The Liquidity Risk Management Guide: From Policy to Pitfalls

5 The Appropriate Liquidity Framework – Introduction to the ‘6 Step Framework’

After discussing liquidity on a rather theoretical note we arrive at the heart of the book, which is to be the practitioner's guide to liquidity management in banks. This chapter, and the following ones, focus solely on the application of liquidity management and the different tools applicable. It is possible to apply the methods laid out in this chapter without having piled through the previous chapters, but a good practitioner should have a fundamental understanding of the various shapes of liquidity risk and how it can manifest itself. By going directly into the application and trying to follow ‘if A happens, then do B’, one is at risk of not having fully understood the risk presented within the bank.

All risk mitigants rely on assumptions and it is only by applying a top-down approach with a wider set of information that one can accept the assumptions to be the most adequate. This is not just a general health warning but has been a major source of some of the larger liquidity scares. The most recent financial crises demonstrated how the different approaches and assumptions resulted in failure of some banks and the survival of others.

5.1 SETTING THE STAGE – FROM POLICY TO A PRACTICAL FRAMEWORK

It is key to pick the appropriate starting point when building a liquidity risk framework. It can be tempting to take a short-cut and simply pull up some widely known metrics and apply them to a bank ...