A financial institution’s stress testing in conjunction with supervisory review – is essential to strengthen financial resiliency to adverse scenarios but how can you prepare for the impact of unpredictable consumer behaviour?
The financial crisis in 2007-2008 brought with it global upheaval, but it also brought reform. In the aftermath, the Basel Committee on Banking Standards (BCBS) published the Basel III framework attempting to strengthen some of the weakness in the current banking sector exposed by the crisis. These included the introduction of the now-ubiquitous regulatory liquidity ratios, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) to ensure financial institutions;
(i) held assets that could be easily converted to cash with minimal loss of value during a time of stress and;
(ii) fund their activities from stable, less-volatile sources of funding seeking to avoid some of the events that unfolded during the crisis, including the first bank run in Britain in 150 years, where customers queued on masse to withdraw their funds from Northern Rock.
Banking, by nature, has inherent liquidity risk. The fundamental principle of ‘maturity transformation’, the process of borrowing short to lend long, means institutions have to maintain a buffer of liquidity to enable meeting all short term obligations as they fall due. These obligations can range from facilitating customer withdrawal requests to honouring lending commitments, but will also include any other cash outflows such as funding management expenses and capital expenditure. Under normal circumstances these can be accurately predicted but adverse conditions makes it increasingly difficult to anticipate due to the behavioural element of an institutions customer base.
Assessing risk through liquidity adequacy
In an attempt to regulate, and in addition to prescribed regulatory metrics, banks are required to assess their liquidity adequacy against a range of potential adverse scenarios beyond the prescribed regulatory metrics. In the PRA rulebook, institutions are formally required to consider scenarios that could plausibly arise, including Institution-specific scenarios, market-wide scenarios over varying time horizons. Yet, despite lessons learned and the strengthening the regulatory framework, 15 years on from the financial crisis, two internationally active institutions have failed recently with both institutions experiencing a run where depositors sought to extract their funds as quickly as possible! This underlines the importance of how institutions satisfy themselves and regulators of their liquidity adequacy. The key challenge in assessing liquidity adequacy is in quantifying the risk . For example, the stock of high quality liquid assets divided by the net outflows of an institution over a prescribed 30 day stress horizon – Institutions have control over the numerator, but cannot directly control the denominator.
The impact of human behaviour and public opinion during a liquidity crisis
Another key area, and possibly the most critical aspect, for an institution modelling a stress scenario is anticipating how their depositors will behave during the scenario. Northern Rock experienced the first UK bank run in 150 years in 2007, with customers queuing outside of branches to withdraw their money from the bank in fear of the security of their funds. One of factors that fuelled the bank-run was the media reporting of the bank’s situation, in particular their request to the Bank of England for emergency funding. This should clearly highlight the risk of the role human behaviour and public opinion can have during a liquidity crisis and it should also be noted that this risk could potentially crystallise based on misconception or misinformation.
The evolving role of technological and societal changes to bank runs
In Michael J. Hsu’s recent 2024 speech at Columbia Law School “Building Better Brakes for a Faster Financial World” he noted several factors that, following observations on the bank runs on Credit Suisse and SVB, have highlighted how bank runs have changed. One of these factors he noted was the speed that outflows can happen. SVB, for example, experienced 25% of their uninsured deposits in one day, an uplift on previous observed outflow rates around the financial crisis. Expanding on Hsu’s observation, there are likely a number of factors for this, both technological and societal:
- Consumer adoption of mobile banking means that customers no longer have to queue outside branches, people are able to quickly, easily and confidently move money between banks from their own devices.
- Evolution of social media has changed how news is shared, consumed and responded to. It is, therefore, easier for information / misinformation to spread and in an unregulated way, unlike traditional news outlets and this can potentially result in an increased ‘herd mentality’ accelerating customer outflows.
- Simplification of the onboarding process for customers makes it easier for customers to open accounts and move deposits around.
Considering how these aspects have evolved since the financial crisis, this should serve as a reminder that much of the accepted prescriptive regulatory metrics have not been recalibrated to take account of how banking, technology and society has developed since its implementation. For example, in the LCR an uninsured deposit would expect to receive an outflow of 10% over the 30 day horizon. Even taking SVB’s unique deposit base into account, their observed 25% uninsured outflow in a day highlights a risk that retail deposits – generally seen as a quality and sticky source of funding at a macro level – could be vastly under-calibrated for the risk at a micro level and that proactive boards, ALCO and ALM practitioners should seek to challenge their assumptions around the speed and the severity of a stress scenario they are assessing their balance sheet against. Hsu’s conclusion is that more targeted regulation is required to address the lessons learned from the recent bank failures seems inevitable, especially as technologically the banking industry continues to evolve at increasing pace and, by extension, the risk to institutions ability to manage their liquidity position effectively in an increasing real-time world.
Liquidity risk is a complex area of Treasury Risk Management and can be difficult to quantify the level of risk an Institution is exposed to. Technological advancements and social developments continue to change how the next liquidity crisis may play out. While prescriptive regulatory metrics continue to improve standardisation, it doesn’t address all risks to an institution’s liquidity. An Institutions own stress testing – in conjunction with supervisory review – it is essential to explore an Institution’s resiliency to adverse scenarios.
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About the Author
Stuart Fairley is the Head of Client Experience at ALMIS® International and works closely with clients in his role. Prior to joining ALMIS® in 2019, Stuart had spent most of his career working in the bank and building society sector and holding a number of finance and project roles. Stuart is a also member of the Chartered Institute of Management Accountants (CIMA).
