Liquidity and funding risk
INSIGHT ARTICLE |
It has been over eight years since the financial crisis in 2008. And it is fair to say that liquidity risk played a large role in broker-dealer failures. Not surprisingly, liquidity risk is getting a lot of attention from several regulatory and governing bodies.
Let’s summarize recent regulatory guidance and their impact on recent examinations for two principal regulators:
In 2010, the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 10-57, Funding and Liquidity Risk Management Practices, which stipulated that they expect broker-dealers to develop and maintain robust funding and liquidity risk management practices to prepare for adverse circumstances, be it firm-specific events or systemic credit events.
In 2015, FINRA released an updated Guidance on Liquidity Risk Management Practices, where it stated that FINRA reviewed 43 firms’ plans for readiness and addressing liquidity during financial stress. FINRA also issued Regulatory Notice 15-33, Guidance on Liquidity Risk Management Practices, where it reported that six firms reviewed could not demonstrate sufficient knowledge and understanding of the impact of the liquidity stressors on their business, or could not survive 30 days without running out of liquidity. The guidance also reported that four firms did not have committed loan facilities in place, nine firms would have difficulty responding to customer withdrawals and 10 firms would have difficulty funding firm inventory.
In 2017, FINRA again re-emphasized the importance of liquidity risk and stated that it would be a focus of their examinations.
SEC (Investment companies)
In 2016, the Securities Exchange Commission (SEC) finalized rules designed to promote effective liquidity risk management throughout the open-end investment company industry, thereby reducing the risk that funds will be unable to meet redemption obligations. The rules also enhance disclosures regarding fund liquidity and redemption practices and require open-end mutual and ETF funds to establish a liquidity risk management program.
As it relates to other funds (closed-end), the SEC has included liquidity and redemption risks as part of its examination of registered investment advisers.
All financial services entities need to continually focus on and update their liquidity risk management procedures, including annual assessments of such procedures in light of current markets and annual stress testing, potentially by a third party. This process should include the following:
- Are the liquidity reserves adequate? Is there sufficient cushion?
- Are the reserves’ maturities long enough?
- Are third-party lines of credit really available during a crisis? Are they irrevocable?
- Have you considered increasing margin or collateral requirements by exchanges and counterparties?
- Have you thought about international regulations, economies, exchanges and counterparties?
Doing so prepares all entities for regulator examinations and also for ever-increasing investor initial and on-going due diligence. Industry entities should almost consider this to be a best practice in a very competitive capital raising environment. One additional thought–entities should also monitor the liquidity risk management procedures of any broker or counterparty they are doing business with.