Liquidity Risk Management Strategy and Tolerance

Emrah Arbak

The 2007–9 financial crisis showed that financial institutions should have active strategies to manage their liquidity and funding risks. In developing such strategies, financial institutions should describe how much risk they are planning to take and what to do when these levels of risk, ie, their risk tolerance thresholds, are breached. The development of such a system is a function of the business model of each institution. Banks that rely heavily on short-term wholesale debt have to frequently roll over this stock at market prices, which exposes them to funding risk. In contrast, banks that are more retail oriented are less subject to a rollover risk but may be exposed to the risk of retail bank runs.

Market conditions also matter. For example, certain types of strategic responses that could be possible in relatively benign conditions may not be optimal, or even viable, in more difficult times. In turn, when market conditions improve, institutions may want to take on more risk in certain areas. Either way, the strategic framework should be flexible and incorporate, as far as possible, the dynamic nature of decision-making under uncertainty.

The aim of this chapter is to