Liquidity risk - Algorithmics advocates different metrics for different components of liquidity risk

London. Toronto - May 7, 2009 -

Algorithmics comments on liquidity risk in Basel II proposals

In its recent submission to the Basel Committee on Banking Supervision's consultative paper 'Proposed enhancements to the Basel II Framework', Algorithmics has focused on liquidity risk and the techniques necessary to effectively understand and manage the three specific risk components which are embedded within the broader category of liquidity risk.

Whilst strongly endorsing the Committee's overall view that the strengthening of supervision is necessary, Algorithmics takes a step further in suggesting that:

  • liquidity risk needs to be considered at a more granular level and should be split into its component parts - funding, market and contingency risk - and then calculated using the risk measures which are most appropriate for each component
  • a more extensive analysis of model risk is required to enable allocation of risk capital according to the complexity of the pricing models
  • leverage caps should not be set uniformly for all banks. They should be dependent on the size of the institution.

Dr Mario Onorato, Senior Director of Balance Sheet Risk Management Solutions at Algorithmics and Honorary Senior Lecturer, Cass Business School in London, said: "In our view, the majority of liquidity risk is funding liquidity risk and it should be measured in cash flow not value terms. Therefore, it should be addressed by supervisors accordingly.

"It is only by splitting liquidity risk into its components and then by calculating each using the appropriate risk measure, that firms will have a complete understanding of their liquidity risk, and regulators will be able to supervise it. Funding liquidity risk should be addressed in terms of the minimum liquidity sources defined by stress scenarios. Other components of liquidity risk that depend on market or credit risk factors can still be addressed with value-based capital measures. It is important for regulators to converge to a common approach so as to avoid regulatory arbitrage.

"In addition, model risk is an area that requires more analysis. Complexity of products and embedded optionality have made banks' risk assessment and representation increasingly dependent on assumptions. Where pricing models and parameter calibrations are not supported by empirical evidence or long-established acceptance in the market, the capital charge should reflect a conservative regulatory ethos.

"Ultimately, enterprise risk management models should not have economic capital as the only cornerstone of oversight. The task of ensuring sustainable growth and long-term value creation should be supported by more appropriate and comprehensive metrics that consider assets and liabilities in an integrated manner. In this environment, liquidity risk becomes an integral part in the setting and monitoring of explicit risk appetite and reward targets."

For a copy of Algorithmics' submission to the Basel Committee please email: liquidityrisk@algorithmics.com  

For Algorithmics' white papers on liquidity risk management see: www.algorithmics.com/EN/publications/whitepapers/

For further information please contact:
Heather Smith
Senior Communications Manager, Algorithmics (UK) Ltd
Direct line +44 (0) 20 7392 5820
Mobile +44 (0) 7515 974223
E-mail Heather.smith@algorithmics.com

Notes to Editors:

Algorithmics is the world's leading provider of risk solutions. Financial organizations from around the world use Algorithmics' software, analytics and advisory services to help them make risk-aware business decisions, maximize shareholder value, and meet regulatory requirements. Supported by a global team of risk experts based in all major financial centers, Algorithmics offers proven, award-winning solutions for market, credit and operational risk, as well as collateral and capital management. Algorithmics is a member of the Fitch Group. www.algorithmics.com

Liquidity risk management approach
Algorithmics' comprehensive approach to liquidity risk management, described as early as December 2007 in two white papers (see www.algorithmics.com/EN/publications/whitepapers/), stresses the need for stress testing in the management of liquidity risk and convergence of local supervisory regimes.

Algo Liquidity Risk is equipped with a state-of-the-art suite of functionalities especially designed in view of recent developments in best practice for liquidity risk management, including integration of market liquidity risk and monitoring of liquid assets, a flexible environment for stress testing, integration of behavioral models, and scenario-based dynamic simulation of future business. Liquidity risk analytics, both static and dynamic, are available, including ability to compare probability distributions of expected cash flows and liquid assets values to obtain an amount of liquid assets that is deemed sufficient to cover even unexpected cash outflows over a selected time horizon.

With its extensive instrument coverage and industry leading inventory of models and structured product building tools, Algo Liquidity Risk's can handle all assets, securities or derivatives, including the most complex products. Coupled with advanced simulation capabilities, any additions or refinements made to the modeling assumptions and scenarios are inherited throughout the solution, thereby ensuring ease of maintenance and consistency across measurement.

The flexibility of portfolio hierarchies and reporting views in Algo Liquidity Risk enables institutions to manage liquidity across legal entities, business lines and currencies. Moreover, the FTP functionality allows institutions to address the requirement for internal pricing of liquidity risk.

Fitch Group is the parent company of Fitch Ratings, a global ratings agency committed to providing the world's markets with independent, timely and prospective credit opinions. With 49 offices worldwide, Fitch Ratings' global expertise spans across capital markets in over 150 countries. Fitch Ratings is headquartered in New York and London.

The Fitch Group also includes Fitch Solutions, a distribution channel for Fitch Ratings products and a provider of data, analytics and related services; and Algorithmics, the world's leading provider of enterprise risk solutions.

The Fitch Group is a majority-owned subsidiary of Fimalac, S.A., headquartered in Paris, France. For additional information, please visit www.fitchratings.com www.algorithmics.com and www.fimalac.com

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