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ERM and liquidity risk
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Liquidity risk measurement
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3
Liquidity risk mitigation
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4
Liquidity risk transfer
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5
Liquidity risk governance
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6
Liquidity risk communication
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7
Here’s what else to consider
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Liquidity risk is the possibility that a company cannot meet its short-term obligations due to insufficient cash or marketable assets. It can arise from various sources, such as mismatched cash flows, sudden withdrawals, market disruptions, or operational failures. Liquidity risk can have severe consequences for a company's reputation, solvency, and profitability. Therefore, it is essential to manage it effectively within an enterprise risk management (ERM) framework.
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1 ERM and liquidity risk
ERM is a holistic approach to identifying, assessing, and controlling the risks that affect an organization's objectives and performance. It involves aligning the risk appetite and strategy, enhancing risk awareness and culture, and integrating risk management across all levels and functions. Liquidity risk is one of the key risks that ERM should address, as it can affect the viability and sustainability of the organization. ERM can help to manage liquidity risk by providing a comprehensive and consistent view of the sources and impacts of liquidity risk, establishing clear roles and responsibilities, setting appropriate limits and policies, and monitoring and reporting the liquidity position and performance.
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2 Liquidity risk measurement
One of the most effective tools for managing liquidity risk in ERM is to measure it accurately and regularly. Liquidity risk measurement involves estimating the cash inflows and outflows under various scenarios and time horizons, and comparing them with the available liquidity sources and buffers. There are different methods and models for measuring liquidity risk, such as cash flow analysis, liquidity gap analysis, liquidity ratio analysis, stress testing, and scenario analysis. Each method has its advantages and limitations, and the choice of method depends on the nature and complexity of the business, the data availability and quality, and the regulatory requirements.
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3 Liquidity risk mitigation
Another effective tool for managing liquidity risk in ERM is to mitigate it proactively and strategically. Liquidity risk mitigation involves taking actions to reduce the exposure and impact of liquidity risk, such as diversifying the funding sources and maturities, maintaining adequate liquidity reserves and contingency plans, hedging the currency and interest rate risks, optimizing the asset-liability management, and enhancing the operational efficiency and flexibility. Liquidity risk mitigation should be aligned with the risk appetite and strategy of the organization, and should consider the trade-offs between cost, profitability, and risk.
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4 Liquidity risk transfer
A third effective tool for managing liquidity risk in ERM is to transfer it partially or fully to other parties, such as banks, investors, or insurers. Liquidity risk transfer involves shifting the responsibility and burden of liquidity risk to those who are willing and able to bear it, for a fee or a premium. There are different instruments and mechanisms for transferring liquidity risk, such as lines of credit, repurchase agreements, securitization, derivatives, or insurance. Liquidity risk transfer can help to improve the liquidity position and performance of the organization, but it also involves counterparty risk, moral hazard, and regulatory constraints.
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5 Liquidity risk governance
A fourth effective tool for managing liquidity risk in ERM is to establish a robust and effective governance structure and process for overseeing and controlling liquidity risk. Liquidity risk governance involves defining the roles and responsibilities of the board, senior management, risk committee, risk function, business units, and external stakeholders, and ensuring that they are accountable and transparent. Liquidity risk governance also involves setting the risk appetite and tolerance, the risk policies and limits, the risk reporting and escalation, and the risk audit and review. Liquidity risk governance should foster a strong risk culture and awareness, and ensure that liquidity risk is integrated and aligned with the overall ERM framework and strategy.
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6 Liquidity risk communication
A fifth effective tool for managing liquidity risk in ERM is to communicate it clearly and timely to the relevant internal and external parties, such as regulators, investors, customers, and employees. Liquidity risk communication involves disclosing the liquidity risk profile, position, and performance of the organization, as well as the liquidity risk management policies, practices, and actions. Liquidity risk communication should be accurate, consistent, and comprehensive, and should comply with the regulatory and market standards and expectations. Liquidity risk communication can help to enhance the credibility and confidence of the organization, and to manage the expectations and perceptions of the stakeholders.
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7 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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