What do you think is a bigger trigger for liquidity risk: a banks own lacuna or the failure of the financial system? It is hard to say. However, a Bloomberg article, The $3 Trillion Bond Trade Citigroup Says Investors Should Fear, leads us to believe that it is more often due to a systemic fissure than an organizational failure.
A close look at the US bond market brings to the fore the prominence of three types of buyers: mutual funds, foreign investors, and insurance companies. In the event of an increase in interest rates, the market might witness an unimaginably widespread selling by these three entities, thus leading to evaporation of the systems liquidity.
To combat the liquidity risk that stems from a systemic failure, central banks need to keep their financing windows open to fund the cash-strapped banks. In that case, regulators must have clear visibility into the quantum of liquidity required by banks. They should see if a 30-day stress period (prescribed for calculation of liquidity coverage ratio as per Basel III liquidity risk management guidelines) is enough for banks to manage liquidity positions. In case it isnt, how should a regulator handle the situation? If monetary circumstances warrant an increase in interest rates, should they go ahead with that or keep the issue in abeyance to avoid a potentially massive sell-off by a few, large bond investors? A dilemma, isnt it?
A way out could be to have banks estimate their cash outflows under organization-specific and market-wide stress scenarios. In an organization-specific scenario, the bank in question could employ various counterbalancing strategies like the sale of marketable securities, accessing a line of credit from other financial institutions, or raising repo borrowings. However, in the case of market-wide scenarios, holding a liquidity position will be tricky for banks. What should be the counterbalancing strategy for a bank in such a situation should it sell its marketable securities like bonds? Given the precarious condition of the bond market dominated by a few investors, this doesnt seem probable; the only option is to seek support from central banks.
Central banks offer Committed Liquidity Facility (CLF) to banks in need of liquidity. For instance, APRA (Australian Prudential Regulatory Authority) approved Westpacs access to AUD 66 billion by the CLF, for the 2015 calendar year.
If liquidity risk is more systemic in nature, even the stronger banks would face a crisis due to their inability to raise funds. With all banks looking up to the central bank as the rescuer, evaluating the magnitude of the support needed is a daunting task. To address this, both banks and central banks might need to include a stress scenario pertaining to evaporation of liquidity due to market dominance by a few players, and assess its impact. Such a stress scenario can shed more light on volatility and saleability of traded instruments, and the eventual shortfall in liquid positions. As part of the stress-testing exercise, banks can define multiple scenarios with shocks of varying magnitudes to variables such as market concentration (by player, by liquid instrument, and so on), and how that impacts the prices of traded instruments. This allows banks to measure the quantum of support sought from the central bank and justify their funding requirements.
Risk practitioners can help define and periodically review market-wide stress scenarios, carry out stress tests to see the impact on the liquidity position, and dynamically reorient risk policies based on the outcome of such tests. In addition, there should be an inter-regulatory body with representations from various regulators for banks, insurance companies, pension funds, and so on. This agency may monitor the regulated entities and restrain them from building concentrated positions in the market, in order to keep a potential systemic risk at bay.