New paradigm for liquidity risk management in Africa
To understand the importance of liquidity risk, it is important to understand the concept of what it entails. Liquidity risk can be defined as the risk where a banks’ financial position, or existence, can be adversely affected by the inability (whether real or perceived) to meet its cashflow obligations. Liquidity risk is therefore inherent in any banking business, given a banks’ fundamental role in facilitating maturity transformation between assets and liabilities.
Liquidity risk gained unprecedented notoriety following the 2007 global financial crisis, where the unfolding crises exposed several weaknesses in banks’ risk management practices, particularly in the traditional liquidity management frameworks. One of the key issues identified was the inadequacy of bank risk management practices to predict and manage liquidity risk. Subsequent to the aforementioned financial crisis, international and national Regulators placed focus on establishing more robust liquidity risk management frameworks for banks. Regulators across Africa followed suite, in strengthening liquidity framework requirements for banks across the continent. Despite the latter, progress has not been uniform, and implementation of the necessary requirements lag more advanced economies; a factor informing the pace of implementation is the fact that liquidity risk is generally seen as the ‘poor cousin’ of market risk and credit risk, and as a regulatory requirement.
With the onset of the COVID-19 pandemic, banks across Sub-Saharan Africa (SSA) entered a new and demanding period for risk management, with banks having to contend with volatile financial markets, and uncertainty around current and future revenues, and cash flow. Most banks across SSA entered the pandemic in a relative strong position, with high capital and liquidity ratios, with many banks weathering the immediate pressure and impact of the pandemic well, thanks to, amongst others, various regulatory crisis policy relief measures. Despite the latter, the pandemic reinforced the salience of liquidity risk management, aimed at ensuring stability and performance of banks. Banks however remain in relatively unchartered territory, with further challenges ahead. It would therefore be remiss of banks to assume that simply because they have survived the storm to date, that they are well-positioned to weather the ongoing COVID- 19 pandemic and the challenges this may elicit on the road ahead.
Going forward it is imperative that liquidity risk be prioritised by the bank boards as a strategic priority. Liquidity risk is impacted by other, traditional risks and thus should not be viewed as a ‘siloed’ approach, when reviewing the banks risk profile. Vulnerabilities in SSA banks are evident in several areas, heightening the importance of a robust liquidity risk management framework within the banks’ Enterprise Risk Management framework. SSA banks are generally characterised by high deposit and portfolio concentration risk, with bank lending activities typically focused on a few key sectors, and a limited number of large corporates, with short-term deposits accounting for a significant share of the financing base of most banks’ loan portfolio. Until recently, Government moratoria, and other crisis-response policy measures, have masked non-performing assets, suggesting that further upside credit risks are lurking on the horizon, especially within portfolios in highly concentrated sectors, impacted by the pandemic. Though concerns pertaining to credit portfolio risk have not (yet) necessarily morphed into liquidity strain for banks, declining credit quality may exacerbate stress on banks’ liquidity levels within the coming months.
Considering the above, it is critical for banks to revisit the effectiveness of the liquidity management processes, and supporting technologies, taking advantage to increase capabilities for reporting, analytics, and stress testing, and align to international good market practice. Banks capable of enhancing their liquidity risk management framework (not only for regulatory compliance purposes) will be better positioned within the ‘new normal’ to assist their respective organisations to manage, gain a competitive advantage, and survive the volatile market it operates within. Success will be underpinned through robust cashflow forecasting, stress testing, transparent and timely reporting, and overall, strategic liquidity management.
Compiled by Carla Bester, Arise Risk and Compliance Officer