Liquidity and funding risk management
Liquidity and funding risk management
This domain tests whether a firm can meet cash outflows as they fall due without unacceptable losses. Expect questions on maturity mismatch, the liquidity coverage ratio, the net stable funding ratio, stress testing, contingency funding plans and APRA APS 210 requirements.
Core rules and concepts
- Funding liquidity risk is the inability to raise cash; market liquidity risk is the inability to sell assets without moving prices. The two interact in a stress event.
- The LCR requires high-quality liquid assets (HQLA) to cover net cash outflows over a 30-day stress period: LCR = HQLA / net cash outflows, minimum 100%.
- HQLA is split into Level 1, Level 2A and Level 2B with haircuts and caps. Level 2 assets are capped at 40% of HQLA and Level 2B at 15% of total HQLA.
- The NSFR promotes stable funding over one year: NSFR = available stable funding / required stable funding, minimum 100%. Long-dated illiquid assets require more stable funding.
- Stress testing should combine idiosyncratic, market-wide and combined scenarios. A contingency funding plan sets triggers, actions and responsibilities.
- APS 210 requires authorised deposit-taking institutions to maintain liquidity and funding policies, stress testing, and a board-approved contingency plan.
Worked example
A bank holds $120 million of eligible HQLA and estimates $100 million of net cash outflows over 30 days. LCR = 120 / 100 = 120%, so it is above the minimum. In a stress scenario outflows rise to $130 million while HQLA stays at $120 million. LCR falls to 92.3%, a breach. Management must sell less liquid assets at a discount, draw on committed facilities or reduce outflows. The reasoning shows that the LCR is a stress ratio, not a current cash balance, and that asset quality and run-off assumptions drive the result.
Traps that cost marks
- Treating the LCR as a solvency measure; it addresses short-term cash stress, not capital adequacy.
- Counting all securities as HQLA without applying haircuts, issuer limits, caps and operational requirements.
- Mixing the LCR's 30-day horizon with the NSFR's one-year horizon.
- Assuming a contingency funding plan substitutes for holding liquidity; it supports execution but does not create eligible assets.
- Ignoring intraday liquidity and collateral calls, which can cause failure even when the 30-day ratio looks adequate.