Liquidity risk, conduit, and securitization issues Essay Example

Liquidity risk, conduit, and securitization issues Essay Example Liquidity risk, conduit, and securitization issues Essay Liquidity risk, conduit, and securitization issues Essay Underestimating the importance of liquidity risk is one of the important facts behind today financial crisis. In the past years liquidity risk has not been taken into account in stress testing, funding strategies, and portfolio management (Wehinger 2008). In large and complex institutions, benefits as well as challenges arises with a potential for internal liquidity provision to seem adequate but with harder to assess funding risks at the aggregate level. According to Wehinger (2008), while designing funding strategies, risks under stressed market conditions with sever liquidity shortages should be included for secured funding. Bank should also consider about securitization of assets and the use of conduits as those can be subject to reputation risks. Central Bank should provide clear specification on the conditions under which it would work as a lender of last resort and Central Bank should consistently communicate those rules with the commercial banks. And most importantly, risk management of bank should take into account the fact that, there is a chance of liquidity to turn into insolvency if liquidity problems weigh on investors confidence and weaken the companys equity base. In the quarterly bulletin of Bank of England (2009), it has been mentioned that overall liquidity conditions have yet to normalise to any significant degree. In order to meet banks longer terms liquidity demands, UK government already extended the term of Bank of Englands Permanent Discount Window Facility. According to the report on Enhancing Market and Institutional Resilience by Financial Stability Forum (FSF) 2008, International standard setters should enhance accounting, disclosure and audit guidance for valuations. Firms valuation processes and related supervisory guidance should be enhanced. Apart from that, reasonableness and consistency tests should be applied for valuation and price verification. In June 2008, The Basel Committee on Banking Supervision published ten principles related to Supervisory guidance for assessing banks financial instrument fair value practices. Those principles are influenced by considering value measurement and modelling challenges faced by banks during the present financial crisis. The main objectives behind publishing those principles are to help banks supervisor while assessing banks valuation processes and to promote improvement in banks risk management and control processes. One of the main amplifiers of the crisis was the lack of transparency regarding the risk profile of institutions and structured products. Wellink, 2009. According to the Basel Committee on Banking Supervision (2009), economic capital model of a bank should be effectively documented and integrated in a transparent way and senior management should consider that model seriously while making business decision and for risk management of bank. For this purpose, bank should emphasize on achieving robust estimates of stand-alone risk on absolute basis and developing the flexible capacity for enterprise-wide stress testing. In order to have transparency in securitisation processes and markets, market participants and securities market regulator should work together to expand information on securitised products and their underlying assets (Financial Stability Forum, 2008). Reform of rating processes by Credit Rating Agencies can also enhance the transparency (US Presidents Working Group on Financial Markets, 2008). PWG (2008) suggests forming a private sector group to ensure the integrity and transparency of reports. Third Pillar of Basel II framework can help Bank to increase transparency (Wellink, 2009 PWG, 2008). Pillar three of Basel II mainly focused on disclosures related to securitisation, off-balance-sheet exposures and trading activities. This paper presents a review of the financial crisis on banking sector and implication of the bank management to cope with this crisis. Several reforms has been suggested in this paper following Institute of International Finance (IIF), Basel Committee on Banking Supervision, Financial Stability Forum (FSF), Bank for International Settlement (BIS), US Presidents Working Group on Financial Markets. Some of the recommendations are already being implemented. However, the recent initiatives at the G-20 level are being considered as a first step towards encompassing reforms to help cope with present financial crisis (Wehinger, 2008). Wellink (2009) also support the initiatives taken by Basel Committee and hope that those initiatives should limit the risk that weaknesses in banks amplify shocks between the financial and real sectors.