008, the FSA produced consultative paper 08/22, titled Strengthening Liquidity Standards, which set out 97 questions for UK banks based on the Basel Committee's Principles for Sound Liquidity Risk Management and Supervision. The FSA also warned that it would be issuing a separate report in Q1 2009 that would set out the reporting requirements for the new liquidity regime which it expected to see implemented by October 2009.

The FSA's requirements centre on three main tenets. Firstly a bank must be able to calculate its total liquidity status ‘on-demand'. Secondly, it must be able to subject its liquidity levels to three stages of extensive stress-testing agreed with the FSA. Finally they must be able to produce documentary evidence that they are in full compliance with these requirements.

These stipulations represent a sea-change in the regulator's approach. Since its inception, the FSA has favoured a principles-based approach that allows banks to choose their own method in which to satisfy the FSA's broad objectives. Prescriptive measures that lay down specific stress and scenario tests for all banks to follow have not been evident until now. It is also a departure from the sentiment underpinning the Basel Committee's guidelines where capital adequacy, rather than liquidity, is the primary measure of robustness and where the most advanced banks are expected to calculate their capital requirements through their own internally developed models and stress tests.

This is not to say that banks have been unaware of the frailties of the industry's approach to modelling and stress-testing, even before the critical events of September 2008 and beyond. Back in April 2008, Riccardo Rebonato, global head of market risk and quantitative research at RBS, spoke of misguided risk models creating a false sense of security by neglecting to focus on liquidity when he addressed the annual meeting of the International Swaps and Derivatives Association. "There was an excessive focus on the capital aspect and insufficient focus on the liquidity aspect," he said.

Clearly this has been recognised by regulators, not least the FSA, but a number of concerns remain for banks. Aside from the cost and the strain of undergoing another major compliance project, and the potential overhaul of existing systems and IT, banks will want to know if the regulators' new liquidity regime will be consistent with the current thinking among the risk management community in terms of formulating new strategies to tackle liquidity risk in the long-term.

JWG-IT, a Europe-based think tank that deals with the IT implications of regulatory changes in the financial services sector, has already produced a report, Liquidity risk management: a new imperative, which looks at the likely back-office impact of these changes. According to the report, the FSA estimates that compliance will cost the UK banking industry around £150-200 million in operational costs with large banks expected to fork out up to £9 million for implementation and a further £1 to 2 million in annual ongoing costs. 

For PJ Di Giammarino, chief executive of JWG-IT, the task of producing comprehensive asset and liability snapshots on-demand and subjecting them to ‘extreme yet plausible' stress tests could have implications of MiFID proportions. "It is a big shift because the information structure of banks does not allow them to do this. The data needed for stress testing scenarios are not easily available and to bring this together in a timely manner will stress the system," he says.

As for the ‘extreme yet plausible' stress-tests, do banks have the technology needed to carry out the simulations? "The technology does exist today but the issue is whether it is up to the necessary standard. Will it be able to simulate extreme yet plausible scenarios? Will it be able to retrieve previous results and out them in context? And will banks be able to produce these results on demand?" asks DiGiammarino.

Furthermore, there is the issue of who within the bank will run the project, once implementation is completed. "There is a Bermuda triangle emerging in the back-office between the treasury department, the finance department and the risk department," says Di Giammarino. There will also be the involvement of the IT infrastructure and application development teams as the changes will involve "some serious horsepower". JWG-IT is currently trying to assemble a community of "implementors" and encouraging banks to formulate their implementation plan.

Right now, the main concern among banks is the short time left before implementation, even allowing for an expected reprieve till 2010. For some though, these regulatory initiatives on liquidity stress-testing have not come soon enough. "Stress-testing has been introduced too late," says Suresh Sankaran, risk and performance solutions, Financial Institutions Services Group at US-based vendor Fiserv. "The horse has already bolted. The regulators have struggled with light-touch regulation for years and now they have decided to try and ram it down people's throats."

What concerns Sankaran more than the aggressive timetable for implementation is the uncertainty about what will follow. "What are the regulators going to do with the data? Who is going to collate it? They have not been forthcoming about its role in this. There are 350 banks in the UK. Does the FSA have the infrastructure to track the liquidity of all of them or will we go back to light-touch regulation?"

Even assuming that the FSA is sufficiently staffed and organised to police its new liquidity regime, the effort will be largely redundant if the intentions of the regulators do not match the conclusions of the risk management community as to what has gone wrong with the liquidity stress-testing of the past and what needs to be put right.

So where did things go wrong and why had banks not been focusing on liquidity before? "Liquidity had been plentiful for a number of years so the idea of stress-testing liquidity would have looked mildly absurd two to three years ago," says Selwyn Blair Ford, a senior domain expert for UK regulation at risk vendor FRSGlobal.

Firms have to concentrate more on scenario-testing as opposed to simple stress-testing, says Blair-Ford. "Stress testing for market risk was always about taking normal pricing models and exposing them to extraordinary price movements. But with scenario-testing, you have to put in various events and what the implications of these events are for other areas of the business. It is only then that you can see where the models break down."

Inevitably, applying such an approach to measuring liquidity risk involves considerable effort and requires risk managers to work beyond their existing and at times isolated remit. "Scenario-testing has to be embedded throughout the bank," says Blair-Ford. "Risk managers have to be able to approach all managers (settlement/IT etc) and a wide range of skills and inputs are involved."

There will also be operational issues says Blair-Ford. "Banks will need a single data repository that is used and trusted. Technically banks have these single data repositories but, from a business perspective, they are rarely used in the right context. People will take the information they want and then look elsewhere for the rest of the data they need. Any individual contract needs to be stress-tested from at least three different perspectives (liquidity, credit and capital) and you do not want to be running these stress tests in three different boxes. I think banks will be driven to use these central repositories correctly or else re-design them so they can," says Blair Ford.

At the heart of the debate about liquidity stress-testing and modelling is the fact that, for the last 10 to 15 years, it has been based on the assumption that market conditions will remain normal. Mathematical methodologies such as Black-Scholes and risk measures such as Value at Risk all make similar assumptions. Consequently, the industry is well versed in models based on stable markets and with an historical cycle no longer than 10 years.

This problem was exacerbated by the aggressive pursuit of profit in the banking industry over the last 10 to 15 years, making it difficult for risk managers to spend money on modelling and stress-testing scenarios that could be viewed as overly negative. "It is very difficult to be pessimistic in an optimistic environment for both risk managers reporting to senior management and for banks communicating with clients," says Jean-Baptiste Gaudemet, professional services manager at risk systems vendor Sophis. "No-one will listen to you."

As the FSA's proposed requirements around liquidity risk have demonstrated, banks need to construct a modelling and stress-testing framework for what is very different market to what has gone before. "They are redoing their models and using scenarios based on a very big crisis and are generally very risk-averse to the point where they may be over-estimating risk," says Gaudemet. "But it will be interesting to see what happens in five years time when the optimism has returned to the market. It is easy to be catastrophic when you are in the middle of a catastrophe. Hopefully the industry will be mature enough in five years time to take this approach." BT

REAL LIFE: What the banks have been doing

The following extracts are taken from written evidence submitted to the UK House of Commons Treasury Select Committee by banks operating in the UK as part of the Committee's investigation into the banking crisis, which was published in March 2009.

One of many questions was related to the liquidity stress-testing practices of the banks. The subsequent variation in responses to this question and others illustrates two major points:

‹ Banks do not adopt a uniform approach to their risk management

‹ Subjecting these banks, the majority of which have an international remit, to the prescriptive proposals of the FSA's new liquidity regime will be a highly ambitious project.

Did you stress your balance sheet against a scenario where the wholesale funding markets closed down?

Nomura:

Yes. Balance sheets stress tests are run monthly by the Global Treasury Department. These stress tests have been a key component of Treasury policy for many years. One of the main scenarios embedded in these tests is a complete closure of the wholesale funding markets.

Goldman Sachs:

The firm's stress test for liquidity purposes includes the risk that financing sources are disrupted ... GS liquidity policy is based upon an ALM structure that assumes a crisis environment and we are pleased to see many of the aspects of our liquidity policies as part of a proposed new framework ... We recognise the need for more co-ordinated, common and regular liquidity reporting to enable the FSA to view the market as a whole.

Credit Suisse:

We stressed for a reduction in the availability of secured wholesale funding market by modelling the implications of a two notch Credit Rating downgrade impacting the bank. We did not model for a complete close down in the secured funding wholesale markets ... We consider that our conservative funding strategy has enabled us to weather the market disruption since August 2007.

HSBC:

As part of its risk management policy, HSBC regularly applies a wide range of stress testing both on individual portfolios, business lines, legal entities and on the Group's consolidated positions. The Risk Management Meeting, Group Audit Committee and the Board receive a variety of regular and ad hoc reports on a number of key issues including stress testing results and recommendations.

HSBC's global policy is to manage our business on the basis of raising deposits first and lending second and not to be reliant on the wholesale markets for funding.

RBS:

RBS ran regular stress tests that included the scenario of no access to key wholesale funding sources. In reality, the duration of the disruption has been extreme and that extended impact was not fully factored into any stress models

Deutsche Bank:

Pre-crisis, we had not incorporated prolonged shut-down of the wholesale funding markets sufficiently into our liquidity stress-test modelling. Additionally, we had not factored in additional risks that subsequently became apparent including repudiation of collateral in the repo markets, non-fungibility of currencies and a large pipeline of ‘stranded' syndication. More broadly, we believe "state-of-the-art" large bank liquidity stress-testing tended to undertake these risks, which emerged for the first time in scale to the current crisis ... We have updated our liquidity stress-testing to incorporate new liquidity risk drivers, such as those identified above. We will endeavour to continue to update our liquidity risk models to reflect the most current thinking on liquidity risks.

Rothschild:

Our risk monitoring has specifically assessed the potential risk of an adverse Rothschild-specific liquidity event rather than a market-wide one. This is the basis for the liquidity stress scenarios and contingency funding plan that are formally in place. We adopt a Rothschild-specific approach for practical reasons given the difficulty of identifying the modelling variables for a market-wide event.

Lloyds TSB:

Lloyds TSB stress-tested its balance sheet against a variety of different scenarios impacting the wholesale funding markets. However, like most banks, we did not stress test against a complete closedown of the wholesale funding markets. Lloyds TSB also stress tested against several adverse economic scenarios.

Barclays:

We perform a number of stress tests, including downside scenarios that are materially worse than current conditions