Guaranteeing liquidity is key to overcoming crises 

The current pandemic and economic shock have caused liquidity risk to loom over an unprecedented number of businesses, many of which are otherwise productive and robust. Without access to emergency liquidity – be that from funding markets or contingency funds – companies will cease to effectively function. Yet often, by the time the topic of liquidity is being widely discussed, it is too late; funding has been accessed en masse, quickly depleting sources and causing the bankruptcies of those slow to react.

Crises such as the European Debt Crisis and Global Financial Crisis have meant liquidity risk is most commonly associated with banks. Indeed, the current crisis has once again thrust liquidity risk amongst the financial industry into the spotlight, as when liquidity is not available, systemic risks materialize, but COVID-19 has, so far, not affected banks in the same way as a decade ago. Lessons learned during those crises and improved liquidity stress testing methodologies have made banks more robust and better able to weather shocks.

Instead, industries such as retail, hospitality and manufacturing are currently experiencing liquidity crises as they are hit by simultaneous crises of supply and demand. More often than not, these companies (Adidas, General Motors and so forth) are suffering from a less developed approach to liquidity stress testing, but there is a great amount they can learn from the banking industry’s approach, safeguarding them and the wider economy from the serious systemic risks of the future.

Reliable and robust liquidity stress testing with Danger Zone

Avoiding liquidity risks requires being able to identify and model trigger events – the Global Financial Crisis, COVID-19 and so forth – and liquidity risks, such as the state of funding markets and contingency funds, in order to make better-informed decisions. Proper liquidity stress testing is key to this, which is why BearingPoint developed the Danger Zone approach. Based on Bank of England research on modelling systemic liquidity crises, it allows you to identify the root causes and react appropriately.

Cost of funding in crisis time
We have helped banks across Europe implement the Danger Zone approach, which is now primed to help sectors beyond banking and finance. With it, you gain a data-based understanding of liquidity risk that can inform rapid action, but the right methodologies are required.

  • Danger Zone assumes each funding market has a critical point of funding availability.
  • Mapping internal and external liquidity factors, plus early warning indicators, onto funding market and business models allows you to parameterize and compare stress scenarios. The anticipation and identification of stresses were two of the most crucial priorities for banks we have worked with.
  • These can be assessed against historical liquidity events and external data and honed further.
  • You are then provided a view of a range of safe and critical scenarios.

Adaptable and effective stress testing methodologies

For liquidity stress testing to make an impact, it must be backed up by a well-established methodology that spans governance, processes, systems and data. This must be tested regularly and engrained into your business, so your staff can work efficiently and effectively when a crisis occurs.

Governance – Feedback from leadership regarding risk appetite, limits and strategies, and properly articulated roles and responsibilities that allow collaboration between risk and treasury units.
Processes – Liquidity risk identification, back testing and validation, and stress test reporting that can be properly integrated within normal and crisis-period management decision making.
Methods – Liquidity benchmarking, stress testing and analysis that can be rolled out in an instant and respond to ad hoc requests when required.
IT architecture – Access to high-quality scenario and assumption data, regulatory compliance and IT systems that are flexible and scalable.

By making sure your approach to liquidity stress testing is linked effectively throughout your business, you can not only quickly and flexibly respond to crises, but also optimize your costs and income during periods of stability.

Liquidity stress testing pyramid

The financial sector has long used this approach to liquidity stress testing and is experiencing the positive results during the current pandemic. If replicated across business and industry, testing will make companies stronger and more robust by alerting them to new economic dangers and inspiring fast and effective responses.

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Learn more about how liquidity stress testing can help your business survive periods of uncertainty and thrive afterwards – get in touch with our experts today.

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