Building a robust liquidity risk framework

Early responses to COVID-19 were focused around liquidity. Here, Naresh Aggarwal looks at risk appetites and the assurances treasurers can provide 

We’ve all heard the adage ‘never waste a good crisis’, so now is perhaps a good time to look at the various activities treasurers will have been performing since the start of the pandemic.
For many companies, the past few months will have highlighted at an operational level whether there was sufficient liquidity in their businesses. We know from our conversations with treasurers that they have been:

• undertaking more frequent cash forecasting;
• reviewing the aged debtors ledger to resolve long-standing queries; and
• drawing on liquidity resources (such as bank revolving credit facilities) concentrating balances held in accounts both domestically and overseas, and balances held in money market funds.

Now that the initial crisis is over, there is a good opportunity to build a more robust liquidity risk management framework. There are a number of key scenarios that organisations should consider (listed below). The list is not comprehensive, but should reflect how other areas of risk are managed in your company.

Identifying risk appetite

Broadly speaking, risk appetite is a measure of how risk averse the board is – ie identifying the balance between risk and return. There is no standard approach to defining risk appetite, but one common measure is to assume no revenues from any sources and to focus on what the outflows could be. A number of different scenarios can then be considered:

• assume no customer receipts;
• assume a stressed environment where normal trading terms were accelerated, for example, moving to cash on delivery of goods or services; or
• assume an increase in the costs of goods sold either due to transport costs rising or the underlying raw materials rising in price.

Each scenario (or indeed a combination) allows the business to identify its minimum liquidity needs and create a range of different funding requirements. This range of outcomes can be used to identify the risk appetite of the organisation and in turn be used to develop a liquidity risk policy that articulates the cost the board is prepared to pay (such as non-utilisation fees) to provide the comfort that liquidity is available when needed.

Companies may also wish to undertake reverse stress testing. The purpose of this test is to start with the liquidity that is available and to then work backwards and determine how many months of no income and only outflows the company could survive for. This is sometimes an easier metric for the board to consider, as it determines how quickly a resolution plan would be required – if at all.

Companies may choose to develop contingency liquidity plans that allow them to access additional liquidity through, for example, raising funds on securitised assets, invoice discounting facilities or even possible insurance. Although these options may be more expensive, they give the board additional comfort over available liquidity.

Testing available liquidity: practical challenges in accessing liquidity

Most treasurers have already checked that their back-up facilities are available for drawdowns and resolved any unexpected issues. We have heard of cases where the drawdown request required the signature of an individual who had been replaced or where certified specimen signatures were not available. Some facilities may require certain conditions to be satisfied prior to drawing, and it is important to check that loan agreements are fully reviewed to ensure they can genuinely be called upon with the notice that the board expects. 

If certain facilities require wet signatures from two individuals, how practical is this in the event of a severe market disruption? To mitigate these challenges, I know of a couple of companies that deliberately drew down all of their facilities prior to the lockdown to avoid any such operational challenges. 

Documentation: learn from the experience

The past few months will have forced many companies to have undertaken tasks or exercises that were not planned. It is important to review these and to document the actions taken where possible and with the right level of detail. 

Although it can be argued that we are unlikely to see another shock to the degree most people experienced in March, there are key learnings that will help companies mitigate any future black swan event and provide a foundation for the board to monitor and regularly review the adequacy of its liquidity risk-mitigation policy.

Summary

Now is a good time to take stock of how your company has identified and managed its liquidity risk. Documenting steps taken and key learnings will be important components when it comes to creating or updating any liquidity policy or standard and help improve the overall controls regime. 

Other resources

Planning liquidity requirements during the COVID-19 crisis, by Naresh Aggarwal

Liquidity Risk Management for Insurers, Policy Statement from the Bank of England Prudential Regulatory Authority

About the author

Naresh Aggarwal is associate director of policy and technical at The Association of Corporate Treasurers