4. Liquidity Risk Identification, Measurement and Management
Finance companies should have a sound process for identifying, measuring, monitoring and managing liquidity risk. This should include a robust framework for systematically projecting cash flows arising from assets, liabilities and off-balance sheet items over appropriate time horizons.
4.1 Identification of Liquidity Risk
A finance company should identify and document all liquidity risk it is exposed to, in the short and long term, arising from company-specific or market-wide events. In the process of identification, the company should identify and recognize each significant on-and off-balance sheet position that can have an impact on its liquidity in normal and stressed conditions. The company should consider the types of events that can expose it to liquidity risk including the impact of other financial risks such as credit, market and operational risks.
Liquidity risk can also arise due to failure or weaknesses in business decisions and company policies, including shortcomings in business strategy. Indicators of liquidity risk, inter alia, may include a high concentration in particular asset or liabilities, asset-liability maturity mismatches, deterioration of the company's financial conditions evident from decreased earnings, deterioration in asset quality and credit rating, increased funding costs and collateral requirements, rapid growth in assets funded with less stable sources of funding, repeated instances of approaching or breaching tolerance limits and deterioration in market indicators (e.g., share price) that are correlated with the financial condition of the company.
A finance company should identify incidents that can negatively influence its perception in the marketplace about creditworthiness and fulfillment of its obligations and hence leading to liquidity risk.
4.2 Measurement of Liquidity Risk
Finance companies should have documented and well tested methodologies for measuring liquidity risk which are updated on regular basis to reflect changing market conditions. For measuring liquidity risk, a finance company may use a range of measurement techniques, time horizons and levels of granularity.
A finance company should be able to measure and forecast its future cash flows arising from all of its positions, whether on-or off-balance sheet, over a range of time horizons in order to assess its exposure to changes in cash flows and liquidity needs over time, considering the composition of its balance sheet. These time horizons range from weekly and monthly for short-term liquidity assessments, up to one year for medium-term, and over one year for longer-term assessments.
Finance companies should use an appropriate method to calculate the net funding requirement. Companies may use cash-flow mismatch or maturity gap for calculating the net funding requirement, which is based on an estimation of the amount and timing of future cash flows with respect to contractual or expected maturity. The calculation of net funding requirements involves the construction of a maturity ladder to analyze prospective cash flows based on assumptions of the future behavior of assets, liabilities and off-balance sheet items and then the calculation of a cumulative net excess or deficit in funding at a series of points in time. The negative maturity gaps or deficits indicate the level of liquidity a company would possibly need to raise in each of the time bands if all outflows occurred at the earliest possible date.
In order to ensure the reliability of the forecasting process, finance companies should implement appropriate internal controls on data aggregation and processing including validation and plausibility checks. Finance companies should also ensure that the assumptions it makes are practical, realistic and properly documented. The validations and back-testing results should be properly documented and communicated to senior management.
Finance companies should set limits for controlling liquidity risk exposure and ensure that they do not have a level of outflows which cannot be funded in the market, taking account of their risk tolerance and historical record. Depending upon their size, nature of operations and business model, finance companies may set internal limits on funding concentrations, discrete or cumulative cash flow mismatches or gaps over time horizons and stress scenarios, cash flow coverage, liquidity buffers, cost of funding, liquid assets ratio, counterparty exposures and undrawn commitments, etc.
Finance companies using originate-to-distribute business models, relying on securitization markets as a source of continual funding, should also consider setting limits on the size of their loan inventory pipeline, since securitization markets may become unreliable during stressed periods.
4.3 Management of Liquidity Risk
Finance companies should establish a funding strategy for effective diversification in the sources and tenor of funding. Companies should establish strong relationship with fund providers and presence in different funding markets to ensure continued access to diversified and reliable funding sources. The company should frequently assess its ability to raise funds quickly from each funding source and should identity the key factors affecting this ability and monitor them closely to ensure that the assessment of fundraising capacity remains valid.
A finance company should maintain a cushion of unencumbered high quality liquid assets as a readily available source of funding to meet unexpected net cash outflows and survive a liquidity stress event. Availability of sufficient stock of high quality liquid assets allows the company necessary time to access alternative sources of funding until other longer term measures can be implemented. Assets are considered to be high quality liquid if they can be easily and immediately converted into cash at little or no loss of value. The liquidity generating capacity of these assets is assumed to remain intact in periods of market stress, in addition to ease and certainty of valuation and low volatility in prices.
In determining the appropriate level of liquid assets relative to the company's liquidity risk profile, finance companies should consider, among other things, the stability of funding sources, cost and diversity of funding (companies with higher funding costs compared to similar peers and/or those that rely on a limited number of funding sources may need to hold a larger stock of liquid assets), short-term funding requirements (companies with a funding mix geared towards shorter term maturity of liabilities should hold a larger stock of liquid assets) and contingent funding needs.
Assets normally pledged to secure specific obligations should be excluded from the stock of liquid assets that are available to meet unexpected cash shortfalls.
Finance companies should ascertain their collateral needs for secured funding to manage their liquidity over various time horizons in both normal and stressed times. A finance company should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. Unencumbered assets have the potential to be used as collateral to raise additional secured funding in secondary markets and as such may potentially be additional sources of liquidity for the company.
SAMA may also impose specific limits for controlling liquidity risk exposure of finance companies as and when deemed necessary.