The asset management industry is expecting a wave of liquidity risk regulation. Ever since the Financial Stability Board (FSB), an advisory body of the G20, identified liquidity risk as one of the most critical ways asset management may threaten the stability of the global financial markets, regulators have been preparing guidelines and recommendations for the industry.
Meanwhile, asset managers are becoming increasingly aware that their current approach to managing liquidity risk is no longer adequate to meet today’s challenges. Recent developments have underlined the need for in-depth discussion as to how liquidity risk management can be handled effectively. We have thought about this question carefully and have come up with our own framework.
A discussion about liquidity risk management frameworks should begin with a definition as to exactly what liquidity risk is. We apply a rather unorthodox definition of liquidity risk. We differentiate between episodic liquidity risk and incremental liquidity risk. Episodic liquidity risk is the risk that it will not be possible to sell assets quickly or cost-efficiently enough to meet funding obligations. Incremental liquidity risk is the risk that subscriptions and redemptions in a fund will result in investor dilution, due to the associated transaction costs for the fund.
That side of liquidity risk is often overlooked. You might say that incremental liquidity risk is the silent assassin of fund performance and investor returns. To be considered effective, a liquidity risk management framework should prevent and mitigate episodic and incremental liquidity risk. Ex-ante liquidity risk management tools help prevent the liquidity risk from arising in the first place. If it does occur, ex-post liquidity risk management tools help mitigate its impact.
A liquidity risk management framework should also include tools to address extraordinary liquidity risk and the associated governance. The decision to use extraordinary liquidity risk management tools should not be taken lightly. Measuring, monitoring and mitigating liquidity risk are key parts of the liquidity risk management framework. In our approach, monitoring liquidity risk comes down to one formula: liquidity supply minus liquidity demand equals the liquidity surplus or shortfall.
The result of the monitoring is translated into a portfolio liquidity risk severity score that is easy to understand. Measuring and monitoring liquidity risk comprehensively does not have to increase the complexity of the procedures already in place. We believe this framework is complete and comprehensive and will be able to weather the storm of liquidity risk regulation brewing on the horizon.
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