Augmenting fund risk management with liquidity stress testing - Banking blog

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The asset management industry has shown its resilience over the past decade and during the recent March sell-off. However, according to the joint committee report on risks and vulnerabilities in the EU financial system, published in September 20201, some sectors of the industry have struggled with redemption requests during the COVID-19 crisis. Bond fund outflows reached record highs during this period, amounting to 4% of the sector Net Asset Value (NAV). This follows prominent fallouts in previous years of various asset managers, and as a result fund liquidity has become a top priority for the entire fund industry.

In parallel, regulators across Switzerland and the EU have been tackling the liquidity issue by developing new regulatory requirements. In the EU, ESMA introduced a requirement having come into force at the end of September 2020 for asset managers to develop a comprehensive Liquidity Stress Testing (LST) framework for funds. In Switzerland, FINMA has carried out a consultation on a new financial institutions ordinance (FINIO-FINMA) requiring liquidity stress testing, currently expected to be adopted by end 2020.

The changes to the regulatory framework: Liquidity stress testing

In the EU, the ESMA guidelines on liquidity stress testing by UCITS and AIFs, applicable from September 30, 2020, cover the design of liquidity stress tests, including assets and redemptions modelling, and also the build-up of associated governance measures (e.g., integration of liquidity stress test results into investment decision making) and validation of the stress test modelling approach.

In Switzerland, FINMA drafted a new financial institutions ordinance (FINIO-FINMA) referring explicitly to Recommendation 14 of the IOSCO guidelines (Recommendations for Liquidity Risk Management for Collective Investment Schemes, February 2018) for asset managers to conduct ongoing liquidity assessments in different scenarios, including fund level stress testing.

How to build a liquidity stress testing framework

Building a robust liquidity stress testing procedure involves the following measures.

  1. Risk identification: Portfolio managers need to identify liquidity risks and vulnerabilities for the different types of funds. Quantitative methods and expert judgement can be combined to identify the relevant risk factors.
  2. Scenario generation: Once the stress testing severity has been decided, scenarios should be generated using historical and hypothetical simulations (using a Monte Carlo approach and testing defined scenarios).
  3. Stress loss calculation: The calculation of losses in the simulations or stress tests will apply to both assets and redemptions.

    1. On the asset side, liquidation strategies with horizontal or vertical slicing provide ways to balance expected returns and liquidation costs. Key metrics such as market depth and market impact can be used to obtain a view on liquidation costs at both individual security and portfolio level.
    2. On the other side of the balance sheet, the redemption distribution should be based on specific characteristics of the investors (concentration, investor type, country), and the post-COVID experience
  4. Aggregation and output: The results of the first stress testing simulations should be used as a basis for defining risk appetite and liquidation strategies, and to identify less liquid securities.

Embedding LST into the organisation

Once liquidity stress testing has been implemented, its effectiveness relies on how successfully it is integrated into the organisation. The governance framework should include:

  • Setting limits and risk appetite, for example limits on illiquid assets, concentration of assets and counterparty credit risk
  • Setting up an early warning system for predicting liquidity shortfalls and design procedures for responding to a liquidity shortfall
  • Integrating liquidity risk within the investment decision process (volume, transaction size, bid/ask spreads, volatility, sensitivities, expected returns)
  • Defining roles and responsibilities and creating a business environment in which liquidity metrics are used to take informed investment decisions
  • Using liquidity management tools, such as redemption fees, gates, swing pricing, dealing frequency, redemption in kind, setting up bank borrowing facilities

Liquidity stress testing governance framework

Figure 1: Liquidity stress testing governance framework (source Deloitte)

Leveraging LST to add value to the business strategy

Liquidity stress testing can be leveraged as a powerful tool to safeguard a fund’s performance through:

  • Basing liquidity strategy decisions on the outcome of the liquidity stress scenarios, by deciding which assets to liquidate and how (e.g., vertical vs horizontal slicing). A fund manager should aim ideally to maintain favored positions even though they would be the most liquid.
  • Comprehensive liquidity dashboards, of liquidity metrics on the asset side, and simulations of both the assets and liability sides showing, for different scenarios, liquidation costs and resilience indicators such as redemption coverage ratio (RCR), as illustrated in Figure 2.

Basing liquidity strategy decisions

Figure 2: Forecast of selected fund profiles (cash flows, NAVs, and liquidity cost) for a given market and redemption stress scenario (not shown). (Source Deloitte)

Conclusion

Liquidity stress testing is becoming a regulatory requirement across continental Europe, but it is also a crucial risk management activity with the potential to improve a fund’s performance. The current uncertainty fueled by prospects of a second wave of COVID-19 and the recent upsurge in volatility in financial markets could have an adverse impact on fund portfolios. In addition to fulfilling the regulatory requirements on liquidity stress testing, asset managers are advised to focus on optimizing their funds’ liquidity profile and explore specific scenarios to ensure they are prepared for potential disruptions.

Please contact Alexandre Favre-Bulle, should you want to find out more about liquidity stress testing.

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1 Joint committee report on risks and vulnerabilities in the EU financial system (ESMA, EBA, EIOPA, Joint committee of the European supervisory authorities, Source: European Securities and Markets authority, September 2020

 

Marcel Meyer

Marcel Meyer – Partner, Audit and Assurance

Marcel leads the Deloitte’s Investment Management practice for Audit & Assurance in Switzerland. He has more than 19 years of experience in auditing and advising domestic and international clients in the Investment Management industry. Marcel has worked extensively with regulated Swiss and Liechtenstein clients as well as alternative investment fund structures such as Private Equity and Hedge Fund managers.

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Alexandre

Alexandre Favre-Bulle – Senior Manager, Risk Advisory, Zurich

Alexandre has more than 16 years of experience in the financial industry covering asset and liability management (liquidity, funding and capital), as well as risk for banks and asset managers. Prior to Deloitte, he has worked for more than 10 years within UBS, mainly in treasury and risk across investment banking and wealth management. He holds an MSc in Physics from EPFL and an MSc in Finance from HEC - University of Lausanne.

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Ian De

Ian de Albuquerque – Assistant Manager, Risk Advisory, Zurich

Ian is a quant working on financial risk (including liquidity, credit, and market) within Deloitte's Financial Risk Management team. He has delivered projects at top tier Swiss banks in the context of CECL/IFRS 9 credit modelling and stress testing, at both model development and validation teams. He holds a Dr.sc. from ETH Zurich.

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